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Many Home Businesses Could Benefit from this Type of Special Insurance Coverage
If a natural or man-made disaster interrupted your company's or client's business — would your business survive? What may have seemed like protection for "someone else’s business" may now be worth serious consideration. Business interruption insurance is not just for large corporations. Home-based businesses should consider this option, particularly if their business’ survival would be put in jeopardy by a disaster.
Here’s how business interruption insurance works, courtesy of Donald J. Dragony, the CFO/VP of Finance and Manager of Business Interruption Claims at Alex N. Sill Co. in Cleveland, Ohio.
Interruption Insurance Basics
Business interruption insurance covers loss of income from fire or other interruptions (“perils”). It pays the expenses needed to keep a firm open and put in the condition it would have been in if there were no such loss. With inadequate or no coverage, income and cash flow may stop. The most popular kinds of business interruption (or “loss of income”) insurance are based on either gross earnings or net income. Both use the same coverage (loss) calculation and arrive at the same result.
The “gross earnings” method, for insurance purposes, is net sales less those expenses you would not incur during the loss period because you did not manufacture, e.g., raw materials. Direct labor and overhead are included elsewhere in the loss calculation. If a firm has an interruption, it must determine how long the interruption will last and how much it will lose based on historical data and estimates. The loss period is the time it takes to restore the property to the condition it was in right before the loss using due diligence and dispatch — a subject of frequent disputes between the insured and insurer.
Here are the terms used in the calculation:
~ Gross sales is the manufacturer’s sales value of the production for the “loss period.” It can be based on historical sales and production (generally 2 or 3 years) and incorporates changes in the economy that would have increased or decreased sales.
~ Sales deductions may include discounts, prepaid freight, commissions, bad debts, sales tax, and other items that would reduce gross revenue and generally have a direct relationship to sales.
~ Net sales are lost sales less sales deductions.
~ Gross earnings deductions include raw materials, consumable supplies, outside services, and other items considered uninsurable because their cost is not incurred (or not necessary) when sales are lost.
~ Noncontinuing (discontinued or saved) expenses are expenses that would have occurred without the interruption less actual continuing expenses for the loss period. Gross earnings less noncontinuing expenses yield the business interruption loss.
Gross sales
Less: Sales deductions
Equals: Net sales
Less: Gross earnings deductions
Equals: Gross earnings
Less: Noncontinuing expenses
Equals: Business interruption loss
Times: Coinsurance percentage
Equals: Collectible business interruption loss
Plus: Extra expense
Equals: Total collectible business interruption loss and extra expenses
To calculate insurance proceeds in a loss:
Collectible percentage of loss = Insurance in force
Insurance % required
Additional Considerations
There are endorsements (benefits or limitations) to consider in business interruption insurance. These include an agreed-upon amount that automatically eliminates potential coinsurance penalties, an ordinary-payroll exclusion (for firms with substantial direct labor costs), additional payroll coverage (e.g., key employee salaries), an extended period of indemnity (money for a period of time after property is restored), and various deductibles to choose from. After coverage begins, there may be other factors to consider. Consult with a business interruption insurance specialist.
Business Interruption Insurance for Service Firms
Service firms may use the gross earnings formula omitting cost of sales and gross earnings. They would use costs and expenses and purchase an “actual-loss sustained” policy, which insures the firm for the actual loss incurred, not to exceed the face amount of the policy and frequently for a period not to exceed 12 months. Calculations for a service firm are as follows: Gross sales Less: Sales deductions
Equals: Net sales Less: Noncontinuing expenses
Equals: Business interruption loss Plus: Extra expenses
Equals: Total collectible business interruption loss and extra expenses Often, service firms purchase different coverage, an “extra-expense policy,” that covers added costs incurred to stay open. An accounting or law firm does not typically lose clients in a fire, but may lose records. To stay in business, the firm needs coverage to recreate the lost files and lost records. They may also need temporary rental space and phone service, even computers, desks, etc. Since this kind of policy does not have a coinsurance provision, it requires a simpler calculation and estimation of maximum coverage needed. HBM This practical, useful information first appeared in The General Ledger newsletter, the free monthly newsletter for members of the American Institute of Professional Bookkeepers (AIPB). Donald J. Dragony, CPA, is CFO/VP of Finance and Manager of Business Interruption Claims, Alex N. Sill Co., Cleveland, Ohio. For further information about business interruption insurance, visit www.AIPB.org or call AIPB at 1-800-622-0121. Previously published in the February 2007 issue of HOME BUSINESS® Magazine, an international publication for the growing and dynamic home-based market. Available on newsstands, in bookstores and chain stores, and via subscriptions ($15.00 for 1 year, six issues). Visit www.homebusinessmag.com
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