Topics covered:

The ground rules

Total revenues

Income and expenses

Coverage modifications

Accounting versus insurance terms

Coinsurance requirement versus actual loss sustained

The Ground Rules

 The worksheet lays the ground rules for developing a dollar figure that will be used as a base for calculating the coinsurance requirement for the business income insurance. The name asked for in the first line is the named insured, who must have an insurable interest in the loss of income. The location requested in the second line must show all locations that are to be insured and whether they are to be covered on a blanket basis.

 The form requires that the worksheet be completed on an accrual basis. Income and expenses must be shown for the time period in which they are incurred as opposed to the time period in which the cash is actually transferred. For example, if a product were sold during the last week of the policy period, the income from that sale would be shown on the business income worksheet as being received during the expiring policy year and not during the new policy year when the cash would probably be received. Most company's accounting systems are kept on an accrual basis.

 The form also requires that the worksheet be completed in accordance with generally accepted accounting principles (GAAP). The principles embody broad guidelines and specific rules and procedures for reporting the financial activities of businesses. The primary purpose of GAAP is to make certain that those writing financial reports and those reading them do so with common understandings.

 Since beginning and ending inventories figure predominantly in the completion of the business income worksheet, it is important that there be a clear understanding of the types of inventory valuation commonly used.

 ·    The specific identification method is used when the inventory is made up of large, readily identifiable items such as automobiles. They are often identified in the inventory by serial number.

·    The average-cost method is usually calculated on a weighted average cost basis. The total cost of the beginning inventory is added to the total cost of each individual purchase of supplies purchased during the year. This total is divided by the total of the number of units in the beginning inventory and the units purchased during the year. The quotient is multiplied times the number of units in the ending inventory. When prices are rising, the inventory will be undervalued and when prices are falling, it will be overvalued.

·    The first—in, first—out method (FIFO) makes the assumption the first items purchased or manufactured are the first ones used or sold. During times of rising prices, the lower priced items are sold or used as supplies for manufacturing, making income appear larger.

·   The last—in, first—out method (LIFO) makes the opposite assumption that the last items purchased or manufactured are the first ones used or sold. During inflationary periods LIFO will make income appear smaller.

·     Other types of inventory valuation methods include the base stock method that assumes that there is an unchanging base of inventory below which it never drops and that only purchases over and above that base are used for current consumption. It tends to undervalue inventory. The moving average method calculates a new average for the cost of inventory every time a purchase is made during the accounting period. This method works well when there is a large quantity of identical units, such as commodities. The simple average method divides the total unit price of all purchases by the total number of units purchased. It is not an accurate method because no weight is given to large purchases.

 From time to time companies change their method of valuing inventories. Should this happen during a business income insurance policy period, the insurance company should be notified and a decision made as to whether the inventory valuation method used in the business income worksheet should be changed. If such an agreement is not reached, a coinsurance penalty or a state of over-insurance could result.

 The agreed value coverage option replaces the coinsurance clause with a value agreed upon by the insured and the insurer. See Business Income Optional Coverages. One point worth reemphasizing is that a deliberate understatement of values in the business income worksheet could be taken as a material misrepresentation and void the entire policy. This is so because the business income worksheet becomes a part of the policy when the agreed value coverage option is chosen.

 The Premium Adjustment Form, CP 15 20 06 95, converts the business income coverage into a type of reporting form that allows the insured to carry a limit somewhat higher than the anticipated net income and expenses and receive a return premium on any limits not used when the policy year is over. This has the effect of giving the insured leeway on meeting the coinsurance requirement. It does not replace the coinsurance clause as does the agreed value coverage option. The business income worksheet calculations required for this endorsement are those for the year immediately preceding the inception date of the policy. The premium adjustment endorsement contains an honesty clause similar to that found in most reporting forms, so the business income worksheet does not take on the characteristics of a warranty as it does with the agreed value coverage option.

 Total Revenues

 Next, the business income worksheet begins the actual calculation of net income and expenses—the dollar figure on which the coinsurance requirement of the policy is based. There are four columns, two for manufacturing risks and two for nonmanufacturing risks. The first two columns use numbers from the year immediately preceding the policy year that is being applied for. The second two columns require estimated figures for the actual policy year for which the insurance is to be effective. The amount of insurance required by the coinsurance clause is calculated on the estimated figures in columns three and four.

 This form recognizes that a business may have both a manufacturing and a nonmanufacturing or mercantile exposure. These exposures may be combined in the next part to develop one net income and expense base for calculating the coinsurance requirement.

 ·    A. Gross sales should include total sales revenue for the twelve months immediately preceding the inception date of the policy. Income taxes are not to be deducted, but sales taxes can be if they were shown separately from the sales price of the product.

·     B. Deduct finished stock inventory (at sales value) at beginning of the year preceding the policy. This refers to finished stock already in existence at the beginning of the year, valued at the sales price that existed at that time. The policy is intended to insure the sales value of production that occurred during the year in question, while this stock was produced before the year in question. A mercantile risk does not require this deduction, because it does not manufacture the goods it sells.

·    C. Add finished stock inventory (at sales value) at end of the year preceding the policy. Since finished stock inventory on hand at the beginning to the year has been taken out of the equation, this unsold inventory must have been manufactured during the year and, thus, is part of the insured value of production that occurred during the year. The inventory must be valued at the selling prices prevailing at the end of the year. This figure is carried over to column three as finished stock inventory at beginning of the year.

·    D. Gross sales value of production is the value of the actual revenue stream that was produced during the year, before certain sales and production costs are deducted.

·    E. Deduct prepaid freight, returns and allowances, discounts, bad debts, and collection expenses from the gross sales value of production. These are items that, to this point, are included in the gross sales value of production but do not contribute to ultimate revenues. Some of them would not even have been incurred as of the time of completing the worksheet due to a short time since the sale had taken place; or as in the case of inventory on hand at the end of the year, the goods would not have been sold yet. Every effort must be made to estimate these numbers accurately and not on a conservative basis. These items are also deducted from the gross sales of nonmanufacturing or mercantile companies.

·    F. Net sales is the result of subtracting the expenses in step E from gross sales (step A) for nonmanufacturing or mercantile companies.

·    F. Net sales value of production is the result of subtracting the expenses in step E from gross sales value of production for manufacturing companies.

·    G. Add other earnings from your business operations (not investment income or rents from other properties) including commissions or rents, cash discounts, and other earnings. These are other earnings that derive directly from the operations being insured and that would be interrupted by an insured peril. Not included here would be speculative income that would not be expected to repeat in subsequent years. An example would be a cereal manufacturer that, due to an unusual fluctuation of wheat prices, was able to buy wheat at extraordinarily low prices during the preceding year.

·    H. Total revenues is the sum of F, net sales and G, other earnings. This figure represents all income from the insured operation from which is deducted some of the costs (but not all of them) of producing (or of buying merchandise in the case of mercantile operations) the goods that are sold.

 The only steps used for the calculation total revenues for nonmanufacturing or mercantile operations are A, E, F, and G. The sales value of finished stock inventory at the beginning of the year and the end of the year are irrelevant for nonmanufacturing operations. The same calculations are performed for columns 3 and 4, but this time they are estimated for the upcoming policy year.

 Income and Expenses

 The worksheet develops expenses and deductions that may be subtracted from total revenues to produce the final figure—net income and expenses on which the coinsurance requirement of the policy is based.

 To develop total expenses and revenues for nonmanufacturing operations, the following steps must be taken in the second and fourth columns; use the supplementary information portion of the worksheet for calculating the cost of goods sold with the following information:

 ·   Opposite the cost of merchandise sold, add the cost of nonmanufacturing stock purchased during the year, including transportation costs.

·    Opposite the cost of other supplies consumed, add the cost of packaging and wrapping supplies consumed, including the cost of supplies for transportations.

·  Opposite deduct inventory at end of year, subtract the cost of nonmanufacturing inventory on hand at the end of the year.

·    Opposite cost of goods sold, enter the total of the four items just listed, which will be the cost of goods sold for nonmanufacturing operations.

 Enter that figure for Item I, opposite cost of goods sold.

 ·    Opposite cost of services purchased from outsiders to resell that do not continue under contract, add those services that pertain to nonmanufacturing operations. An example might be the cost paid to a contractor to install an appliance purchased by a consumer.

·   Opposite total, enter the sum of costs of goods sold and services purchased from outsiders, which is subtracted from total revenues to yield net income and expenses from nonmanufacturing and mercantile operations. This is the figure on which the coinsurance requirement for nonmanufacturing or mercantile risks is calculated. If the risk also manufactures, the figure is combined with net income and expense from manufacturing operations to produce combined net income and expenses in line J 2.

 The computations for manufacturing operations proceed as follows.

 ·    I. Deduct the cost of the following (net of any discount received). These are the only variable costs that are allowed to be deducted from total revenues to arrive at net income and expense from which the coinsurance requirement is calculated. There are other variable costs involved in production that are not allowed, thus making the amount of insurance required under the coinsurance clause higher than the amount that could be collected after a loss. Some of these disallowed variable costs will be listed later. Again, use the supplementary information to calculate the cost of goods sold.

·    Cost of goods sold: inventory (including stock in process) at the beginning of the year. This inventory is that of raw stock, factory supplies, and other supplies that are on hand at the beginning of the year. They will be going into the manufactured goods that will be sold during the year and, therefore, are part of the costs of those goods.

·     Add to that inventory the cost of raw stock, factory supplies, merchandise sold, and other supplies (including transportation costs) bought and consumed during the year. These also become a part of the manufactured goods that are included in the net sales value of production. The cost of merchandise sold refers to goods sold by the manufacturer but not manufactured by it. An example might be a computer hardware manufacturer who includes software, purchased from others, in the sales cost of the hardware. Should the risk contain nonmanufacturing or mercantile operations, the cost of merchandise sold can be placed in the second and fourth columns to be combined with manufacturing net income expenses in step J 2.

·    Cost of goods available for sale is the sum of the inventory on hand at the beginning of the year and that bought and consumed during the year. However, not all the goods available for sale are sold during the policy year, which is the reason for the next step.

·     Deduct inventory (including stock in process) at the end of the year. The purpose of the worksheet is to calculate net income and expenses derived from goods sold during the policy year. Any inventory of raw stock, factory supplies, and other supplies that are still on hand at the end of the year did not become part of the cost of the goods sold during the year and must be subtracted from the cost of goods available for sale that year. This figure should be carried forward to the third column as inventory (including stock in process) at the beginning of the next year.

·    Cost of goods sold is the sum of all the material costs that the worksheet allows to be subtracted from the total revenues calculated. It is important to understand that the cost of goods sold as developed in the business income worksheet is not the equivalent of the term "cost of goods sold" as used in the financial reports of the insured. The latter contains other costs that are not allowed in the business income worksheet.

 Return to Item I and enter the cost of goods sold. The following is deducted from total revenues:

 ·  Cost of goods sold, as previously discussed.

·    Cost of services purchased from outsiders (not your employees) to resell that do not continue under contract. Often a part of the manufacturing process is contracted out to jobbers because it is more cost efficient than doing the process in plant—assembly of parts, for example. Similarly, mercantile operations might contract the installation of a product they sell. Usually the contract does not require that payments continue in the event of a business interruption. If that is the case, the cost of the contracts is added to the cost of goods sold as part of the sum that is subtracted from total revenues to develop net income and expenses. Should the contract provide that payments to the jobber continue in spite of a business interruption, then the cost of that contract would be left in total revenues to be insured.

·  Power, heat, and refrigeration expenses that do not continue under contract.

·  All payroll expenses or the amount of payroll expenses excluded.

·   Total equals the business income exposure for twelve months.

·     J.1. Net income and expenses (business income basis for coinsurance if a coverage modification does not apply) is the final result of the of the worksheet to which the coinsurance percentage indicated on the declarations page is applied. Coverage modifications that might apply are the agreed value coverage option, which would replace the coinsurance clause; the payroll limitation form; and the power, heat and refrigeration deduction form.

·     J.2. Combined (for firms engaged in both manufacturing and nonmanufacturing operations) is the step in which the net income and expenses for both the manufacturing and nonmanufacturing operations in one company are joined to provide one figure to use as a basis for calculating the coinsurance requirement.

 Coverage Modifications

 The business income worksheet calculates additional expenses.

 ·     K. Additional Expenses. Estimated for a twelve-month period with a beginning date supplied by the insured.

·     K.1. Extra expenses. List expenses incurred to avoid or minimize suspension of business and continue operations. For use with CP 00 30 only.

·   K.2 Extended business income and extended period of indemnity. Provide loss of business income following resumption of operations for up to sixty days or the number of days selected under the extended period of indemnity option. For use with either CP 00 30 or CP 00 32.

·     K.3 Combined. Total of all amounts from K.1 and K.2

·     L is the total of J and K, which equals estimated business income exposure for twelve months plus extra expenses. This figure is used to determine the approximate amount of insurance needed based on the number of months necessary to replace the property—which may exceed twelve months—the amount of time necessary to resume operations and to restore operations, restoring the business to its preloss condition.

 Accounting versus Insurance

 There are a number of terms used in the business income worksheet that are either not used in the accounting profession or, if they are used, carry a different meaning. It is important for the insurance practitioner to recognize that these differences exist and to alert the insured to them. Simply transferring numbers directly from the insured's financial statements to the business income worksheet could result in the insured carrying too much or too little insurance.

 ·    Sales value of production, found in lines D and F of the business income worksheet, is a term not likely to be used by the insured in his accounting. Normal accounting procedures would have inventory valued at cost, but in lines B and C, inventory is valued at sales value. This is because, on the business income worksheet, the assumption is that profit is earned upon completion of production. This assumption is not used, however, with respect to finished goods when adjusting a business income loss. In order to insure the sales value of finished goods, a selling price endorsement must be added to the property insurance that covers the inventory. Yet, the profit that would have been earned by goods that were unfinished when the loss occurred is insured by the business income coverage form.

·    Inventory. Even after choosing one inventory valuation method over another, an insured can be motivated by tax or other considerations to be conservative or liberal in establishing the value of inventory. What might make sense from the tax perspective could be exactly the wrong decision for completing the business income worksheet. Inventories should be valued as closely as possible to their real value in the stream of production that would be interrupted in the event of a loss.

·    Cost of goods sold are variable costs that would stop should production be interrupted. They are subtracted from total revenue on the business income worksheet to produce net income and expenses, the base on which the coinsurance requirement is calculated. The larger the value of cost of goods sold, the less insurance that needs to be carried. The business income worksheet limits the cost of goods sold to the difference between beginning and ending inventory plus the cost of the following items purchased during the policy year: raw stock consumed, factory supplies consumed, cost of merchandise sold, and other supplies consumed.

 There are other variable costs that might or might not continue in the event of a loss. Whether they continue would depend on if the loss were total or partial and the duration of the business interruption. For instance, a lease might specify that rent will abate if the building is unusable for more than sixty days. For sixty days, rent would be a covered continuing expense. If business remained interrupted beyond that time, rent would become a noncontinuing expense.

 If the expenses are noncontinuing, no business income insurance recovery would apply to them even though they were not used in calculating the cost of goods sold on the business income worksheet. Examples of possible noncontinuing expenses that would be included in accounting cost of goods sold but not the business income worksheet cost of goods sold include ordinary payroll; power, heat, and refrigeration expense; advertising expense; postage and telephone expense; travel expense; maintenance expense; and depreciation expense. The first two items in the list, ordinary payroll expense and power, heat, and lighting expense can be subtracted from net income and expenses by endorsement.

 Coinsurance Requirement versus Actual Loss Sustained

 The possible noncontinuing expenses would not be insured if they, in fact, did not continue after a loss even though they are not allowed to be subtracted from total revenues in the coinsurance calculation. This is because the insuring agreement promises to "pay for the actual loss of Business Income you sustain" in a business interruption. The apparent inequity of being forced by the coinsurance clause to buy more insurance than can be collected in a loss is justified on a number of accounts.

 One justification is that predicting a business income loss is an inexact science. By not subtracting every conceivable noncontinuing expense from total revenues, the insured is provided a cushion of insurance should unexpected expenses continue.

 Also worthy of consideration is that the insured never knows whether the interruption of production will be partial or total, nor how long the interruption will last. Which variable costs will not continue will depend on the extent and duration of the loss.

 Finally, the rates developed for business income insurance take into consideration that the coinsurance base has not excluded all of the expenses that might be discontinued after a loss.