Liability insurance: Covering business interruptions when they happen

By Marcie D. Bour, CPA, ABV, CVA, CFE, BVAL, CFFA

Disasters have plagued mankind for as long as we have records, and for just as long, smart people have sought ways to protect themselves against the liability of the unexpected. Insurance, it might surprise you to know, has been around in one form or another for thousands of years. Four and five thousand years ago both Chinese and Babylonian traders were transferring risk. The first US insurance company provided fire insurance in 1732, almost 300 years ago. And Benjamin Franklin founded the Philadelphia Contributionship for the Insurance of homes from loss by fire in 1752.
 
Most business owners today have insurance policies, and some include a section on "business interruption." Business owners should very the type and amount of coverage to make sure that they have the appropriate level of coverage based on the extent of a possible loss and the coverage available. 
 
If you're not sure what business interruption is, how to identify a claim, and what the key elements of a claim are, here's a quick rundown.
 
Feeling Lucky?
 
I'm from Florida, and many of you may have heard about the recurring hurricanes that often make their way to our coasts. A Mason-Dixon Poll released May 28, 2009 shows “most residents in coastal states still do not feel vulnerable to the catastrophic destruction and deadly force that can be brought on by a storm and most have not adequately prepared for coming storms.” The poll found:  83% of coastal residents haven't fortified their homes, 62% do not feel vulnerable to a hurricane or to hurricane-related flooding (remember, these are people who live on the coast!), and 66% do not have a hurricane survival kit with items such as batteries and flashlights. The frightening part of this survey is that the sentiment and the numbers have not changed much since the 2006 Mason-Dixon Poll. 
 
Insurers, it turns out are taking threats these days more seriously if residents aren't. It turns out in many cases insurance companies have reduced the amounts and types of coverage available in some areas, and even refusing to offer it in some especially disaster prone areas. Moreover, they are limiting losses in policies by more clearly defining exactly what a covered loss is.  Although with the current soft insurance market, some types of coverage may become available again.
 
Standards from the ISO & "Declarations" Basics.
 
So what is business interruption? In the context of insurance, it is an interruption to business income caused by damages to property. The loss resulting is can be covered by insurance. The Business Owner's Policy (BOP) is an "off the shelf," cookie cutter policy written by the Insurance Services Office (ISO) with standard language. Most small business purchase BOPs. A manuscript or custom policy is usually developed for mid-sized and large companies where the amount of the premium affords both parties time. Some specialized industries require manuscript policies. A Hybrid policy has some standard and custom language.
 
The first and arguably most important section of an insurance policy is the "Declarations" page, which defines, very specifically: Who is insured? What property is covered? In what amount is the coverage? What are the deductibles and co-pays? Are there any special exclusions or endorsements to the policy? This helps an owner figure out if he or she has the basis for a claim and provides a road map to the policy coverages. 
 
The "off the shelf" ISO policy (2001) states: "We will pay for the actual loss of ‘Business Income’ you sustain due to the necessary suspension of ‘operations’ during the ‘period of restoration’… The suspension must be caused by direct physical loss or damage to property at the ‘described premises’…." In order to understand the coverage that a policy offers, you have to understand the terms used in defining the coverages.
 
  • Business Income: Business income is specifically defined in the policy as net income that would have been earned AND continuing normal operating expenses that would have been incurred. Payroll may be treated separately depending upon the policy coverage.
  • Physical Loss or Damage. As a general rule, there can be no recovery under of business income under a business interruption (or use and occupancy) insurance policy without actual damage to or loss of physical property. Moreover, that damage must caused by a peril which is covered under the policy.
  • Described Premises: The particular location of the property or a portion of it as designated in an insurance policy.
  • Period of Restoration: This period begins with the date of the physical loss or damage and continues to the date when the property should be repaired, rebuilt or replaced. However, if the business is resumed before the property has been repaired, rebuilt or replaced, the period ends when the business is resumed.
  • Period of Indemnity.  This is the time which the insurance policy covers the insured loss (normally the lesser of the time it should take to repair or replace property, or the time limit stated in the policy). Some policies have waiting periods before coverage begins.
  • Period of Interruption. The amount of time the business is affected, which may exceed the period of indemnity.
·                      
The loss is covered during the period of restoration, to the extent that the period falls within period of indemnity. In other words, a loss may begin on June 1, but due to the waiting period in the policy, the period of indemnity many not begin until June 4, 72 hours later. It takes 12 months to repair the damages. The policy only provides six months of coverage, so the period of indemnity ends after six months, even though the period of restoration is 12 months. 
 
Policy Coverage
 
For a business loss to be covered there must be physical damaged caused by a covered peril. A fire or explosion is a covered peril that is simple to identify. However, there are certain types of perils which are specifically excluded including: losses caused by the enforcement of any law, earth movement, government action, nuclear hazard, utility service failure, war or military action, and water. There are other types of perils which may be specifically included, sometimes subject to limitations, in policies. 
 
  • Interruption by Civil Authority.  Losses caused by orders of city or governmental authority which prohibits access to your premises due to direct physical loss to the property are covered under some policies. There may be a time limitation of the period of indemnity of one, two or three weeks.
  • Off-Premises Power or Water Failure. Losses caused by an interruption of power or water supply to the premises due to a covered peril to off-premises water mains, pipes, generating plants, switching stations, transformers or transmission lines are also covered under some policies. The period of indemnity may have a waiting period, deductible and limit. 
·                      
In addition to covered perils, there are other types of coverage which may apply to some policy holders.
 
  • Extra Expenses. Extra expenses are those cost that a business operator incurs as a result of a covered period to avoid or minimize his or her business income loss. These extra expenses are covered to the extent that they reduce the amount of the loss of the insured. 
  • Extended Period: Some policies provide for an extended coverage period to allow a business to return to normal operations. This period is usually limited, and is in addition to the period of restoration. 
An insurance policy is a contract which transfers certain risks to the insurance company in exchange for the premium that you pay. As such, the contract will dictate exactly what is covered. Read the policy! There are other policy provisions which can impact a policy holder including deductibles and coinsurance. Since some policy holders are gamblers, they only insurance the most that they are willing to lose. If the a business earns net profits of $100,000 per year, a business owner may guess that the most he will be shut down is 6 months and obtain $50,000 of business coverage. Coinsurance provides that unless you have met the policy coinsurance requirements, the insurance company does not have to pay your full claim, only a portion of it. A common level of coinsurance is 80%.
 
Be Reasonable
 
So there is business interruption and a claim it going to be filed. The business owner has some obligations in the process. All policies include provisions that require a policy holder to act in a reasonable manner. 
 
The "Duty to Mitigate" provision requires that the insured must act in a manner which a reasonable person would if they had no insurance, and must take all reasonable steps to prevent additional loss. The "Due Diligence and Dispatch" provisions require a policyholder to do what is necessary to get the business open, and act reasonably and expeditiously. What is reasonable and expeditious is often not clear cut.  A policyholder must keep "Necessary Records" to support a claim for any continuing expense (you'll need to show it was there in the past), and "Duties in Event of Loss" requires prompt notice to the Insurer of the loss, as well as providing a description of the loss.   
 
How to figure the loss? Courts have established (Cotton Brothers Baking Co. v. Industrial Risk Insurers) that "a projection of earnings is an accepted method of calculating business interruption losses." The policy will provide a definition of business loss that should be used in calculating the amount of the loss.
 
There are some factors beyond the scope of this article which can complicate the calculation. The policy holder has the obligation to provide records to prove his or her loss. Good records are helpful in proving a claim. If records need to be reconstructed, the timing of income and expenses may become important. For example, a professional may provide services which are billed at the end of the month, and then due within 30 days. The revenue from the services is not received in the month that the services are rendered. The accrual basis of accounting matches income and expense. However, when reconstructing records it may be difficult to accomplish this. It is also important to consider external factors which impact the business in calculating the loss. These include competition, the company’s market share, capacity, and industry trends. Sometime subsequent events may impact future business income including government regulation. In any case, the business loss claim should be reasonable and supported by company records and sound calculations.
 
This is a lot to consider! As you delve into this subject, and actually get to filing a claim for a client owner you advise, you may need some help.   One resource I've found especially helpful, and fully recommend, is The Business Interruption Book:, Coverage, Claims, and Recovery, by Daniel T. Torpey, et al, The National Underwriters Company.   And groups such as The National Association of Certified Valuation Analysts (NACVA) regularly offer webinars, in-person training events, and other resources.   
 
Marcie D. Bour, CPA/ABV, CVA, CFE, BVAL, CFFA is a President of the Florida Business Valuation Group 
 

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