The issue

The answer

Using a valued business income form

Problems with valued form

The Issue

 The insuring agreement in the Business Income (And Extra Expense) Coverage Form, CP 00 30 10 12, states, "We will pay for the actual loss of Business Income you sustain due to the necessary 'suspension' of your 'operations' during the 'period of restoration.'" Business income is defined as net income (net profit or loss before income taxes) that would have been earned or incurred and continuing normal operating expenses incurred, including payroll.

 The insuring agreement seems straight forward enough. To calculate the actual loss of business income after a fire, figure what the insured business's net profit before income taxes would have been had no loss occurred. Add to it the normal operating expenses that continued during the restoration period after the loss. For example, $100,000 net profit that would have been earned before the fire loss plus $300,000 continuing normal operating expense after the fire equals a $400,000 business income loss figure.

 That calculation makes the business owner as well off as he was before the loss. The profits that would have been earned are safely in pocket, and the operating expenses that were actually paid out after the fire are reimbursed. Both the profit and the operating expenses would have been covered by earnings before the fire. After the fire, they are covered by insurance. It does not matter what the operating expenses might have been before the fire (other than to help calculate the before-loss profit) because the existence of a profit assumes that all operating expenses, whatever they were, were covered by earnings with funds left over.

 But what if the expenses before the fire would not have been covered by earnings, that is, no net profit? The insured would have been facing an operating loss at the time of the fire. The definition of "business income" in the policy notes that this loss be shown instead of a profit. Does that mean that this negative number, the loss, is added to the normal operating expenses that continued during the restoration period to calculate the business income loss? In other words, is the operating loss the insured would have suffered had no fire occurred subtracted from the actual operating expenses that were paid out after the fire? Is the insured meant to be left with a deficit after the business income insurance reimbursement for continuing expenses after the fire?

 The Answer

 The two parts of business income as defined should be considered together. If the business was operating at a loss before the fire, then the net income portion of the definition is a negative number, which, when added to the continuing normal operating expenses, diminishes the amount of coverage received by the insured. For example, a $100,000 net loss that would have been sustained before the fire loss plus $300,000 continuing normal operating expense after the fire equals a $200,000 business income loss figure.

 Courts have agreed with this answer. In Liberty Mut. Ins. Co. v. Sexton Foods Co., 854 S.W.2d 365 (Ark. App. 1993), the court said the following:

 In order to assess the amount of the loss, the amount of business income should be determined by adding the amount of net income and the amount of continuing normal expenses; if net income is a positive number (which will occur whenever there are net profits), the amount of business income will be the sum of two positive numbers, and the insured will be entitled to recover that amount; if, however, net income is a negative number (which will occur whenever there is a net loss), the amount of business income will be the amount of continuing normal operating expenses reduced by the amount of the net loss; if the amount of the net loss that would have been incurred had there been no business interruption exceeds the amount of the normal operating expenses actually incurred, the resulting number is a negative number, and there can be no recovery for an actual loss of business income.

 In deciding a similar case, a Tennessee Supreme Court judge in Continental Ins. v. DNE Corp., 834 S.W.2d 930 (Tenn. 1992) wrote that "ignoring 'net income' whenever there is a net loss would put the insured, in all cases when there is a net loss, in a better economic position from having its business interrupted than it would have occupied had there been no interruption of its business operations. Such an interpretation would obviously be inconsistent with the purpose of providing insurance, as well as with the decisions of other cases involving similar issues."

 Using a Valued Business Income Form

 The discussion about calculating a business income loss for a company that is operating at a net loss is particularly important for certain types of companies. Research firms, which may operate at a net loss while developing new products or conducting research, and high-tech companies, which may rely on grant money and stockholders equity during their developmental stages, are two examples of companies that may be operating at planned net losses at the time of a covered loss.

 Consider a high-tech company that raised operational money through a public offering. This company's business plan includes operating in the red for five years. It will take the company that much time to develop a product from research it has licensed, work out the bugs, take the product to market, and begin to earn income from it. During this time, the money raised through the public offering is funding operations. If business is suspended by a loss for six months in the middle of the five-year plan, it continues to draw on stockholders equity in order to stay alive. But it will not make any progress in its business plan during the interruption, causing it to fall short of plan and, possibly, fail.

 In addition, a high-tech company may be especially exposed to a high level of continuing expenses because it needs to keep its technical employees on the payroll during the down time. The standard business income coverage form would not adequately cover these continuing expenses because the loss calculation combines the net profit or loss with the continuing expenses. If the net loss is -$200,000 a month and continuing expenses are $250,000 a month, the insured would only be able to collect $50,000 a month, well short of the $250,000 necessary to cover continuing expenses. In severe cases, no business income recovery would be possible, making the coverage useless.

 No matter how carefully the standard business income coverage form is explained to an insured prior to a loss, many insurance buyers believe that the limit purchased will be the limit paid. It is very difficult after the loss to adequately explain why premium was paid for a coverage that is reduced or completely wiped out when the recovery calculation is done.

 A method to handle this situation is with a valued business income coverage form.

 The valued form was the first business interruption form available and was drafted by Henry R. Dalton, a Boston insurance agent of the late 1800s, according to Business Interruption Insurance: Its Theory and Practice, Robert M. Morrison JD, CPCU (National Underwriter Co., 1986). It is not currently available as a standard ISO form but is available from a number of insurers, mostly in the London or surplus lines markets.

 Valued forms pay a set amount for each period of business suspension as specified in the policy declarations. The time period could be twenty-four hours, one week, or one month. At one time this form was referred to as the per diem or per day form because the early forms set the unit of recovery at twenty-four hours.

 Because the limit is established prior to the loss, there is no need to perform a lengthy calculation to establish the amount of loss after it occurs. This means that the issue of a net loss or net profit is addressed prior to the insurance being purchased. There also is no coinsurance clause.

 Problems with Valued Form

 There are several reasons that professionals are cautious of using the valued form of coverage. One reason is that some underwriters believed it created a moral hazard. Companies might profit from the coverage, actually ending up better off during the time of interruption than they would have been if it was business as usual.

 This is a valid concern. Careful underwriting of a company's business plan is necessary to counter this possibility. The form should be used as a tool to craft coverage that is suited to companies in their developmental stages, and careful review of the company's business plan is necessary. It should not be used just because a company is operating at a net loss.

 Another potential problem with the valued form is that insureds assume the burden of setting the limit of coverage. Even though this method does not rely on the insured's internal financial data when adjusting the loss, it does require careful preparation of a business income worksheet by the insured when the coverage is underwritten. Special attention must be given to the amount of anticipated continuing expenses, as well as any extra expense that might be incurred. The insured must realize that the limit established for each unit of recovery (day, week, or month) is the maximum amount recoverable during each recovery unit.

 In addition to the per unit limit, the form also lists a maximum amount recoverable. As an example, a form may provide for a loss payment of up to $5,000 per day with a maximum payable of $900,000. This means that the insured could recover up to $5,000 per day for a total of 180 days. However, if less than $5,000 a day is paid during a partial suspension, the $900,000 cap still applies.

 Companies with seasonal swings, or companies that are directly affected by outside economic factors, also need to take special care in developing the limit of insurance. Since there are maximum limits payable per unit and per loss, it is important that the limit accurately reflect seasonal and economic upswings.

 Underwriters may require additional financial data from the customer before offering the coverage. The agent handling the account should be able to discuss the client's financial plan in depth with the underwriter in order to provide the information that will be needed.

 Another reason to possibly avoid using the valued form is, in the event of a partial suspension of business, the form pays a percentage of the per unit limit. It is important that companies understand that the amount paid each day will be decreased proportionately when a partial shutdown occurs. This percentage is equal to the value of lost production or income divided by its normal value prior to the loss. The formula for a partial suspension is as follows:

 Lost Production x Working Day Limit = Partial Loss Payment

Normal Production

 As an example, a company may lose $50,000 in production during a month that normally would generate production valued at $200,000. If the recovery limit in this situation is $5,000 per day, the partial suspension would be adjusted as follows:

 $50,000 = 1 x $5,000 = $1,250 recovery per day

200,000 4

 The partial loss formula would be triggered when only a portion of the business is suspended because of a loss. It also comes into play as a company begins to resume operations after a total suspension.

 Any business, broker, or insurance adjuster who has been involved with a business income claim understands the problems that arise in the settlement process. A business income loss is much more difficult to handle than a direct property loss, at least partially because economic circumstances can change between the time the coverage is purchased and the loss occurs. The valued form removes some of the uncertainty that can affect the recovery. The premium charged for a valued form could be higher than for a standard business income form. However, in certain situations the benefit would greatly outweigh the possibly higher premium. It is a useful tool in designing coverage that is suited to a particular type of insured.