There are a couple of recent events which caused me to reflect on the quality of job we are doing to help our clients manage their risk by designing an effective insurance program. The first was attending the annual conference for the AAIMCo. I had the fortune to sit next to a forensic accountant. One of his roles is determining the value of a business income claims after the loss occurs. I suppose I already knew this but spending a few day swapping stories made it crystal clear we as insurance professionals are not doing a very good job at helping our commercial clients.
The second was being asked by a friend and fellow consultant to review an article he wrote for IRMI outlining a recent case he had served as an expert witness on. The case centered on a business income claim, where the insured ended of being significantly underinsured.
Thinking back along my underwriting career most of the business income programs have been fraught with errors. Some featured poorly designed coverage for simplicity’s sake. Some used unrealistic limits which the insured had no hope to collect in event of a major insured shutdown. Some were designed with the producer’s safety in mind. Some caused the insured to pay excessive premium.
Business Income can be a difficult coverage to structure. Unfortunately, it is also a critical component of an effective insurance program. We as insurance professionals and risk managers need to do a better job.
Before I get started on talking about the steps in designing coherent business income coverage programs, I want to point out a couple of coverage basics. The coverage does not cover lost sales. Rather it net profits and continuing expenses had the lost not occurred. Net profit is an entirely different thing than sales. Net profit varies as a percentage of sales depending on the type of business and how each individual business is managed. Consider Amazon had $386 Billion in sales while their net profit was only $21 Billion in 2020. Their profit margin was 5.4%. Therefore, their maximum annual business income exposure was only $21,000,000,000 plus continuing exposure.
To design effective program, you will have to investigate various aspect of the client’s operations and performance. For example, you’ll need to determine how long the restoration period may extend, the level of seasonality, if there are any additional challenges or barriers to re-attaining their exist level of revenue, and what their financial performance looks like throughout the year.
Depending on lease requirements, many businesses who lease a place of operations may be able to quickly relocate to a suitable location. Therefore, their exposure may be to a restoration period significantly shorter than 12 months. Thus, resulting in structuring business income coverage with a limit much lower than a full annual value, lower coinsurance requirement, and a significant reduction in premium.
On the other hand, some operations may lend themselves to a longer restoration period. For example, a manufacturer who relies on specialized equipment to perform functions may have a period of restoration longer than 12 months as it may take more time to replace and install the equipment. Therefore, to appropriately cover the period of restoration, they may need a limit greater than the annual business income value.
Analyzing how long anticipated period or restoration must be performed before we can make informed choices about limit and coinsurance levels. Approximating or estimating the time it would take to rebuild is not easy. The client may have some valuable input if they built the structures for their operation. But a more likely scenario is they are either renting the structure or they purchased the building. Property claims adjusters and contractors may be able to shed light on estimating an anticipated time frame when the structure would have to be rebuilt.
In the case of renters who would be able to relocate the insured may remember how long a period it took to move into the location and make it functional for their operations. Such information may be valuable in estimating the length of period to structure the business income terms and limits around.
Often, little thought is given to the seasonality of profits. This is particularly the case when the client opts for either a monthly limitation or the maximum period of indemnity business income options. Consider businesses whose sales are highly seasonal such as toy retailers. Frequently, their “profits” are concentrated in the last 2 months of the year. From January to Thanksgiving, they operate at a loss. It is not until the Christmas season that they make any profits. That is the basis for the term “Black Friday.” Many retail outlets go from being in the red to making a profit in the short time between Thanksgiving and Christmas holidays.
The basic Business Income Form (CP 00 30) automatically provides 60-day extension of the period of restoration for businesses to re-attain the level of operations they had prior to the loss. For some businesses where traditional advertising and marketing activities aren’t likely to generate new customers or bring old customers back would have a greater need for additional time. Both ISO and AAIS (American Association of Insurance Services) offer coverage extensions which extend the restoration period up to 360 after the period of restoration ends. Insurance professionals should be aware of commercial enterprises who need extra time to get back into the position they were in before the loss.
Finally, effective design of an effective business income coverage requires analysis of the client’s financial statements. Reality is the first step in designing a program which works best for the insured is completing a Business Income Worksheet. The business income worksheet will form the starting point of where you go to customize the coverage to meet the client’s needs. You cannot complete an accurate business income worksheet without reviewing the insured’s financial statements.
I have observed some insurance professional express reticence in asking for a copy of the client’s financials under the guise of probing into too much personal data. We need to get beyond it. Our job is to provide a professional service, not unlike a medical practitioner. Just as one does not expect their doctor to be reticent about asking about our drinking or exercise habits. We need to be confident and dig to have the information we need. Fortunately, tax forms which businesses are required to file provide virtually all the information we need to complete a worksheet.
Some of you all are probably wincing right now. Many agents have a difficult time completing a business income worksheet. Truth be known, many underwriters have a difficult time understanding business income worksheets. But the short story is business income worksheets are not much more than modified profit and loss statements. It is highly recommended both agents and underwriters learn their way around financial statements.
Once you know where to find the data lies in the insured’s tax returns it should be relatively easy to construct complete and accurate business income worksheets. With a little bit of Excel know-how, one can easily create a program or spreadsheet to do the work for them. I have created an Excel Program that not only assists with completing a Business Income Worksheet, but also assist in analyzing business income exposures. Click here to get an idea of how to create one.
Once you have an accurate business income worksheet in hand, you have a good annual picture of the client’s business income needs. From there you can begin to customize their terms and conditions and structure them to provide more cost-effective coverage.