Protect yourself with insurance that shields revenue streams ordinarily used to pay fixed costs.
December 29, 2011
by Jeffrey Smith and Joseph Gipp
“It will take three weeks for the replacement parts to arrive from Germany.”
Not the best news when customer orders must be filled within days and portions of the manufacturing operation will be idle for weeks until equipment or parts arrive. Of course, this is one of the reasons why manufacturers have business interruption insurance. But to ensure full recovery in the event of a loss, be aware of certain facts related to purchasing coverage and filing a claim.
Equipment failure, fire and water damage, or the theft of inventory and equipment, all lead to revenue losses. Business interruption insurance protects revenue streams that would ordinarily be used to pay fixed costs such as loan obligations, rent expense, property taxes and employee salaries, plus generate shareholder profits. Fundamentally, it insures loss of net income plus necessary continuing expenses.
However, not purchasing enough coverage will stick you with a portion of any loss – in effect, making your company a co-insurer. A company that acquires $40 million in coverage and has $80 million in exposure may only have insured 50% of any business interruption loss from the first dollar of loss. In such a situation, a $6 million loss might only result in $3 million in insurance recovery because the business has co-insured half the loss.
While there are various types of this insurance, most are broadly based on profits or gross earnings. The most significant differences between the two relate to the period over which losses are recoverable and how payroll is insured.
Gross earnings forms generally indemnify losses only until the lost or damaged property can be re-built, repaired or replaced, whether or not the business has reached its previous level of sales. Profits forms continue to provide loss coverage until the business resumes its normal level of sales, subject to a maximum period of indemnity.
To highlight the differences between the two, consider a food manufacturer that experiences the breakdown of a key piece of equipment. The business is unable to manufacture a range of its products for 30 days and thus loses a number of customers to a competitor who can supply the required products.
Under a policy with a gross earnings wording, the loss indemnity period would be limited to the 30 days required to replace the damaged equipment. Under a policy with a profits wording, the period would continue until the business achieves the volume of sales it would ordinarily have had – subject to the maximum indemnity period in the insurance contract. Typically the period is 12 months, which can be reduced or extended.
Manufacturers need to consider whether gross earnings coverage would be adequate in the event of a significant business interruption or whether it’s worth paying higher premiums for profits coverage. In some instances, this may not be an option. For companies involved in just-in-time production, insurers may not want to provide coverage under a profits wording because the risk of customer losses is simply too high.
Gross earnings and profits forms treat ordinary payroll expense differently. This expense is the wages of hourly paid employees and non-management salaried employees who are not essential to the company’s continuing operations. Management should consider the pros and cons of insuring this expense. Sometimes payroll costs can be avoided through layoffs; other times layoffs are impractical or impossible, when, for instance, union contracts prevent them.
Consider payroll costs
Ordinary payroll costs are insured under gross earnings wordings, unless there is a specific exclusion or limitation endorsement. Such endorsements can be useful to avoid spending money to purchase coverage that may not be required. However, under a profits form, ordinary payroll costs are not generally insured unless a company purchases an additional coverage endorsement (for a specific period of time that is not the normal loss indemnity period).
Weigh the advantages and disadvantages. Is ordinary payroll coverage necessary to retain employees and avoid the time and expense of hiring and training new staff? Or would it be better to save on the premium and lay off employees in the event the business is temporarily shut down, then replace them when the company is back in business?
Professional fees coverage is one other important provision to include in an insurance contract. If one day your company experiences a serious loss from a business interruption, you’ll expect a fair calculation of this loss.
Quantifying a business interruption loss is complex and can also be subjective, involving the use of assumptions. You’ll want a knowledgeable forensic accountant to document and quantify this loss and look out for the financial interests of your business.
Manufacturing revenue losses occur from property damage, or theft of inventory and equipment, but often they arise as a result of equipment failure. Capital-intensive manufacturing operations are dependent on sophisticated equipment. All the more reason for adequate, appropriate business interruption insurance. One day, the life of your business may depend on it.
Jeffrey Smith is a partner in the Financial Advisory Services practice of BDO Canada LLP (www.bdo.ca). Contact him at (416) 775-7801 or JSmith@bdo.ca. Joseph Gipp is a partner and national leader of BDO’s manufacturing industry practice. Contact him at (416) 369-3091 or JGipp@bdo.ca.