One of the risks a business can face and is often overlooked is a failure during the transfer of an identified risk. The process of transfer involves a client’s key business information being understood and summarised so it can be effectively passed on to and accepted by a third party. This is conducted via contracts and an insurance broker acting as an agent for the insured in managing this transfer.
Whilst human error is often present, there is a specific risk regarding the transfer of business interruption (BI) exposures, simply because of the complexity of an insured’s finances which is typically only fully understood by qualified accountants. In addition, there is the nature of the insurance product to cover BI which is not always readily understood by an insured’s finance team due to the terminology used. Although the policy wording has changed little over the years and stood the test of time, it’s not always straightforward to grasp the nuances.
Therefore, an insured needs an advisor to help with the transfer of its risk who can speak the language of its accounting department but is also fluent in BI insurance. There are many who are conversant in both dialects but few who are fully bilingual.
So what is the risk following an error in the transfer process due to a language barrier? Let’s explore two scenarios caused by a misunderstanding of an insured’s accounts as well as an insurer’s intentions not being correctly communicated to the insured in respect of BI.
01
Unlike third party coverages, the vast majority of BI cover is issued on a Sum Insured basis as opposed to ‘First Loss’. The difference being that a business is insured for its ‘Value at Risk’ rather than simply up to a chosen amount. The implication is that most policies are subject to ‘average’ (aka underinsurance). Underinsurance may apply if the Sum Insured is less than the amount at risk calculated under the basis set out in the policy, typically by measuring the ‘but for’ projected insurable interest looking forward from the date of incident. This is essentially what the insurers could have been on the hook for.
If a Sum Insured is chosen rather than calculated, there is a danger that the value may not accurately reflect the risk borne by the insurers.
Say an airport decides to insure its standing charges only (maybe the minimum coverage as required by lenders) and choses an amount of $50m. If the policy does not explicitly say the individual charges which are to be insured and the actual full standing charges of the business are expected to be US$100m, insurers would consider that only 50% of the risk has been insured and therefore any BI claim would be reduced by 50%.
This is an example of the language of the insurers not being correctly translated.
02
Gross profit is the most common form of business interruption coverage. It seeks to indemnify a business for the actual loss sustained in respect of the impact to a profit and loss statement due to damage caused by an insured peril. The basis of coverage is revenue at risk, less any costs which are incurred in proportion to said revenue. I.e 50% reduction in revenue would equal roughly the same % saving in the cost. Whilst some costs may reduce following a longer outage period, these should not be deducted from the Sum Insured.
The issue, however, is the definition of insurance gross profit differs to accounting gross profit. They have different purposes for being calculated, insurance being the statement above, accounting gross profit being one of several metrics to measure the past activity/profitability of a business.
Businesses have a small bit of freedom on how they calculate their accounting gross profit. Typically, direct costs are deducted as part of cost of sales to arrive at gross profit. However, direct can be mean labour, depreciation, maintenance, all which may be a fixed cost per the insurance definition above. They would likely continue if there is a loss and should therefore be insured, not deducted.
A common issue in the world of BI, especially in markets where business interruption is not always a standard cover under an IAR policy, is that when requested for their gross profit sum insured, businesses simply include their historic accounting gross profit. This is likely to result in understating the amount at risk, firstly due to fixed costs being deducted as above but also by not considering growth of the business. An insured is protected for future not past profits. Failure to declare an adequate sum insured can again result in underinsurance being applied to a BI claim.
Brokers who have accountants that are also BI insurance specialists as consultants can help mitigate this transfer risk by properly understanding a business’ finances, addressing its profit coverage needs and ensuring the policy is bespoke to the risk.
WTW is an insurance broker and gives its views on the meaning or interpretation of insurance policy wordings as brokers experienced in the insurance market. Insurers may take a different view on the meaning of policy wordings. Any interpretation or thoughts given are not legal advice, and they should not be interpreted or relied upon as such. Should a legal interpretation of an insurance contract be required, please seek your own advice from a suitably qualified lawyer in the relevant jurisdiction. While all reasonable skill and care has been taken in preparation of this document it should not be construed or relied upon as a substitute for specific advice on your insurance needs. No warranty or liability is accepted by WTW, their shareholders, directors, employees, other affiliated entities for any statement, error or omission.
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