Common pitfalls in business interruption insurance.

COMMON PITFALLS IN BUSINESS INTERRUPTION INSURANCE

Tips on what to look for to ensure complete--not partial--recovery from a disaster.

Economic ruin from a business interruption may be averted through adequate insurance coverage. However, how to calculate such coverage is often misunderstood. A prospective insurance buyer should not attempt to make this determination; it should be left to CPAs and others with expertise in the field.

Business interruption insurance insures a business for earnings that would have been generated had no interruption occurred. This article discusses the common fallacies that arise in dealing with business interruption insurance. These may stem from the form of the policy--gross earnings or net income. They also may arise because insurance agents themselves are unfamiliar with how to calculate coverage properly or because the insured is inexperienced at filing a claim. Moreover, recoverability may be impaired when the due diligence and dispatch clause of the policy is not met.

THE GROSS EARNINGS FORM

Although insurance and accounting terms may sound similar, CPAs should be aware that definitions differ. For example, practitioners should not confuse "gross earnings" with "gross profit." Gross earnings is a technical insurance term with only limited similarity to the accounting concept of gross profit. It refers to a subtotal in the formula below:

        Gross sales
minus   Sales deductions

equals Net sales minus Gross earnings deductions equals Gross earnings minus Noncontinuing expenses equals Business interruption loss times

Co-insurance percentage equals Collectible business

        interruption loss
plus    Extra expenses

equals Total collectible business

interruption loss

The formula begins with "gross sales"--a term that's defined similarly by accountants and insurance companies. "Sales deductions," however, consist of discounts, commissions, bad debt and other items directly related to sales. "Gross earnings deductions" include only raw materials and consumable supplies. This insurance concept is not the same as the accounting concept of cost of goods manufactured, because gross earnings deductions don't include any other inventoriable manufacturing expenses--for example, direct labor and overhead. These expenses are considered elsewhere. Therefore, gross earnings is quite different from gross profit.