In this post, we examine some of the fundamentals of business interruption (BI) insurance and the value that forensic accountants bring to navigating the complexities of claims associated with business interruption.
The Fundamentals of BI Insurance
What is BI insurance? BI insurance replaces business income when a covered cause affects operations. BI policies are complex and when the worst happens, calculating the loss of business income can be challenging.
Business income is net income, i.e., net profit or loss (before income taxes) that would have been earned or incurred had the disruption not stopped operations, plus continuing operating expenses incurred during the period of restoration. BI insurance is designed only to restore the insured back to where it would have been financially, had business continued as normal. It does not make the insured financially better or worse, nor does it cover the cost of property loss or damage.
What, then, is a covered cause? Covered causes are defined in the policy; these generally include fire, hail, ice, lightning, vandalism, weight of snow, wind, explosions and falling objects. Causes generally excluded from coverage are bacteria, earth movement, flood, military action and war, mudslides, nuclear reaction or radiation, offsite power outage, or a virus, such as COVID-19.
Triggering the Business Interruption Claim
Three conditions – once met – may trigger a claim to recover income lost due to an interruption:
- A direct physical loss or damage at the described premises caused by or resulting from a covered cause.
- A necessary suspension of operations.
- An actual loss of business income.
If any one of these events does not happen, then a claim cannot be opened.
Business Interruption Claims and Miscalculations: What to Watch For
Several common miscalculations that cause the insurer to overpay include:
- Calculating lost revenue rather than lost net income overstates the loss
- Not applying the deductible/waiting period
- Finally, insureds do not always apply the indemnification period
In addition to genuine miscalculations, BI claims can also include fraud. The FBI estimates that non-medical insurance fraud costs $40 billion every year. Insurers should carefully examine each claim to ensure claimants are not intentionally manipulating their financial health, and thereby being overcompensated.
The following is a list of red flags to watch for when evaluating a BI claim:
- The insured insists on settling the claim quickly.
- The insured’s financial records show the operation had been generating losses or minimal revenue, yet the claim reports a considerable loss.
- The insured cannot produce invoices or receipts for extra expenses or produces those with missing information.
- The claim was made shortly after the policy started, after the coverage amount was increased or right before the policy ended.
- The insured previously asked hypothetical questions about losses like the alleged loss.
- The insured’s financial records contain abnormal or uncertain information.
- The insured refuses to provide applicable documentation to support the claim.
If any of these red flags are present, it may be necessary to engage a forensic accountant to assist in the evaluation of the claim.
What to Expect When Working with a Forensic Accountant on BI Claims
When an insurer engages a forensic accountant, their primary responsibility is to review and evaluate the insured’s loss calculation. The forensic accountant is not expected to independently calculate the insured’s loss, nor are they responsible for determining if the claim meets the standard required.
First, the forensic accountant will want a copy of the business interruption policy in order to understand what is covered. These policies specify the period of restoration, including the deductible/waiting period and the maximum period of coverage, or period of indemnification. There may be specifications in the policy regarding maximum indemnification per month. Finally, the BI policy will indicate whether extra expense is covered, and if so, what costs are included.
Next, the forensic accountant will request a wide variety of documents from the insured – financial and more – to develop a baseline for how the business was performing before the covered loss. Typical documents include:
- Audited financial statements
- Current year unaudited profit and loss statement and balance sheet by month
- Budget or forecasted financial statements for the year of loss
- General ledgers and bank statements
- Invoices and employee timesheets in cases where extra expense coverage is included in the claim
- Sales, inventory, and payroll records
- Other, non-financial, supporting documentation such as an overview of the business operations, a summary of the loss event, and a summary of the repair/remediation process
- Documentation that verifies the period of restoration
In order to prove the start and end of an interruption, the following may also be requested:
- notification to insurer of suspension (for example, letters or emails)
- invoices or billings from parties engaged to remediate or repair, and other claim reports (for example, hard costs claims)
The forensic accountant may also request industry reports to compare the performance of the insured’s operations to similar operations in the industry and to determine seasonality trends if necessary.
Next Steps: Confirming the Calculation of Loss of Business Income
With this groundwork in place, the forensic accountant will request a copy of the insured’s calculation of loss of business income. Any workpapers and schedules prepared by the insured will be needed. At this time, the insured should stipulate any assumptions or methodologies used in the calculation.
The first step in calculating loss of business income is to determine the period of restoration. Once the period has been established, a base period of similar length from historical financial results should be used. For example, if the period of restoration is three months, then the base period used should be three months. Revenue regularity can affect the base period though. If revenue has seasonality, then the time frame of the base period may need to be adjusted. In addition, there may be other factors affecting revenue to consider, such as
- a new operation for which historical financial records do not exist
- competitors entering or leaving the market which can affect future earnings
- a recession or pandemic that may positively or negatively affect an insured’s business.
With the period of restoration established, there are two methods for calculating lost net business income:
Method #1 adds net income that would have been earned or incurred and continuing expenses, and then subtracts the deductible to arrive at lost net business income.
Method #2 starts with expected revenue, subtracts actual revenue (in cases where operations are not completely shut down) and subtracts offset revenue to calculate total revenue. Next, noncontinuing expenses, which can be calculated as a proportion/percentage of revenue, are subtracted and finally the deductible is subtracted to arrive at lost net business income.
Claim Evaluations with VERTEX
At VERTEX, we have a rigorous methodology for the claim evaluation process. It starts with understanding the insured, their operations and the circumstances and potential timeline around the loss event. Next, we send a preliminary request for information to the client/insurer or directly to the insured, if preferred, and use that information to evaluate and analyze the insured’s claim. Once we have completed this initial analysis, we submit our recommendation on the claim amount to the client. Then we assess the insured’s loss claim carefully, including any assumptions made by the client to analyze the insured’s calculations. We identify any questions regarding the claimant’s methodologies. Finally, we create independent work papers that identify and quantify discrepancies, if any, with the claim amount.
VERTEX experts have the experience and education to work through any issues that might arise during a business interruption claim. We have worked with many clients, of many types to resolve issues and bring about a successful conclusion.
To learn more about business interruption claims, the role of forensic accountants and how VERTEX can help, please contact John F. Boyle, MSM, CCA, CCP, Vice President, (620) 218-4637.