Adjusting business income claims and calculation of the amount payable is typically considered difficult to understand and complex. When claims professionals look for how-to information they discover it is hard to find. Yes - several books have been written on coverage, theories and principles but most fail to provide the step-by-step information on the process. That information is virtually impossible to find. As a result many insurers routinely refer business income claims to CPAs and forensic accountants with the effect that insurers incur substantial adjustment expense. With a little training most small business claims can by processed in-house claims personnel. The purpose of this article is to provide an introduction of the basics to the seemingly dark, secret side of the business interruption/income claims process. Coverage, required records and the step-by-step process to measure the business income loss will be discussed.
The ISO BP 00 03 and the Insurance Services Office, Inc. (ISO) CP 00 30 and CP 00 32 Business Income (with and without Extra Expense) Coverage Forms define business income as: “Business Income means: a. Net Income (Net Profit or Loss before Income taxes), that would have earned or incurred if no physical loss or damage had occurred...and b. Continuing normal operating Expenses, including payroll.” This is frequently called the “Bottom-Up plus Continuing Expenses Method.” The word “baseline” is used by accountants and knowledgeable adjusters to describe this policy provision. But you won’t find the word “baseline” defined in the ISO BP or CP Business Income policy forms.
The “Baseline” is used to evaluate or measure the amount payable for business income under various claims scenarios. The “baseline” is also used not only to calculate the business income loss payable but also the amounts payable under other coverages, depending on what an insured does or does not do following a covered loss. The baseline and claims scenarios are discussed below under the baseline and “to the extent” calculations.
Net Income plus continuing expenses is called the Bottom-Up Method but the most commonly used method is the Top-Down Method, aka: Gross Earnings Less Discontinued Expenses. The two methods refer to the position of the gross revenue at the top of a typical Income Statement (aka: P & L Statement) or a tax return, and the Bottom-Up refers to the net profit located at the bottom of an Income Statement or tax return.
Initially, the adjuster needs to confirm the following elements: 1) That the cause of loss is covered; 2) that business operations were interrupted or “suspended” and; 3) that the suspension resulted in the loss of business income. If there are coverage questions, the field adjuster should use a non-waiver agreement or reservation of rights letter and proceed to handle the business income loss and investigate further to resolve the coverage issue.
Sales, Billing and Tax Records
The handling adjuster or examiner should request that the insured, his or her bookkeeper, or accountant provide cash flow information confirming daily sales or billing. This is done by taking a retrospective look at the business’s sales or billing performance preceding the date of loss. The following records may be needed, depending on the severity of the loss:
- Daily Sales or Billing Records
- Income Statements
- Expense Ledger or Ledgers
- Federal Tax Returns
- Sales Tax Records
- Real Property and BPP Lease/ Loan Documents
- Business Personal Property Leases
- Floor Plan Financing Records
- Bank Records
If the loss has a limited period of restoration (or suspension), such as a small water loss, only a few weeks of sales or billing records may be needed. If the covered cause of loss is more serious, additional records will be needed. For example, lease/rental/mortgage documents are usually not necessary to handle minor losses. If the damage or loss is catastrophic more documents will be required. For instance, two (2) or more years of business and tax records are essential to handle catastrophic or large losses. If the loss involves seasonality, prior year’s books, records, and income statements corresponding to projected period of suspension are crucial to quantifying the business income loss.
Gross Revenue less Discontinued (or Abated) Expenses:
The handling adjuster/examiner needs to determine which expenses have discontinued (abated) and which expenses are unavoidable and continue during the period of restoration or suspension. For a number of reasons expenses may discontinue following a covered loss. The primary reason expenses discontinue is that they are not incurred. If an expense is not incurred the expense cannot be reimbursed to the insured business.
If employees are laid off and not paid, payroll is not incurred and discontinues. As to CP policies, ordinary payroll (hourly worker payroll) may be excluded unless a CP 15 10 06 07 endorsement is selected by the insured. The Businessowners policy includes 60 days of ordinary payroll coverage but only if it is “incurred”. If the period of restoration exceeds 60 days, ordinary payroll will be considered a discontinued expense after 60 days. If the business premises is leased and sustains heavy damage the lease’s “abatement clause” may apply so that lease payments discontinue during the period of restoration.
For secured business personal property that is leased or may be collateral for loans, such as dealer flooring financing a loss payable endorsement is usually attached to the policy. Secured business real and personal property is recorded with the Secretary of State and/or the County Recorder’s Office. Retailers also obtain money loans and use their inventory as collateral. Business Personal Property (BPP) coverage insures several categories of movable property which can include unscheduled and scheduled BPP. Business property that is leased, such as vehicles or equipment used in the business, may be insured by other insurers but lease payments are typically paid by the business. The same situation applies to loan payments where business property is used as collateral. In the event of a total loss the other insurer pays the loss and the lease or loan payments will discontinue or abate. Real and business personal property is usually destroyed as the result of serious or catastrophic losses. Although lease and loan payments may abate, there will be an increase in loss payments under structure and business personal property (BPP) coverages.
When operations are suspended in a retail/mercantile business the Cost of Goods Sold (COGS) abates because the goods are not sold and not expensed off the business’ balance sheet. In other words, COGS expense was not incurred and discontinues. Many other types of variable expenses can abate depending on the severity of loss and may include utilities, business personal property and real property taxes, advertising, shipping costs, depreciation on destroyed business property, payroll, etc.
Top-Down Method (Gross Income Less Discontinued Expenses):
Gross Loss of Revenue
Less Discontinued Expenses
Plus Incurred Extra Expense (EE)
Equals the Loss Payable
In practice, the Top-Down Method is used in most cases to quantify the loss of Business Income for the period of indemnity.
Doing the Math – The Methods
Whether you use the Top-Down or Bottom-Up Method, the period of restoration or suspension must be projected.
The next step is to establish the loss of sales and billing revenue, and then quantify the discontinued and continuing expenses for the relevant period to establish the period of indemnity.
Various methods are used to quantify revenue and expenses to arrive at the business income loss in dollars and cents. All of the methods use a “retrospective” approach as they require looking back at the business’s historical records preceding the date of loss. As to the loss of revenue, the business’s historical daily sales and billing can be examined and the averaging method can be used to quantify daily, weekly and monthly loss of revenue.
As to expenses other methods can be used to quantify expenses that discontinue or continue. Expense ratios can be used to quantify the variable expenses as a percentage of sales. Variable expense ratios can be derived from income statements, aka: Profit and Loss Statements and tax returns and forms. Prior sales tax records can also be helpful. Annual income statements usually show percentages for each expense during the period covered by the income statement.
As to retail or mercantile businesses, the cost of goods sold (COGS) discontinue when business operations are interrupted during the period of restoration/suspension.
Most federal tax returns include an IRS Form 1125-A – Cost of Goods Sold Form. Corporate IRS forms will include the cost of goods sold as a line item. The Cost of Goods Sold as a percentage of the gross revenue can be quantified with an expense ratio using information in these tax documents.
Proration can be used to quantify fixed expenses, such as rental or lease payments, for any month or part of a month during the period of suspension or restoration.
The loss of net profit for each day of operation can also be ascertained using income statements for any period to establish a daily gross revenue and net income. This is done by dividing the gross revenue or net profit by the number days of operations in the period covered by the statement. The results represent the average daily sales or daily net profit for the projected period of indemnity.
Because of the complexity of payroll coverage the actual dollars and cents total of “incurred” or “discontinued’ payroll should be used to evaluate the loss payable.
Extra Expense (EE)
Extra Expense coverage is used to “avoid or minimize” the “suspension” of “operations” or to resume partial “operations” at the insured location or elsewhere for the period of restoration. The third extra expense provision provides coverage to “repair or replace property and to replace or restore lost information or damaged records.” The “to the extent” provision applies to the third category of EE which is used to measure the amount of coverage which is based on the amount of reduction of the Business Income loss. (See Chapter Five § 5.6 page 162 & § 5.7 page 163-164 in “Small Business Net Income Loss Fundamentals”)
Loss Determination and “to the extent” Provisions
Handling a business income loss is measured by the “baseline” and the process detailed in the BP or CP policy provisions. As to the BP 00 03, the Business Income cover is described on page 6 and 7 under f.(1) Business Income and page 30 at paragraph 7. Resumption of Operations.
The “Loss Determination” and “Resumption of Operations” provisions of the CP 00 30 (with EE), on page 6, and CP 00 32 (without EE), on page 5 and 6, of the Business Income Forms will inform the adjuster as to the process of quantifying the loss. The BP and CP provisions provide guidance in establishing the insurer’s obligations as to payment. The following are comments, and some supporting case law, regarding the process:
- Reduce Business Income loss “to the extent” the business can resume operations. The loss to the insured business is determined by comparing the actual income earned and expenses incurred during the projected period of restoration and the resumption of operations to the same period assuming there had been no physical loss or damage had occurred. (See W.S. Shanban & Co. v. Commerce & Industry Ins. Co., 475 F.2d 34 (9th Cir. 1973) ;
- The business must use damaged and undamaged property (merchandise, stock) to reduce the Business Income loss; specified in the BP and CP Business Income forms;
- Deduction of Salvage Retained in the Extra Expense provisions at 3rd category regarding repair or replacement of any property.
Expenses are recouped when the business resumes operations at the loss location or elsewhere and the business makes a net profit. (See Legier & Co. v. Travelers Indem. Co. No. 09-6674 Slip op. at 7 (E.D. La. April 28, 2010 and Consolidated Companies, Inc. v. Lexington Insurance Co. (616 F.3 422 (US App Ct – Fifth Circuit – Aug. 17, 2010 (Westlaw – WL 211751) See B.F. Carvin Construction Co. v. CNA Insurance Co., No. 06-7155, 2008 U.S. Dist. LEXIS 53678 (E.D. La. July 14, 2008) (The policyholder is not permitted to recover “continuing expense” if the business resumed operations and had a net profit) (Also see Chapter Five - §5.9 – Resumption of Operations at page 173 in the book)
A provision regarding recouping expenses is not listed in the BP or CP policies but it is proper in practice.
- Deduct expenses paid by others or other insurance. BP and CP policies include provisions regarding other insurance and others that pay the loss.
A basic principle of all insurance is to protect and indemnify the insured from loss and to make the insured whole again. Insurance is not intended to put the insured in a better position than before the date of loss. Business Income insurance is designed “to prevent the insured from being placed in a better position than if no loss or interruption of business had occurred. (See B.F. Carvin Construction Co. v. CNA Insurance Co., No. 06-7155, 2008 U.S. Dist. LEXIS 53678 (E.D. La. July 14, 2008) (The policyholder is not permitted to recover “continuing expense” if the business resumed operations and had a net profit).
It’s clear that Business Income and associated coverages provide excellent protection and benefits that allow the insured to resume normal operations. With some training front-line adjusters and examiners can acquire the skills to handle and adjust business interruption/income losses.