Most businesses would never think of going without property and liability insurance. Even if they do wish to go without it, often times that’s not even an option. For many, the mortgagee requires the purchase of insurance to protect their financial investment.
The reality for many insureds is that the key to surviving a disaster may very well depend on the firm’s loss of income protection. The fact of the matter is, “When trying to control financial risk, insurance is the cornerstone. And business income insurance can prove to be the foundation for survival of a business whose operations have been interrupted by a devastating loss” (Adjusters International).
So what is Business Income insurance?
Business Income, as it relates to Business Income insurance, is defined as the net income (net profit or loss before income taxes) that would have been earned or incurred, plus continuing normal operating expenses including payroll. Business Income insurance provides a business whose operations have been interrupted by a covered cause of loss, with income equal to what the firm would have enjoyed had no loss occurred. The goal of Business Income insurance is to pay for the sale that would have been, had no loss occurred.
How does it work?
Business Income insurance is not sold as a stand-alone policy but as an endorsement to the property or package policy. The coverage of Business Income insurance is triggered by the total or partial suspension of business operations due to loss, loss of use, or damage to all or part of the building or business personal property as the result of a covered cause of loss. The key point here is that the Business Income loss MUST be covered under the property coverage form for the policy to pay out.
Business Income insurance typically has a 72-hour deductible, meaning no coverage exists until the 72 hours are up. It is important to understand that this means the policy does not go back to day one to determine the amount of loss; it will pay only for loss of income after the deductible period.
It is the policyholder’s obligation to prove a Business Income loss. Proof usually comes in the form of documentation. It is imperative that the insured keeps good records (profit and loss statements, tax forms, payroll records, etc.) to verify the amount that has been lost. The insurance company will compare the records to the previous year’s and previous month’s records to help determine what the loss actually is.
Coverage Options and Limits
Now that we understand how important and critical Business Income coverage is for an insured to prevent financial ruin, the next step is to understand the coverage options available, which one is best for your client and what limit should be selected.
Before we discuss the different coverage options, it is important to note that when determining the limit of liability, the worst-case scenario should be examined by asking: What is the longest period of time the insured may be shut down, and what would be the worst months for the insured to be out of business? Most businesses underestimate the amount of time it takes to return to normal operations. You should not overlook the time it takes for cause and origin investigations and debris removal. Securing permits can take 2-3 months, while reconstruction of the property can take several months.
Below are the most common coverage options available for Business Income insurance:
1. Coinsurance is the most common method used to determine Business Income limits, especially for those with a maximum expected period of recovery of six months or more. It is also favored because the rates are lower than other options and recovery is not limited by monthly maximums or limited payouts. However, there is a downside to the coinsurance method; the insured may become a coinsurer if the limits are not adequate enough to pay the full amount of the Business Income loss. The insurance company would penalize the insured for not buying the correct amount of coverage. The coinsurance calculation is the same as it is for property coverage Did/Should x Loss.
The best method for determining the correct limits for the coinsurance method is to complete a business income worksheet. Having a CPA or accountant assist in completing the worksheet is highly advised.
2. The Monthly Limit of Indemnity method waives the coinsurance, however, it imposes a monthly maximum payout based on a fractional percentage chosen. The standard options are 1/3 (payout 3 consecutive months), 1/4 (payout 4 consecutive months), or 1/6 (payout 6 consecutive months). The most that will be paid in each period of 30 consecutive days is the limit of insurance multiplied by the fractional percentage you choose. This option is intended for businesses that do not expect a period of recovery beyond six months.
Below is an example of how the monthly limit of indemnity method is applied:
| When: | The Limit of Insurance is: |
$ |
120,000 |
| The fraction shown in the Declarations for this optional coverage is: |
¼ |
||
| The most we will pay for loss in each period of 30 consecutive days is: |
$ |
30,000 |
|
| ($120,000 x 1/4 = $30,000) | |||
| If, in this example, the actual amount of loss is: | |||
| Days 1–30: |
$ |
40,000 |
|
| Days 31–60: |
$ |
20,000 |
|
| Days 61–90: |
$ |
30,000 |
|
|
$ |
90,000 |
||
| We will pay: | |||
| Days 1–30: |
$ |
30,000 |
|
| Days 31–60: |
$ |
20,000 |
|
| Days 61–90: |
$ |
30,000 |
|
|
$ |
80,000 |
||
| The remaining $10,000 is not covered. | |||
Another factor to consider in choosing this option is that in some cases, much of the initial expense may be incurred in a specific 30-day period. Thus, an equal payout per month may not meet the insured’s needs. If an insured does not collect the full amount available in a given month there is NO carry over of monies to the next month.
3. Another method available is the Maximum Period of Indemnity. This option limits actual loss sustained for 120 days, subject to the limit of insurance. No coinsurance applies, but the policy will only pay for 120 days. At the end of that period there is no more coverage, even if the insured still has monies left within their limit of liability. This option is intended for businesses that do not anticipate an expected period of recovery greater than four months.
4. Actual loss sustained is another method where the coinsurance clause does not apply. The limitation for this option is that the loss must still be proven, and the proof is the amount that will be paid. There is typically a 12-month payout for this option, and many higher hazard clients (i.e. restaurants) are not offered this option.
5. Agreed Amount is the final coverage option that is available for Business Income insurance. This option pays out the limit that is agreed upon by the insured and the insurance company. The coinsurance clause is again waived and a completed and signed Business Income worksheet is made part of the policy. Many insurance companies are not willing to offer this option due to the many variables in a Business Income loss that could impact the payout.
This is certainly not the entire story behind Business Income but an overview of what the coverage is and how it can be written. Working with the insured’s CPA or accountant is always recommended when determining the limit of insurance needed.
Not understanding the coverage and writing it incorrectly to meet your insured’s needs can not only be costly for your insured from a premium standpoint but also may have a disastrous effect on your insured if they suffer a devastating loss.
In-depth courses on Business Income are typically offered from your local agents’ association along with other insurance educational facilities. These courses are usually inexpensive, especially in comparison to the disastrous results that may occur if you are providing this coverage incorrectly to your clients, or worse, not offering the coverage at all.
Business Income coverage can be one of the most misunderstood of all property coverages, which is why it is so important that you take the time to learn and understand it.
Sandra Haley is the Senior Vice President of Underwriting & Marketing at Hospitality Insurance Group.
Please be advised that the opinions expressed are the views of the author alone and should not be attributed to any other individual or entity and shall not constitute a legal opinion.