INSURANCE

When a disaster strikes your business location, the location may be temporarily unusable. Your business will not be producing income and may continue to incur fixed costs (rent, utilities, etc.). Standard property insurance does not cover the loss of income caused by the temporary closure of the business. Business interruption insurance can be included in the property insurance coverage to cover this loss.

Business interruption coverage covers:

• The income your business would have made during the period your business location is unusable. This amount is determined by your historic financial records.
• The costs and expenses incurred by your business even though the location is unusable. Again, these fixed costs are determined by analysis of historical financial records.
• Costs incurred in having to move and operate from a temporary location.
• "Extra expenses" that may be incurred by keeping the location open. Extra expense coverage is offered by insurers to lower business interruption costs. For example, if your business can stay open by renting a piece of equipment, then the extra expense of the rental would be covered because the insurer would rather pay the extra expense of the rental than the cost of a shut down.

Business interruption insurance is probably the most valuable coverage your business can have. It is also coverage that is frequently overlooked by businesses. This is because it is easy to forget that income cannot be produced without an operating business or the business owner believes property insurance will cover all losses. Again, property insurance only covers the physical loss or damage to the location and contents of a business - it does not cover the loss of income while the location is being repaired or the continual fixed costs while the location is being repaired.

Business interruption coverage is difficult to purchase. This is because the business owner must make an educated guess about future business profit and base the amount of coverage on those projections.

Business interruption policies have significant coinsurance penalties for under insuring. A coinsurance penalty is a deduction applied by the insurer to the claim amount paid. Depending on the type of policy, the penalty can range from 20 - 50% of a claimed loss.

Another difficulty is that insurance policies define the amount of insurance coverage required in terms of "gross earnings" and most policies define "gross earnings" in a substantially different method than your business accountant would. Critically important that you have your accountant give you a determination of your "gross earnings" in the manner described in your policy's definitions. The University of Wisconsin has a form that you can print out that follows the most common definition - but, each policy can differ and you must review your policy's definition in detail.

Let's look at what can happen if your business has not purchased the correct amount of insurance and a coinsurance penalty is applied.

Assume, your business has "gross earnings" of $100,000. Assume your policy has a 80% coinsurance requirement. This means your business must purchase at least $80,000 in coverage or 80% of $100,000. This requirement in the policy is to prevent businesses from purposefully under reporting their income to lower premiums. If the business does not have 80% of its gross earnings in coverage a penalty will be applied.

The penalty is the resulting figure from dividing the amount of coverage actually carried by the amount required to be carried multiplied by the loss.

So, for example, if the business noted above had a business interruption loss of $50,000, but had only carried $50,000 in coverage, then $50,000 / $80,000 (remember the amount required to be carried) = .625 x $50,000 (the loss) = $31,250. That is, even though the company carried $50,000 in coverage and suffered a $50,000 loss, the actual insurer payout on the claim is only $31,250 - leaving the business short on its loss by $18,750. As you can see, you cannot base needed coverage amounts by an anticipated loss, but by an accurate reporting and calculation of gross earnings defined in the policy.

Insurers are becoming increasingly aware of the difficulty business owners have with these policies. A large number of insurers now include in their policies the Premium Adjustment Endorsement. If your policy does not, consider asking for the endorsement. The Premium Adjustment Endorsement helps eliminate the risk by allowing the business to over insure. At the end of the policy period, the premiums are recalculated and any excess premiums are returned. Thus, the business owner can purchase a higher limit of policy without wasting premium dollars.

The value of Business interruption insurance is best illustrated by example.

STEVE’S FLOWER SHOP (EXAMPLE)

Steve’s Flower Shop rents a commercial space in a downtown area. Steve’s income is derived primarily from purchasing wholesale live flowers and creating arrangements and selling those arrangements at retail. Steve’s shop has coolers to preserve the arrangements, an area to create the arrangements, and a retail space for customers. Steve’s rent and utilities are his highest expense. To save costs and increase profits, Steve’s purchases its wholesale flowers in bulk through a local distributor with a long-term contract. Let's say Steve’s clears $500 per day. Of that amount, $350 is cost for utilities, rent, wholesale product, supplies, and etcetera. Steve’s makes $150 per day which is acceptable to Steve - this is his retirement business after years as an overworked business lawyer.

Then… the storm comes. Steve’s shop is wiped out. The commercial space is uninhabitable. The coolers are gone. A shipment bound for a customer is gone and the stock is gone. Steve submits a claim to his property insurer. Within a few days, the insurer has put Steve in touch with a contractor and has cut a check to Steve to replace the equipment.

The contractor, owing to a lack of supplies in the devastated area, cannot begin work for two weeks. The cooler company cannot deliver new coolers for two weeks. Once work begins it will be another two weeks until operation can resume. Steve’s will be out of business for one month.

Steve must make his rent and utilities payment - these payments do not stop because of disaster. To keep his wholesale contract, Steve must place a minimum order with his supplier. Steve’s is still incurring $300 per day in expenses. Steve cannot sell any flowers. Steve’s will still have $9,000 in expenses for the month and no income for that month out of operation. Put in terms of profits, it will take Steve’s two to three months of profit just to zero out the loss in expenses.

It is even grimmer if Steve depended on the $4500-5,000 of profit as his sole source of personal income. Steve still must pay personal expenses - with no income. Can Steve even survive the three months to cover this one month of lost income?

IF STEVE’S HAD BUSINESS INTERRUPTION INSURANCE

If Steve’s Flower Shop had Business interruption insurance, then the insurance would cover the amount lost due to the interruption based upon the time, quantity, and value of the lost production. Steve would submit a claim based upon his business records showing that he "would have" had $15,000 in sales with $10,500 in expenses and a profit of $4,500. Steve’s Flower Shop would have this amount covered in addition to the property coverage replacing the physical location.

IF STEVE’S HAD "EXTRA EXPENSE" COVERAGE

If Steve’s can still get wholesale flowers, then Steve’s may be able to open up temporarily at another location. Steve finds another location that charges additional rent for the short term rental. Steve can rent a cooler. Steve has to drive further to make deliveries. But, Steve’s can get up and running in a few days. With "extra expense" coverage, the extra expenses of increased rent, cooler rental, and increased delivery costs would be covered in order to get the business up and running. In fact, the insurer may help to get this done because extra expense is typically much cheaper for the insurer to pay than a full business interruption loss.

The example here is over simplified. However, it is reflective of the reality of most small businesses. Many small businesses fail after a disaster. The businesses fail, not because of a lack of property insurance, but because the business could not recover from the loss of income.