Business interruption insurance has been around in various guises for more than 200 years. Yet, despite changes, many businesses complain that the cover often fails to meet their needs.
The first serious attempt to insure loss of profits was made in 1797, but as book-keeping methods were so primitive the idea was still-born. The case of Barclay v Cousins in 1802, established the legality of insuring loss of profits in the UK. The next move came from the French who, in 1806, had a go with their “chômage” (enforced idleness) insurance. This paid a sum for loss of profits in proportion to the material damage loss suffered. It was a crude measure of indemnity and was later known in the UK as the “percentage of fire loss” policy.
In 1821, the Beacon Fire Insurance Company launched its innovative time loss policy. This paid a weekly allowance to tradesmen. It was better than previous efforts but was flawed as it took no account of partial losses.
The big breakthrough came in 1899, when Ludovig Mann devised the turnover-based policy. This included a formula for measuring loss by comparing turnover for the period affected, with the turnover in the corresponding period in the year before the loss.
Policy wordings were standardised in 1939, but it took until 1950 for the “difference” basis to evolve. This measures turnover, less certain expenses such as purchases (with an allowance for opening and closing stock), rather than the old “addition” basis of calculating net profit plus standing charges. The advantage of this is that it avoids omitting a standing charge.
The dreadful, designed-by-committee dual wages basis appeared in 1952, but thankfully was replaced by 100% payroll cover in 1976.
Falling short
Despite all this, business interruption insurance still fails to provide the cover required by modern business. Part of the problem is the mystery surrounding it, leading to a lack of understanding and a tendency to fall back on traditional ways of arranging cover. The loss of expertise following recent mergers and acquisitions has not helped, and will get worse as market consolidation continues. The lack of widespread interruption analysis reports and contingency planning are also factors.
Some businesses have complex interruption features, but most have common needs. For example, indemnity periods are generally for 12 months. This is unlikely to be adequate for a small business after a major loss, let alone for a large one. It is not just a question of how long it takes to rebuild or find alternative premises. More often the problem is the time for the purchase of high-tech machinery.
Even when it is possible to get back into full production quickly, it is unlikely that the gross profit of a business will revert as fast to its pre-loss level. Trained workers and other key staff may have gone; major customers will certainly have done so and the reputation of the business may have suffered long-term damage. It could take several years, even with an intense marketing campaign, for the insured to regain their market position.
Indemnity periods of at least two years should be the norm. Too few insureds and their advisers recognise this need, and too few insurers respond with premiums reflecting the degree of risk.
Another flaw is that the popular gross profit basis only provides cover for increased cost of working, if the gross profit from the additional sales generated at least matches the increased costs incurred. Cover for additional increased working costs, which is not subject to this so-called “economic limit”, is generally reserved for a handful of trades, such as newspaper publishers. This is because in these trades, it is recognised that sales must be maintained at any cost if the business is to survive. Customers are not renowned for loyalty and once lost, may be impossible to recover.
Insurers could cater for the majority of businesses by providing wider cover for additional costs automatically, as a percentage of the gross profit policy limit. Businesses with more extensive needs could be assessed individually.
While most businesses need lengthy indemnity periods and automatic cover for additional costs, it is improbable that a business will suffer a total loss. “First loss” covers, whereby the insured calculate their gross profit and then choose a lower amount to insure, are not popular with many insurers.
Risk managers find this attitude hard to understand. A firm that has assessed its own degree of exposure and is prepared to insure just for the amount it feels it could lose, is likely to be more risk-conscious and have paid greater attention to contingency planning than one that insures for the full amount of gross profit out of ignorance.
Modern business practices have changed enormously. A partnership approach with suppliers is now more common, often with single sourcing of components. The Japanese-style “just-in-time” delivery system is widely practised, reducing the need for extensive warehousing, but greatly increasing a firm's dependency on its suppliers.
Few businesses insure against their suppliers having a major loss, even though this could be just as disastrous as an incident affecting their own premises. Insurers could remedy this by providing a suppliers' extension as standard up to a certain percentage of the policy limit, with optional higher limits.
Culture of inconsideration
The move to providing standard sums insured under small business packages has been beneficial to them as it has reduced the dangers of under-insurance. However, it has helped to breed a culture of not considering the adequacy of sums insured, and many underwriters now simply do not know how to calculate business interruption rates properly.
Therefore, pricing of larger cases is often hit-and-miss, as most insurers lack an adequate statistical base. Insurers should address this, but also need to improve their interruption analysis of individual risks and gear pricing more to the degree of hazard and exposure, and less to the vagaries of the market.
Contingency planning is still in its infancy, despite extensive publicity. As one survey showed, the awareness of the need for contingency planning is high, but many firms still fail to draw up a plan. Of those that do, around 60% either fail to test their plan or consider the effectiveness of their plan doubtful. The folly of this is shown in the apocryphal tale of a City firm that was unable to implement its contingency plan following the Bishopsgate bomb in April 1993, because the sole copy was in a safe in an area of the building cordoned-off by the police.
Contingency plans should identify the hazards affecting a business and assess the potential impact. The plan should then be audited and tested to ensure it is effective in both the crisis-management phase during the immediate aftermath of the incident, and also later during the recovery phase.
Effective contingency planning reduces both the incidence and impact of a loss. More insurers should provide expert advice to encourage and help policyholders draw up and test plans and then give premium savings to reflect the improved risk.
None of this is rocket science, but then neither was Ludovig Mann's 19th century turnover-based policy. Business interruption insurance need not be complex.
