Analysis: Business interruption - Lost in translation

As brokers gather in Manchester next month for the British Insurance Brokers’ Association’s annual conference, Biba is warning that firms taking out business interruption cover face a high risk of underinsurance.

At the heart of the problem is the issue of insurers and insureds not speaking the same language. Firms often misinterpret the specific definitions of the terms used by insurers when selecting cover.

As early as 2008, the Chartered Institute of Loss Adjusters took stock of the issue. At a CILA conference that year, a survey revealed that 52% of declarations on declaration-linked business interruption policies were too low.

“Our concern is that there has been a lack of clarity for some time now, for insurers, adjusters and customers, over certain aspects of BI policies,” the body says.

The problem seems to arise when the definitions of specific terms get lost in translation.

“For example, there is often a big difference between the technical meanings of words in a policy and the way those words are used in everyday business,” adds the CILA.

“The way indemnity periods are worked out can be confusing. In these circumstances, it is hardly fair to expect customers to have the right answers.”

Gross profit

David Kelly, commercial claims and business interruption specialist at Morgan Clark, says: “Underinsurance in business interruption is incredibly common and this is mainly due to the way gross profit is defined by insurers as opposed to the way it is defined in the insured’s accounts.

“Declaration-linked policies as opposed to sum insured policies have attempted to address this problem, but by definition depend on declarations being made and made correctly.

“There is a lack of declarations being made as financial year-ends and renewal dates seldom, if ever, coincide and insureds become confused as to what figures they should supply.”

According to the CILA, the confusion around ‘gross profit’ arises from the term having no fixed definition, despite being used in common business parlance. In contrast to this, policies include an explicit definition that might be at odds with what the customer accepts as the meaning of the term.

Andrew Schütte, partner at Keoghs and member of the Forum of Insurance Lawyers, says: “Underinsurance has dogged BI for a very long time. The main reason is a lack of understanding of what is covered.

“Gross profit in a BI policy is a term of art that means something different to what gross profit means to an accountant or a finance director.”

In addition to this, the CILA says that insurers often pre-define gross profit, resulting in policies that may not be suitable for certain policyholders.

The CILA warns: “Businesses purchasing insurance can fail to appreciate the significance of this point, even after their insurer or broker brings it to their attention, such that any misunderstanding crystallises in a potential shortfall in coverage when an incident occurs.”

Simon Jones, director of Quadra Claims Services, agrees: “The greatest cause of underinsurance is that the gross profit as defined in the policy will differ in almost every case from the actual gross profit in the financial accounts, with the main culprit normally being wages.”

The CILA believes that as the issue arises from the “erroneous assumption” on the part of the policyholder that the definition of gross profit in their policy is the same as in their accounts, an easy fix may be to introduce a new term altogether.

It has suggested the terms ‘insurance profit’, ‘insurance gross profit’, and ‘insurable profit’ as possible replacements for ‘gross profit’. 

Indemnity period

As part of its 2018 manifesto, Biba has pledged to continue “stressing the importance” of selecting a suitable indemnity period.

Schütte explains: “An insufficient indemnity period could be considered a form of underinsurance. It means the insured may not have cover for the full period of any outage.”

Many policyholders select a 12-month indemnity period. Gavin Dollings, director of commercial underwriting at Covéa Insurance, finds this inadequate as the majority of businesses will need more time to rebuild and replace infrastructure and machinery.

He adds: “The other fundamental issue is that when policyholders request longer indemnity periods, they will typically take the 12-month figure and multiply it by the length of the required indemnity period. For example, for 24 months, they simply double the sum insured.

“This makes no allowance for current or planned business growth and if the starting point is based upon historical results, the gap widens further.”

Jones says: “In relation to maximum indemnity periods, while these may be too short on occasion, we would expect almost all policyholders to understand the relevance and implications of selecting the length of the anticipated interruption period without any further explanation being required.

“It will be different for every business, even those operating in the same sector and will be related to the level of other risk management undertaken. It will be a matter of judgement for each policyholder and the potential for getting it wrong will be the same whatever questions or advice are included on a declaration form.”

Jargon monsters

Schütte believes there is a misunderstanding on the part of brokers and insureds on what BI policies actually cover.

“From a lawyer’s perspective, a large number of disputed first party claims arise over differing views as to what BI covers,” he says. 

“That is an indicator that the message as to what is being covered may not be getting through. BI is, undoubtedly, a technical product and it is striking that a number of the leading reported cases on insurance brokers’ professional indemnity claims concern the broker’s failure to advise its policyholder clients properly about business interruption insurance.”

Declaration form

In addition to its work promoting the value of suitable indemnity periods, Biba has pledged in its manifesto to create a new BI declaration template that can be used across the market to reduce underinsurance.

“It is hoped that the work that we are currently undertaking will assist members and their clients in addressing the issue of BI underinsurance,” says Graeme Trudgill, Biba’s executive director. “We hope to have the template out by the Biba conference on 16 May and that greater use of a declaration can reduce some of the underinsurance issues the CILA has highlighted.”

Mark Wing, partner at Clyde & Co, is cautiously optimistic. 

“Forms rarely fix problems,” he says. “Though a new form that asks different and better questions might help companies improve their understanding of where the risks lie.”

Kelly says: “The use of a simple declaration form could help tremendously in setting correct levels of BI insurance. This should be issued at each renewal and laid out in a similar format to a normal set of accounts.”

Schütte says: “A new declaration form could reduce the risk of information being ‘lost in translation’ between finance directors and insurers when it comes to being adequately insured and to making a fair presentation of the BI risk.

“This should be to the benefit of both parties, in that policyholders should get the cover they need and insurers should earn more premium.

“Firm figures on BI underinsurance are hard to come by but worldwide estimates run into the billions.”

Dollings says that Biba’s pledge to create a new BI declaration template will be well received by the insurance industry.

“The benefits will be clear,” he says. “Insureds will get the assurance that adequate cover is in place and insurance companies will achieve adequate risk premiums.”

Michael Ledgerton, head of major loss at Questgates, is doubtful that a form would alleviate the problem of underinsurance in its entirety, but believes it can go some way in helping.

“It could at least help to eliminate any ambiguity over how declared values/sums insured were initially calculated,” he says.

“The challenge would be to design a form that was simple enough to encourage take-up, but detailed enough to capture all the required information.”

Ledgerton believes that having a different form for each industry sector would run the risk of over-complicating the process, but could work for smaller businesses such as hotels or pubs.

“It is important to state that a form is never going to be a substitute for a proper detailed review of the business and the cover required,” he says.

Schütte believes that for the problem to be properly resolved, a better understanding of the product is needed across the market.

He says: “We have worked with the Lloyd’s Market Association to run business interruption masterclass programmes at Lloyd’s for the last four years but more BI training is needed across the market, including for the broking community. 

“The market ought to harness the experience of those who know their way around BI to spread knowledge throughout the business, all the more so given the fact BI is often the lion’s share of any first party claim and the rise of BI exposures in cyber insurance. 

“As well as education, there is a case to be made for simplifying and decoding BI wordings. The mechanics of BI make it one of the most complex insurance products out there.”  

There have been proposals in the past to change the methodology for calculating the sum insured by looking at gross revenue rather than gross profit.

The CILA argues that this would eliminate confusions around policy wordings, “dramatically reducing” the risk of a policyholder becoming underinsured.

The body, however, concedes that replacing gross profit with gross revenue will be “a significant and fundamental alteration and will not be without its challenges”.

Jones says: “A previous suggestion has been for all BI policies to become gross revenue policies.

“This would require the declaration/calculation of the correct level of turnover, which should cause no confusion, and then underwriters would calculate the appropriate premium given the loss experience and expected savings for the particular business/industry concerned.

“An obvious problem is that no business will be an ‘average business’ in each sector and, therefore, there would be winners and losers in terms of the actual value at risk and level of cover/premium collected, which might explain why this idea has never really taken off.”

The CILA has also argued that there would be further hurdles, including the need to review the certification and authorisation levels of various underwriters, and the need to re-evaluate various co-insurance and reinsurance arrangements.

Jones adds: “In our mind, now that the problem has been identified, considered and discussed ad infinitum, it would be a simple matter to just alter or add to the one question on the declaration form that asks for the level of gross profit cover for the next 12 months.

“It may be better to ask for the disclosure of sales per the last accounts, together with the cost of purchases (adjusted for stock movements) plus any other costs the insured consider varies 100% with turnover with a note that in the event of a claim, the amount of loss payable will be reduced to the extent that any costs listed do not vary with turnover.

“The projected level of turnover for the next 12 months should also be disclosed. While this may be slightly more onerous and still not perfect, it may be the best solution available.”

Either finding a replacement term for gross profit or installing a new system of evaluating the level of the sum insured are potential solutions that may go some way in addressing the issue. If no action is taken, it seems that business interruption underinsurance is likely to remain a problem in the long term.