The core principles of business interruption explained
If the unexpected strikes and your business is interrupted, having the correct sum insured and maximum indemnity period (MIP) on your business interruption (BI) policy is vital if you are to recover the full value of your loss. BI indemnifies the policyholder for lost turnover or gross profit that would be earned ‘but for’ the insured event. The cover is forward looking and the sum insured must reflect future growth in the business. Budgets or medium-term forecasts may be used to establish the BI sum insured, and the adequacy of the insured sum is also linked to the MIP selected.
Underinsuring your BI policy can be costly in the event of a claim. Some policies are subject to an ‘Average’ condition whereby the settlement value may be proportionately reduced based on the ratio of sum insured over value to at risk.
In order to avoid this, ‘declaration-linked’ policies were developed, which contain no ‘Average’ condition. However, there are penalties under these policies if the value declared is materially different to the value at risk.
Prior to the Insurance Act, mis-declaration of the BI sum could lead to insurers avoiding cover for the claim as a whole - both property damage and business interruption losses. The Insurance Act has limited insurers’ remedies in the event of underinsurance, reverting to a form of average based on premium paid and that which would have been payable if the sum had been correctly declared, though the application of the provisions is yet to be tested.
Maximum indemnity period considerations
The policyholder is required to select the period of time for which they want to buy BI cover - the MIP. This period must be sufficient to allow for the physical reinstatement of damaged assets and for the business to recover to anticipated levels of turnover. MIPs can be as short as 12 months, but in my experience this is not usually sufficient time for most businesses to fully recover from an insured event. The following factors need to be considered:
If a building is damaged, insureds must consider the cost and time impact of both rebuilding and partial repair. Most claims involve partial damage rather than total loss and require repair rather than a complete rebuild. On a pro-rata basis relative to the extent of damage, partial reinstatement nearly always takes longer than a complete rebuild.
Insureds who own their own buildings must consider the potential time impact of planning, health & safety and regulatory processes. Leasehold property can take longer to reinstate than owned property as landlords’ decision-making process may not be aligned with the tenant’s drive to expedite the recovery of the damaged building.
Plant and equipment
You will also need to factor in the impact of any long lead-times when replacing production-critical plant or equipment. Insureds are unlikely to be able to influence manufacturer’s supply timelines, so we recommend assessing potential lead times and the subsequent economic impact conservatively when considering repair or replacement options.
The nature of your customer relationships and frequency of transactions will help determine the business recovery time that needs to be built into the MIP. If an annually negotiated supply contract for the regular supply of goods is interrupted, it could result in losing the customer at the next renewal, for example.
The duration of the MIP must therefore be sufficient to allow time to recover lost customers or replace them with new business to restore business activity to the level anticipated before the loss.
BI can be complicated but there is no excuse for getting the basics wrong. Working with your broker to map the risks your business faces and ensure you have the right insured sum and MIP are vital first steps.
For more information, please contact Adrian Brennan, Claims Consultant at Echelon on +44 20 7558 3237 or email firstname.lastname@example.org