Guide to property and business interruption

The cost of rebuilding your premises or replacing equipment after a major incident, whether weather-related or man-made, may be more than you think. In fact, professional valuers Charterfields found the average level of underinsurance was 20% in 2011-12 and in almost a fifth of cases it was more than 50%. In addition, a study by Rushton International suggested that approximately 90% of buildings and 80% of plant and machinery were underinsured.

Underinsurance is a critical issue and may even mean the difference between survival and failure, post-loss. If you insure for the wrong figure you may not receive the full value of your loss if you have a claim. This is the case even with a partial loss – if the overall sum insured is inadequate, insurers will apply ‘average’. This means they will reduce the claim settlement figure in proportion to the level of under reported insurance value.

To put this in context, if you have insured your building for £4,000,000 but it would actually cost £5,000,000 to rebuild it, then if you suffer property damage totalling £200,000, your insurer will only pay you £160,000 (less any policy excess). You would have to find the remainder of the money yourself. This is because you are 20 percent underinsured, so the claims settlement is reduced by 20 percent.

A common reason for underinsurance is mistakenly using the market value, asset register or accounting written down value, rather than rebuilding costs, when setting the sum insured. Another is not taking into account special features that increase the cost — such as listed status, the presence of asbestos or currency fluctuations affecting the price of equipment that has to be sourced overseas.

Marsh recommends that all organisations have a professional valuation of buildings and contents carried out at three to five year frequencies. Professional valuers should take account of issues such as building materials, increases in labour costs, professional fees, debris removal and plant hire costs. They will normally advise on the additional provisions necessary to reflect price increases during the rebuild period. Once a professional valuation has been carried out, buildings, plant and equipment sums insured can be adjusted annually for inflation by applying one of several indices used by valuers and contractors in the construction industry.

Every organisation should have a simple business continuity plan, detailing the likely scenarios that could arise and the responses that should be taken to ensure ‘business as usual, while mitigating the risks associated with business interruption. If business interruption poses a serious threat to your organisation, specialist business interruption insurance policies are available.

A common misconception surrounding business interruption insurance policies is that insurance gross profit – which is used to set your sum insured – is the same as accounting gross profit. This is not the case.

If you use the wrong definition you risk being underinsured and not having the cover you need if you have a claim. For example, you probably want to have cover for wages, so you can retain your skilled employees if a loss occurs and you cannot trade for a while. You need to use the correct definition to make sure items like wages are included in your sum insured.

Insurance gross profit is defined as: turnover less purchases, provision for bad debts and any other expense deemed variable (adjusted for year end stock and work in progress variation).

The indemnity period in a business interruption policy is the period, starting from the occurrence that led to the loss, for which you want to have cover for loss of insurable gross profit. It can take a considerable time to get back into business and then to regain customers, suppliers and your expected trading position, so you need to think carefully about the right indemnity period for your business.

When setting the indemnity period, you should consider issues such as the following:
• Reinstatement/rebuilding time of buildings, e.g. availability of suitable alternative premises, tendering procedures, obtaining planning permission.

• Lead times on machinery and stock, e.g. will these have to be custom built or involve overseas suppliers?
• Availability of raw materials
• Recovery of normal production capacity
• Subcontract facilities
• Market recovery time
• Any seasonal factors.

Business interruption is undoubtedly a very painful and often stressful issue for owners and managers alike. However, by being prepared, some of this pain can be eased and uncertainty reduced.

Tom Ernoult is the Head of the National Commercial Practice at Marsh, which provides insurance broking and risk management services to SMEs.