When I work with clients who suffer a business interruption loss, one of the questions I often encounter is, “What is a coinsurance penalty and why am I not getting paid for my entire loss?”

In short, if a policy has a coinsurance clause it means that the business must maintain a minimum amount of insurance, in relation to their actual value at risk, in order to recover 100% of their losses. For example, if the insured value at risk is $1 million and there is an 80% coinsurance clause, then the insured must carry $800,000 worth of coverage to recover 100% of their losses up to $800,000. If they are insured for only $600,000, or 75% of the required value of $800,000, then they would recover only 75% of each dollar of actual loss. The 25% not recovered is a penalty for being underinsured.

The previous example illustrates why it’s so important for a business to have accurately stated business interruption values at risk. Business owners and corporate officers need to understand that it’s critical that values at risk be updated, at a minimum, on an annual basis.

If a business is in a period of growth and its insurance is based upon values from one, two, three, or more years ago, then the business may be inadvertently underinsured for a business interruption.

The best way for a business to avoid this situation is to work closely with a broker and with a forensic accountant who specializes in business interruption valuations. Together this team can come up with the right coverage for business interruption values at risk.

Schools have several aspects that make them unique risks when evaluating values at risk for a business interruption loss. One of the areas that separates schools from other industries is that there is often a huge lag, or ramp up, for the school to repopulate following a major disaster.

I’ve recently heard from brokers who specialize in insuring schools that they have been able to redefine the “period of restoration” to be the entire school year affected, rather than only when the bricks and mortar are back in place. If it’s true that the “period of restoration” can be applied to the whole school year affected, then that would be awesome news for schools who suffer a business interruption loss! School administrators should check with their insurance broker to verify whether the “period of restoration” in their policy includes the whole school year affected.

One thing that school administrators should keep in mind when renewing policies is the valuation for the extended period of indemnity. For example, if the school calculates their value based on a one year value, assuming they would lose an entire year of tuition and associated income, what happens during the extended period of indemnity of 180 days? The school may have coverage for the extended period, but may have depleted their policy limits during the period of restoration. The bottom line is to make sure to include limits related to an extended period of indemnity.

Brokers often ask me which business interruption values at risk worksheets I prefer or think are the best.   I guess the answer depends on if you want to use them to wrap fish or make paper airplanes.  Aside from those two uses, they are all about equally worthless.  I know this sounds harsh, but I have never, in 16 years of calculating business interruption losses, seen an adjuster pull out the VAR worksheet in order to adjust a business interruption loss.

Because the values at risk worksheet is not used to value a business interruption loss after an incident, why in the world would someone use it before an incident?  The correct items to use to estimate business interruption values at risk are the following:

1. a copy of the applicable policy.
2. historical financial and operational data for the company.
3. projected financial and operation results and plans.
4. applicable industry and economic data.

The fact is that all businesses are unique and the VAR worksheets are generic.  A few months ago a broker asked me to create a generic VAR model for moving and storage companies.  The broker assured me that all of the businesses were “the same,” with the same operations, same margins, use the same software, and that there is nothing unique about any of the businesses.

I picked up two profit and loss statements, at random, from his desk.  The first company makes 90% of its income from storage and 10% from moving operations.  The second company makes 90% of its income from … you guessed it … moving operations and 10% from storage.  They are businesses with two completely different risks and business interruption exposures.

I advise businesses to work with a forensic accountant with a vast amount of experience in business interruption claims to assist them in evaluating their business interruption values at risk.  Business owners and managers can do it that way or they can roll the dice and hope, when the fire occurs, that the number generated on the worksheet was close.

I hear this from clients a lot: “But we have business interruption insurance for our lost sales!  If we have business income coverage, doesn’t the insurance company have to pay us for our lost sales?”  This issue in particular can be really frustrating for risk managers, corporate officers, and business owners.

I usually answer this concern with this phrase:  It Depends. I say the phrase ‘it depends’ so often regarding different aspects of preparing a business interruption insurance claim that I’m going to start tracking those issues in this blog.  When I say ‘it depends’ to my clients, I’m not trying to be like Bill Clinton rationalizing the meaning of “Is”.

I’ve seen some policies, most are placed outside of the United States, that allow the insured party to recover lost gross sales (with no adjustments) in the event of a business interruption. What happens more often in the U.S. is that business interruption insurance policies have an additional clause that allows for a deduction of saved, discontinuing, or non-continuing expenses.  This adjustment often produces a number that is very close to the business’ contribution margin.

As a general rule, the insured will not recover variable expenses that are associated with lost sales.  (Think Cost of Goods Sold.)  There are other expenses that are not variable such as rent and depreciation that may, or may not, be recovered depending on the circumstances.

It is important for risk managers, corporate officers, and business owners to understand their business interruption values at risk and what they will recover following a loss. Truly understanding the values at risk number allows businesses to purchase the correct amount of coverage, create the correct business continuity plan, and make fully-informed financial decisions following a business income loss.

Are you or your client concerned about not recovering lost sales after a business interruption loss?  Ask me a question below, in the Comments section, and I’ll help you sort it out.

I hear it all the time: we were busy.  We were in a period of growth!  How could we stop our work in the middle of this booming period to evaluate our business income values at risk?  Besides, we don’t really want to talk to the insurance broker again–they’re always trying to upsell us, right?

I am not an insurance broker and I am not on the payroll of any insurance broker.  As an independent source, a forensic accountant who’s life work it is to settle business interruption insurance claims on behalf of the insured, I’m telling you that it’s important for a business to regularly adjust its values at risk and policy limits–and to work with your broker to do so.

Many business interruption policies contain a coinsurance clause.  A coinsurance clause means that the business is carrying a specific, minimum amount of insurance.  Let me show you how the coinsurance clause + values at risk number can affect the outcome of a business interruption settlement.

In year 1, a business does a million dollars worth of business.  The business interruption policy states that the coinsurance percentage is 80%.  Between year 1 and year 2, the business experiences growth, so the required business interruption insurance limits change, as required by the coinsurance clause.

As you’ll see in the following example, the reimbursement percentage is directly affected by the required business interruption insurance limits–and this is the reason why a business should evaluate its values at risk regularly:

The business still has not revised its values at risk number, which directly affects its reimbursement percentage in the event of a business interruption loss. If the business were to suffer a $400,00 business interruption loss, here’s how those two different reimbursement percentages dramatically affect the settlement a business would receive from its insurance company:

The example I’ve created above is a simplified version of what can happen to a business during a business interruption settlement if its values at risk are incorrect.  I can think of numerous examples of businesses I’ve worked with who’ve missed out on collecting hundreds of thousands of dollars because of misplaced values.

Many businesses make the mistake of using only historical information without regard for future business income values at risk.  Values at risk should always reflect the anticipated values in the coming year, in other words, the year during which the policy will apply.

In the end, it is a business’ responsibility to ensure that its values at risk are correct.  If your business is complex, I suggest that you work with a forensic accountant so that you can understand your values at risk and in order to make fully-informed business decisions.

If your business has not recently updated its values at risk, I encourage you to talk to your broker and get on the path to correcting the situation.  Take the time now–unless, of course, you can see into the future and therefore know when the fire is going to happen.

If your business carries business interruption insurance, you’re responsible for determining and reporting your values at risk to your insurance company.  Many businesses come up with this number one time in order to place business interruption coverage, and then don’t think about their values at risk number again–sometimes for years.

Businesses that carry business interruption insurance should re-evaluate the values at risk number yearly or whenever the business experiences a significant change.  The business interruption values at risk number should reflect the anticipated business interruption value at risk in the coming year–the year to which the policy will apply.

Businesses can save money on insurance premiums

Because of the tough economy these past couple of years, many businesses have suffered from a financial standpoint.  Businesses that have felt an economic impact due to the poor economy should review their values at risk to ensure that they are not over-insured, keeping in mind the anticipated outlook for their business in the coming year.

Businesses in this situation could be over-paying for insurance premiums they will never recover–and can potentially save money on insurance premiums.  The best course of action is to re-evaluate your business interruption values at risk and then talk to your broker.

On the other hand, if your business is seeing the light at the end of the ‘economic crisis’ tunnel and actually experiencing some growth–huzzah!  You still need to re-evaluate your business interruption values at risk because you could run into trouble if your policy contains a coinsurance clause.  I’ll discuss that scenario in my next post.

I, for one, was happy to slam the door on 2009 and am ready to do some business in 2010.  So if you’re a risk manager, corporate officer, or business owner, we can help you understand your values at risk so that you can make fully-informed business decisions. We’ve helped businesses, both large and small, with similar concerns about their values at risk, achieve the results they need to move forward with confidence:

“The end result was ideal not only for our insurance renewal process, but also provides us with a useful tool for understanding and measuring our BI exposures going forward,” John P. Sullivan, Vice President and Treasurer, JDSUniphase.

I wish everyone out there good health, happiness, and the very best in business this year.