Business interruption insurance: Key elements of BI insurance
In the previous article, we unpacked risk advice and insurance cover and how they can be used in managing risk. In the fifth blog in this series, we focus on the key elements of business interruption insurance, namely calculating your indemnity period and gross profit.
This is the maximum period that your insurer will pay you out for an insured event. The indemnity period is calculated from the date of the insured event, through the period of reinstatement until to the date when it is expected for a business to achieve the projected turnover, had the incident not occurred.This period also needs to include external factors like the investigation by the insurer and any protracted negotiations involving the labour department, government organisations and forensics.
The biggest shortcoming for businesses is failing to project far enough ahead. If this period is incorrectly calculated as being too short, your business may not be able to recover to pre-loss production and turnover levels in the same time frame. The golden rule is to err on the conservative side of this calculation.
By way of example, let’s say the factory you own burns down in the middle of November. Because it is the festive season, most contractors and suppliers have shut down. This means that your business will not be able to start the reinstatement process during December and half of January which would erode your indemnity period. So only in January, could you start to rebuild the factory, replace equipment and commence operations etc. Ask yourself how your indemnity period is accommodating such delays.
What you need to know
- It is better to overestimate than to underestimate the indemnity period.
- You need to look beyond your immediate surroundings and consider the worst-case scenarios.
- As a rule of thumb, your indemnity period shouldn’t be less than 12 months.
- Don’t be short-sighted in terms of going for cheaper premiums rather than ensuring your business’s long-term survival, as these insured events are usually a low frequency event.
Calculating gross profit
Correctly calculating gross profit (GP) is a way to ensure that your business is adequately covered in the event of business interruption.
- The gross profit calculation is based on your business’s results of the last full year. That calculation will give you the rate of gross profit figure that will be used for the calculation of the sum insured.
- Take the forecast and budget for the year going forward, and apply those figures to the gross profit from the previous period. Keep in mind that you’ll have to make adjustments for any growth and development for the year ahead.
What you need to know
- Understand that you are using historical data and projecting it to future earnings.
- Always forecast by using the turnover of the forthcoming period of insurance – not the current period of insurance. So, you should be factoring in the turnover of the following year when looking at your gross profit calculations.
- The business interruption sum insured is subject to average and therefore care needs to be exercised. If you get the GP sum insured wrong and you are covered for too little, the insurer will only pay out a portion of your loss.
- Average is a ratable proportion of what the sum insured is to actual GP. Meaning, if you are insured for R100k, your actual GP is R200k, the insurer will only pay out 50% of your claim.
- Always add VAT.
- If VAT is not applied to the sum insured, you will be 15% underinsured to start with, making average inevitable.
- All financial statements exclude VAT – these are the basis for your BI cover, so therefore VAT must be added in.
To avoid average and the incorrect application of VAT on the BI GP sum insured, the use of a formal GP calculator is advisable. There are a number of these very important tools available for your use.