Consequential losses also need cover

THE FIRE policy for a factory may be arranged very well. The insurer may also settle the claim speedily and fairly. But there will always be a time lag as between the date of the fire and the date on which the reinstatement is completed and production resumed.

During this interim period, the entrepreneur may find himself in trouble. His factory is either producing less or not producing at all. The earnings keep dwindling if not stopping totally. Yet all business expenses have to be met. Wages and salaries have to be paid. Overheads like rent, interest and insurance need to be taken care of whether there is production or not.

In order to protect businessmen in such situations, the insurance industry provides what is known as the Consequential Loss of Profits (Fire) Insurance. For almost every industry, this insurance is advisable. In cases where reinstatement of the damaged building, plant and machinery can take a long period and where expenses to be met whether there is production or not are very large, this insurance is a must.

What does the policy cover?

The consequential loss of profits policy will pay for loss or reduction of net profit before taxation due to fire or any other peril insured under the fire policy (material damage) concerned.

It also pays for all standing charges which continue to be payable during the period of interruption. Additionally, any increase in the cost of working necessarily and reasonably incurred in order to maintain normal business activity and reduce the consequential loss is also payable. An example would be getting the normal work carried out elsewhere paying higher rates.

The policy is issued only in conjunction with the fire policy for the property relating to the business and only relates to perils covered under the basic fire policy. If the material damage claim is not payable, there will be no payment under the CLOP policy also.

However, there is an added commercial advantage if the CLOP cover is taken. The insurer will process and settle the material damage claim with a sense of urgency. The taxi meter is on for the CLOP cover. Sooner the reinstatement of the damaged/destroyed property and restoration of production to normal level, the lesser will be the amount payable for the CLOP claim!

Indemnity period

In policies that cover material damages, the period of insurance is the period during which the insured is indemnified. But in a loss of profits policy, the period of insurance and the indemnity period may not be identical. Let us say the period of insurance is one year from January 1 to December 31. The period of indemnity chosen in the policy may also be one year. But it will start on the day of occurrence of a damage and end not later than one year from that date. All losses due to drop in production during the indemnity period will be taken care of by the insurer in terms of the policy.

The indemnity period chosen can be a few months, one year or even more. As the policy covers the earning of the business lost during the indemnity period, the selection of indemnity period calls for careful and imaginative assessment by the insured. The required period will differ from trade to trade and will depend on prompt availability or otherwise of replacement machinery, possibilities of getting the work done during the period of breakdown by outside contractors and other related factors.

Sum to be insured

As in the case of the indemnity period, great care has to be exercised in arriving at the sum to be insured. Where a fire policy covers a physical asset, it is relatively easy to arrive at the sum to be insured. But in a loss of profits policy, the sum insured has necessarily to be what the Americans call "a guesstimate".

This problem arises because the sum insured has to take care the net profit before taxation + standing charges during the period of decline in production. It will be easy to fix the sum insured for the period of insurance but the CLOP policy provides cover for the indemnity period which could start much later and continue for the estimated indemnity period in the policy. Therefore in arriving at the sum insured, the management will have to take the net profit before taxation + standing charges for the previous year's turnover as a base. On these figures taking into account the expected increase / decrease in production and/or sales during the current year as also possible indemnity period an adjustment has to be made in for arriving at the sum insured.

Realising all these problems, the industry provides that for a CLOP policy, the premium paid when taking the policy is only a deposit. In the event of any shortfall in the gross profit, the policy provides for a refund of premium up to 50 per cent of the deposit based on the annual audited figures for gross profit during the period of insurance.

Turnover basis of insurance

The policy may be issued on turnover basis, output basis or difference basis.

Here the insured is engaged in trading activity or manufacture and supply of goods on existing orders without accumulation of stocks. Any reduction of turnover in monetary terms will serve as a measure of indemnity if the insured is in the habit of stocking manufactured goods and supplying out of it even during the interruption period.

Output basis

Here the quantity of output is the index. Any interruption in activity resulting in reduction of output even though the sales are kept up from buffer stocks will make way to true indemnity. Where the insured produces a single product, this basis will be easy to follow. Care should be taken where the insured is a multi-product manufacturer.

Note: If there were to be bye-products to the main product, the output basis may not be the ideal one (example: oil refinery). In such cases, another index, namely, "throughput basis' based on the quantity of raw material fed in, may be suitable.

Difference basis

In the normal method the standing charges are to be listed out and incorporated in the policy schedule. Any omission may result in under-insurance.

Instead of listing out of the standing charges, it may be worked out as under: Standing Charges = (Turnover + Closing stock) - (Specified working expenses + opening stock).

Insurer will not pay for

Under-insurance against material damage under the fire policy.

Depreciation in the value of undamaged stocks after a fire.

Cost of preparing fire and profits claims (auditor's fees for certifying the loss of profits claim can however be covered on payment of additional premium).

Litigation costs for fire and profits claims generally.

Third party claims.

Loss of goodwill.

Failure to recover book debts owing to the destruction of records.

Difference between value of stock at the time of fire and value at the time of subsequent replacement.

Deterioration or spoilage of goods that are not actually damaged by fire.

Additional clauses to improve coverage

Accumulated stocks clause: In adjusting any loss, due allowance shall be made if shortage in turnover is postponed by its being temporarily maintained from accumulated stocks of finished goods in the warehouses.

Departmental clause: If business has different departments/sections, each earning a different rate of gross profit, this clause can be incorporated so that the gross profit suffered by the affected department will be indemnified. It must he established quite in advance that the accounts of the business are arranged in such a way that independent trading results of each department are ascertainable.

Claims

As the insurance company will be advised regarding the occurrence of damage due to fire or any of the insured allied perils, only a letter has to be addressed to the insurance company that a loss under the LOP policy has arisen and they should arrange to adjust the claim early.

However, it must be ensured that (a) The surveyor appointed by the insurance company is given full co-operation by one and all concerned; (b) All such records as may be required by the surveyor for completion of his task are made available to him; and (c) All steps are taken to avoid any aggravation of loss.

Basis of settlement

The sum insured is only a provisional estimate based on the expenses actually incurred in the immediately prior financial year and the revisions expected on the basis of the budget for the insured period.

When a claim occurs, the procedure will be to take the standing charges and net profit for the last financial year as the base.

Then, a check will be made as to the revision in the trend of working from year-end to the date of the occurrence of loss. For the period of interruption, the actual sum insured will be considered to be that for the previous financial year multiplied by a factor for the revision in the trend of working.

During the period of interruption, the increased cost of working will also be paid for and the loss payable would be determined by applying that proportion of the sum insured to the percentage drop in production during the interruption period. This is often a complicated accounting exercise and the surveyor also will be a senior Chartered Accountant.

For ascertainment of liability, the insurance on gross profit is limited to the loss of gross profit due to reduction in turnover and increase in cost of working.

Modern developments

Though earlier, the consequential loss policy was issued only in respect of fire insurance, modern industrial and commercial requirements have paved the way for consequential loss cover as an adjunct to: Machinery breakdown insurance, contractors' all risks insurance, marine-cum-erection insurance, boiler insurance and electronic equipment insurance among others.

In respect of all these developments, the basis for handling losses is by and large the same as for fire insurance.

In all cases, the decision whether to go in for consequential loss insurance or not will depend on the period for which the business interruption may occur; and the magnitude of standing charges that would have to be borne whether there is any production or not and the speed with which production can be restarted in alternative premises.

For instance, for many IT companies a fire loss could probably involve only increase in cost of working for a certain period with no violent impact on net profit. This is because an IT company can restart its internet and software development work in alternative premises almost immediately.

N. Ramachandran

(The author is an insurance consultant. He can be contacted at: nramac@md3.vsnl.net.in).

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