Business income or business interruption insurance can be a confusing insurance coverage for manufacturers. Small manufacturing companies often are insured on a business owners or BOP type policy form which offers business income coverage on an actual loss sustained basis for up to 12 months – meaning that if the company suffers a loss that causes them to cease operations fully or partially – like a bad fire – then the policy will pay the actual monthly expenses and profits lost during that shut down for up to twelve months. Easy peezy so to speak, but there is some downside to this ease, which I’ll discuss in a moment.
For larger firms, policies often require a stated limit of coverage and this is where it gets sticky, not just for clients, but also for their agents.
Okay, so why does the situation get sticky or difficult when business interruption insurance is written on a stated limit?
The answer is because so few brokers know how to complete a business income worksheet which is the starting point for getting this coverage right. I’ll admit that the standard ISO worksheet is complex and I’ve had plenty of CFOs tell me it’s an F’d up way to calculate the exposure, so let me simplify it a bit.
Business income or business interruption insurance is intended to pay for a firm’s ongoing business expenses and lost profits while it is fully or partially out of business due to a covered loss.
There are three important elements to this that must be met in order for coverage to be triggered.
- There must be a partial or full cessation of business operations.
- That cessation must be caused by a covered peril or cause of loss.
- There must be physical damage or loss to the insured premises. There are extensions for loss or damage or nearby the premises, and there are some extensions for governmental actions like street closures nearby, but again these extensions are very limited.
During the pandemic many businesses filed claims under business income because they had to shut down for an extended period of time. Those claims were mostly denied because they failed to meet conditions 2 and 3. In fact, many policies exclude claims from viruses and other biological contaminations.
Now, back to how you calculate what type of limit you need to insure for. The basic premise here as I mentioned earlier is to cover all your ongoing expenses when you’re faced with a shut down. Rent and other occupancy costs, payroll, which I’ll detail more about in a minute, equipment leases, loan payments, insurance, legal and accounting and so forth are all examples of ongoing expenses.
Raw materials, packaging, freight, transportation costs, etc. are all example of items that likely will not continue should a shut down occur.
Let’s get back to payroll for a moment – this is an area where I see the calculation go wrong. You can exclude a portion of payroll. That exclusion can be by the classification of workers and after a certain time limit.
For example, a manufacturing plant may not need to keep line workers on payroll following a covered event after 30 days or 60 or 90 days. If there’s a small fire that triggers a shut down that can be remediated in say 2 months then it makes sense to have insurance reimburse or pay you for those idled workers during the recovery period so you don’t lose them.
But, it may not be economically feasible to keep those workers on payroll past 120 days, so you should endorse your business income coverage to reflect that exclusion of expenses past 120 days.
You likely do want to keep your managers and higher level workers on payroll to completion of the claim. These issues need to be considered when formulating your business income limits so you’re not over-paying for coverage you don’t intend on using as well as not understating the limit you will need to recover.
Profit. The business income calculation also should include lost profits you should be recovering while out of commission.
Now that you have a sense of what’s in and what’s out, boil that down to a monthly number because the next thing to consider is how long will a cessation last? How long will it take to recover?
Again, this is where I see many policies get it wrong and underestimate the duration of a claim. You want to think of these as worst case scenario. Underestimating the duration of a claim can be devastating.
Think for a moment what would happen if your plant burned to the ground, and please don’t think it can’t happen – even superior constructed buildings can go down. How long would the permitting process take?
How long would it take to find and deploy the right architect and GC? Source all the building materials and specialized machinery, and then get it built, ready, tested and operational.
Once you figure out the ultimate worst case scenario time wise in months you’ll now have your two critical factors down – the monthly nut you need to cover and the number of months you need it for.
This is your ultimate limit of insurance, unless there is a ramp up time for fully recovering your operations and cash flow. For example it may take 6 or more months to bring all you customers back and buying your product so that needs to be built into the formula as something known as the extended period of indemnity or recovery.
Earlier I mentioned that smaller manufacturing firms that qualify for a BOP policy get business income coverage automatically for 12 months on an actual loss sustained basis without having to go through this calculation is “easy”.
But there is a catch which may be evident in my comments a minute ago – recovery may take more than 12 months. Then what?
This is a shortfall of the Business Owners or BOP policy. Easy is good, but it ,may not be perfect and this is a consideration a skilled broker needs to evaluate on where the BOP is the right solution for the smaller manufacturer.
Other considerations on business interruption insurance
The secondary part of calculating business income insurance is also calculating something called extra expense and there’s another page to the worksheet that covers this time element insurance. Briefly, extra expenses are those costs you may incur to expedite the recovery process.
I could probably make an entire article here, but in the interest of time, suffice it to say that careful consideration needs to be given to extra expense. The good news is that when you’ve gone through this once, it probably only needs a brief updating each renewal.
Other issues that need consideration are co-insurance, potential contingent business interruption issues, civil authority sub-limits, and extensions for excluded perils like flood and earthquake.
I realize this is a lot to take in, but I hope this video gives a good overview of the issues at hand with business interruption for manufacturers.
The overall goal here is to illustrate that while it’s complex, it’s not impossible to figure out.
This is where the role of the skilled broker can shine to help you get the right limit of coverage to protect your business and provide you peace of mind if disaster strikes, that you can recover.
If you’re looking for a high level of expertise to protect your manufacturing business, then give me a call – I’d love to hear from you.