7/29/2004
Does Your Business Have the Right Commercial Insurance Coverage?

By DANIEL M. EDWARDS, MA, CA•IFA, CA•CBV, CFE, Partner Claims Valuation & Litigation Support

Regrettably, many business owners do not fully understand their insurance coverage until a claim occurs. Once a claim occurs, if they do not have sufficient coverage, or if they have the wrong type of coverage, they may not receive adequate compensation for the losses suffered.

Accountants often assist insured businesses in the determination of the amount of a loss. For example, a business which suffers a fire may have claims for loss of earnings; extra expenses; clean-up costs; loss of inventory; and damage to property and equipment. The amount recoverable will depend on (a) the type of coverage purchased, and (b) the amount of the insurance coverage.

Property Damage

Coverage for property damage may be based on either replacement cost or actual cash value. Where the coverage is for actual cash value only, a deduction for depreciation (of capital property) will be made (or, in the case of inventory, there will be a deduction for inventory obsolescence). In either case, the amount payable may not be sufficient to replace the items lost or damaged. Further, in many policies with replacement cost coverage, the insured must replace the lost or damaged property, or the basis of settlement will revert to actual cash value.

Business Interruption

Coverage for business interruption loss is more complex. In Canada, there are two primary types of coverage for business interruption loss: (1) coverage for loss of Gross Earnings; and (2) coverage for loss of Profits. Be careful – in insurance policies, these terms have specific definitions which differ from the corresponding accounting definitions. The term “Gross Earnings” means net sales (or, for a manufacturer, net sales value of production) minus the cost of materials and supplies. The term “Profits” means net profit before tax plus insured standing charges (generally fixed or semi-fixed expenses). The policy forms are generally referred to as a Gross Earnings form or a Profits form respectively.

Gross Earnings and Profits Forms

Gross Earnings are calculated before deducting the payroll cost (“Ordinary Payroll”) of “ordinary” workers who would be laid off during a disruption. Therefore, unless excluded by endorsement, Ordinary Payroll is insured under a Gross Earnings form. In other words, during an interruption, the policy will respond to the cost of maintaining and paying the ordinary employees. This may be necessary if, for example, the employees would be difficult to replace (due to specialized skills), or if they must be paid pursuant to a collective agreement.

Profits are determined before adding back Ordinary Payroll to the bottom line. Therefore, unless included by endorsement, Ordinary Payroll is not insured under a Profits form. During an interruption, the policy would not respond to the cost of maintaining idle employees. This is sufficient if, should a disruption occur, the employees would be immediately laid-off, without pay. Alternatively, a business may purchase limited Ordinary Payroll coverage, for (say) the first 90 days following an insured event.

In a manufacturing plant, an example of the Ordinary Payroll would be the plant labour, generally paid on an hourly basis. Management staff, along with salaried employees (for example, involved in administration or sales) would usually not be Ordinary Payroll – they would be fixed expenses (to be considered when calculating the amount of coverage required).

There is another important difference between the Gross Earnings form and the Profits form. The Gross Earnings form normally covers the business interruption loss until the replacement or repair of the damaged property can be completed with due diligence and dispatch. On the other hand, the Profits form covers the business interruption loss until sales return to normal. The type of coverage required depends upon the nature of the business, and, in particular, the extent to which the business depends upon customer relationships. For example, a gas station at a busy city intersection would return to normal almost immediately, whereas a manufacturer with a few major customers may lose some customers to its competitors.

Sufficient Coverage is Essential

Aside from the type of earnings loss coverage required, the business owner must ensure that sufficient coverage is purchased. This may involve a number of considerations. Firstly, the amount of the coverage will be compared with the amount required for the 12 months following the date of loss. Secondly, one must be careful to correctly determine the amount of coverage required. Many business owners may assume that if the business has traditionally generated annual profits (before tax) of $100,000, then coverage in the amount of $100,000 would be sufficient. However, this is not the case, because the definitions of Gross Earnings and Profits are not based on “the bottom line.”

The responsibility for ensuring that a business has the right type of coverage for business interruption loss, and the required amount of business interruption loss coverage, lies with the business owner and his/her insurance broker or other insurance professional. However, we at Soberman LLP have the experience to provide informal guidance in this regard.

Daniel M. Edwards

We are pleased to announce that Daniel M. Edwards joined our firm as partner in our Claims Valuation & Litigation Support Group on April 1st.

A designated specialist in Investigative and Forensic Accounting and Business Valuation, Daniel has 14 years experience in the quantification of losses or payments in insurance and litigation claims.

Our Claims Valuation & Litigation Support Group advises both plaintiffs and defendants, and both insurers and insured persons or businesses in connection with insurance or litigation claims. Our professionals have the experience necessary to provide a fair and appropriate recommendation regarding the amount payable or the damages suffered.

Daniel is joined by Kristin Matthews, Helen Sbeit and Michelle Silverberg.

The contact information for our Claims Valuation & Litigation Support team is as follows:

Daniel Edwards, 416 963 7221, dedwards@soberman.com
Kristin Matthews, 416 963 7239, kmatthews@soberman.com
Helen Sbeit, 416 963 7199, hsbeit@soberman.com
Michelle Silverberg, 416 963 7200, msilverberg@soberman.com

This article has been prepared for the general information of our clients. Specific professional advice should be obtained prior to the implementation of any suggestion contained in this publication.