Author: Chris Boggs
Business income coverage is unique because the factors used in calculating the amount of protection the insured is required to purchase differ from the factors used when calculating the amount of compensation owed/paid following a business-closing loss. Because of the different calculation methods, there is a difference between “insurable" business income and “compensable" business income.
Insurable Business Income
Insurable business income is initially a function of the applicable revenues and expenses contemplated in ISO's Business Income Report/Work Sheet. The ultimate insurable business income limit is developed by applying the estimated worst-case period of restoration to the 12-month business income exposure. Both the development of the 12-month business income exposure and the calculation of the worst-case period of restoration (POR) are briefly described in the following paragraphs.
12-Month Business Income Exposure
An insured's 12-month business income exposure is calculated and placed in J.1. on the CP 15 15 – Business Income Report/Work Sheet. If the insured is a combined manufacturing and non-manufacturing operations, the 12-month business income exposure is line J.2. The J.1. (or J.2.) amount is the insured's gross income (gross sales or gross sales value of production) minus a few specifically listed non-continuing sales-related expenses and production-related expenses listed below:
- Sales-related expenses are expenses incurred or potentially incurred following the sale of a product or service and include:
- Prepaid freight - outgoing;
- Returns and allowances;
- Bad debts; and
- Collection expenses.
- Production-related expenses represent the cost of buying or building the products/services being sold to the customer and include:
- Cost of goods sold (Note: not calculated according to GAAP standards);
- Cost of services purchased from outsiders to be resold that do not continue under contract;
- Power, heat and refrigeration expenses that do not continue (if CP 15 11 is attached);
- Excluded payroll expenses (if CP 15 10 is attached); and
- Special deductions for mining operations (if the insured is a mining operation only).
No expenses other than these sales-related and production-related expenses are deducted from the gross income to develop the 12-month business income exposure. Because these are the only expenses considered, the insured does not need to know nor estimate which expenses will continue, be reduced or disappear following a loss, known as the period of restoration.
Worst Case Period of Restoration
The worst-case period of restoration (POR) is a function of the correct estimation of time. How much time will pass before the insured is once again operational following a worst-case loss? When a loss occurs, specific actions and steps must be taken before the insured is “back in business." There are at least 10 pre-construction, construction, and possibly post-construction activities that directly affect the period of restoration (the period of time the business is closed).
- Pre-construction activities:
- Time to adjust the direct property loss;
- Building plans must be drawn and approved;
- A contractor must be found and hired;
- The insured must apply for and wait for building permits to be issued; and
- Site preparation must be scheduled and completed, including clearing the site of damaged or destroyed property.
- Construction and post-construction activities and issues:
Rarely are the time realities considered following a worst-case scenario loss. Although these 10 requirements are not necessarily linear, following is a visual example of a time line following a worst-case scenario loss:
- Time required to rebuild (may be adversely affected by #10);
- Time required to restock;
- Rehiring and hiring new employees;
- Replacement machinery and equipment must be found, purchased, installed and made operational; and
- Federal, state or local government may involve themselves following a loss (an ordinance or law issue).
Regardless what the building owner believes, the time required to return to operational capability is much longer than estimated because of the realities of time.
Developing Insurable Business Income
Once the worst-case period of restoration is calculated (in days or months), that amount of time is divided by one year (either months or days) to develop a percentage. The 12-month business income exposure is multiplied by this percentage; the result is the insurable business income. This process is laid out in the following example:
|12-Month Business Income Exposure (J.1.):|| ||$1,000,000|
|Estimated POR: 420 Days|| || |
|Period of Restoration Percentage (420/365):||X||1.15|
|Insurable Business Income:|| ||$1,150,000|
Compensable Business Income
Compensable business income is the actual amount of business income paid to cover the amount of income lost during the period of restoration. This is the amount necessary to indemnify the insured. Compensable business income is some amount less than the insurable business income because it is based on net profit or loss before tax plus continuing normal and ongoing (continuing) operating expenses incurred during the period of restoration.
Unlike insurable business income, the compensable business income calculation deducts operating expenses that do not continue or are reduced following a covered loss. This represents the amount arrived at when all reduced or discontinued operating expenses are subtracted to produce the continuing normal operating expenses.
Business Income Defined - Once Again
ISO's two business income coverage forms (CP 00 30 and CP 00 32) define business income as follows:
Business Income means the:
Applying this definition and the amount it represents, the insurance carrier agrees to indemnify the insured for its actual loss of business income suffered during the period of restoration. If all coinsurance conditions are met, the only limit on protection is the limit of coverage purchased.Compensable business income indemnifies the insured by returning it to the same financial condition that existed prior to the loss or, in the case of business income protection, would have existed had no loss occurred. But the amount necessary to indemnify the insured does not equate to the amount of insurance purchased because the method for calculating the 12-month business income exposure differs from the method for calculating the compensable business income loss. The 12-Month Business Income ExposureRemember, only two classes of expenses are considered and deducted when developing the insured's business income exposure: sales-related expenses and production-related expenses.
- a. Net Income (Net Profit or Loss before income taxes) that would have been earned or incurred; and
- b. Continuing normal operating expenses incurred, including payroll.
- Sales-related expenses are deducted from gross sales (or gross sales value of production) to produce the insured's "Total Revenues" (line H of the CP 15 15).
- Production-related expenses are subtracted from Total Revenues, leaving the 12-month business income exposure (J.1. or J.2.).
Only those expenses are deducted when completing the business income report/worksheet. No other non-continuing or reduced expenses are considered in the business income limit calculation (the insurable business income). Because of this, the 12-month insurable business income total is always going to be more than the compensable business income amount, except, possibly when a loss exceeds the contemplated worst-case scenario.
What's the Difference?
Estimating the difference between the insurable business income exposure (J.1.) and the compensable business income exposure is nearly impossible. Prior to the loss there is no way to accurately guess how much of which expenses will continue, which will be reduced, or which expenses will disappear — and it really doesn't matter.
Recognizing that there is a difference between insurable and compensable business income is important if for no other reason than to be able to explain the difference to the insured. Disappointment and dissatisfaction are a function of expectation. If the insured expects more than is due, that's where the problem lies.
When Might the Difference Be Noticeable?
Any business income loss may serve to highlight the difference between insurable and compensable business income, but such difference is more likely noticeable when there is a “short-term" loss (one that is shorter than the estimated period of restoration. Consider the example insured presented previously: the insured's estimated worst-case period of restoration was 420-days (14 months). This estimate resulted in an insurable business income limit of $1,150,000 on a $1 million 12-month business income exposure (J.1. amount).
A covered fire damage loss results in the insured being shut down for seven months. By interpolation, the insured expects to receive $575,000 ($1,150,000 x 50%). But because 30 percent of the normal operating expenses ceased during the shutdown, the insured's compensable business income loss totaled only $460,000. The additional $115,000 is not required to indemnify the insured for the lost net income plus the operating expenses that continued during the business' closure.
Remember, indemnification requires the insurance carrier pay only for the lost profit plus the continuing normal operating expenses during the period of restoration — the actual loss sustained. Paying any more would improve the insured's position and violate the principle of indemnification.
What Can Be Done to Adjust for this Difference?
Nothing! Nothing can be done about the difference between insurable and compensable business income due to the application of the business income form's coinsurance penalty. The business income coinsurance penalty is calculated by applying the same deductions used to develop the 12-month business income exposure in the CP 15 15 – only sales-related and production-related expenses are applied to the estimated gross sales. Non-continuing operating expenses are not deducted nor considered in the coinsurance condition.
Lowering the limit of coverage to account for the difference between the insurable and compensable amount does nothing but subject the insured to a coinsurance penalty and possible under-insurance.
The Benefits of the Difference
Although nothing can or should be done to adjust for the difference between insurable and compensable business income, there is a benefit that flows from the difference – a financial safety net. Because there is a difference between insurable business income and compensable business income, the insured has:
- Some limits available to cover its 60 days of extended business income protection (click here to read an article on extended business income protection); and
- The possible availability of some additional limits should the period of restoration run longer than expected.
Beyond Business Income Basics
When developing the business income limit, the insured does not consider or calculate which normal operating expenses will or will not continue. But, following a loss, the insurance carrier does consider and ultimately deducts from the loss payment all non-continuing normal operating expenses. To do otherwise would violate the principle of indemnification.
Insurable versus compensable business income is only one of several topics discussed in detail in the VU December 20 webinar, “Business Income: Are You Sure You Protected ALL the Insurable Income?" In this webinar we detail:
- Completion of the Business Income Worksheet (CP 15 15);
- The difference between "insurable" and "compensable" business income;
- How to insure the additional loss of income that occurs once the business reopens; and
- How to properly insure the exposure created by dependent properties (contingent business income).
The VU looks forward to seeing you.
Last Updated: December 8, 2017