The standard Business Income (And Extra Expense) Coverage Form CP 00 30 04 02 says, "We will pay for the actual loss of Business Income you sustain due to the necessary ‘suspension’ of your ‘operations’ during the ‘period of restoration.’" Business Income is defined as:
- Net Income (Net Profit or Loss before income taxes) that would have been earned or incurred; and
- Continuing normal operating expenses incurred, including payroll
Recovery under this provision is typically established by calculating the business’ net profit before income taxes that would have been generated had no loss occurred, plus the normal operating expenses that continued during the period of restoration after a loss. For example, if a business would have earned $100,000 in net profit before the loss and it incurred $100,000 in continuing normal operating expense after the loss, the business income figure would be $200,000. The FC&S Bulletin opines that this standard calculation “should put the policyholder in the same position as it was before the loss. The profits that would have been earned are safely in pocket, and the operating expenses that were actually paid out after the loss are reimbursed. Both the profit and the operating expenses would have been covered by earnings before the fire. After the fire, they are covered by insurance. It does not matter what the operating expenses might have been before the fire (other than to help calculate the before-loss profit), because the existence of a profit assumes that all operating expenses, whatever they were, were covered by earnings with funds left over.”
This formula, however, is somewhat problematic for those businesses that were operating at a net loss at the time of loss. For example, if it is found that the business was operating at a net loss of $100,000 (-$100,000) and it incurred $200,000 in continuing normal operating expense after the loss, the business income figure would be $100,000. In other words, under the language of this provision, the net loss would be offset by the operating expenses and, depending on the calculations, the formula could yield to a zero ($0.00) recovery.
Courts have agreed with this answer. In Liberty Mut. Ins. Co. v. Sexton Foods Co., 854 S.W.2d 365 (Ark. App. 1993), the court said:
In order to assess the amount of the loss, the amount of business income should be determined by adding the amount of net income and the amount of continuing normal expenses; if net income is a positive number (which will occur whenever there are net profits), the amount of business income will be the sum of two positive numbers, and the insured will be entitled to recover that amount; if, however, net income is a negative number (which will occur whenever there is a net loss), the amount of business income will be the amount of continuing normal operating expenses reduced by the amount of the net loss; if the amount of the net loss that would have been incurred had there been no business interruption exceeds the amount of the normal operating expenses actually incurred, the resulting number is a negative number, and there can be no recovery for an actual loss of business income.
In deciding a similar case, a Tennessee Supreme Court judge in Continental Ins. v. DNE Corp., 834 S.W.2d 930 (Tenn. 1992) wrote that:
[I]gnoring ‘net income’ whenever there is a net loss would put the insured, in all cases when there is a net loss, in a better economic position from having its business interrupted than it would have occupied had there been no interruption of its business operations. Such an interpretation would obviously be inconsistent with the purpose of providing insurance, as well as with the decisions of other cases involving similar issues.
Carriers will also rely on Dictiomatic, Inc. v. Mercury Cas. Co., 958 F.Supp. 594 (S.D. Fla. 1997), where a court held that “business interruption insurance may not be used to put the insured in a better position than it would have occupied without the interruption,” to deny or offset recovery for operating costs if the business was not doing so well prior to the loss.
A decision in California has recently leveled the playing field on this issue. In Amerigraphics v. Mercury Casualty Company, 182 Cal. App. 4th 1538 (March 23, 2010), the Court declined to follow Dictiomatic and held that:
[i]f a catastrophic event damages an insured’s business premises and prevents the insured from being able to operate, any business in that situation would face two distinct problems: (1) a loss of money coming into the business (loss of income), and (2) payment of ongoing fixed expenses, even though no money is coming in. A reasonable insured would see that the definition of “Business Income” has two distinct components: (i) net income, and (ii) continuing normal expenses. Because the definition provides that “Business Income” includes both items, a reasonable insured relying on the plain language of the clause would reasonably conclude that the policy covers both items. Indeed, we note that the “Business Income” provision appears in the policy under the preceding heading of “Additional Coverages.” Given its placement in the policy and the plain language of the provision, it would be objectively reasonable for an insured purchasing the policy to construe it as protecting both its lost income stream and as defraying the costs of ongoing expenses until operations were restored.
Under both parties’ interpretations, an insured business will be paid if the business were operating at a profit prior to the covered loss. It is only when a business was operating at a net loss greater than its operating costs that it would not be paid at all under Mercury’s interpretation. But there is nothing in the policy language to suggest to an insured that if a business is not earning a profit it should not expect coverage for its continuing expenses during the period it cannot operate. It is not unusual for business income to fluctuate from year to year. A business should not have to be concerned that if it does poorly for one or two years and a covered catastrophic loss occurs during that time frame, then the business will not be paid anything under the “Business Income” provision. In essence, Mercury‘s interpretation relies on the implied assumption that only a profitable business would be protected by the provision. A business that is just starting out may operate at a temporary loss until it becomes established and secures a customer base. If that business knew that there would be no coverage under the “ Business Income” provision of the policy for ongoing expenses if it suffered a catastrophic loss, there would be no point for that business to purchase the additional coverage.
In essence, Amerigraphics at least allows recovery for the continuing expenses despite the net loss, which is a breath of fresh air for many businesses.
In order to protect start-up companies or businesses who operate at a net loss for at least five (5) years, brokers and risk managers often recommend the use of a Valued Business Income Form. The valued form was first drafted by Henry R. Dalton, a Boston insurance agent, in the late 1800s.
Valued forms pay a set amount for each period of business suspension. The time period could be twenty-four hours, one week, or one month.
Because the limit is established prior to the loss, there is no need to perform a lengthy calculation to establish the amount of loss. This means that the issue of a net loss or net profit is addressed prior to the insurance being purchased. There also is no coinsurance clause. Valued forms remove some the uncertainties that can affect recovery under the standard forms (ie. operating at a net loss). Valued forms, however, come with high premiums and not every business may benefit from their use.
The FC&S Bulletin warns on the use of valued forms:
There are several reasons that professionals are cautious of using the valued form of coverage. One reason is that some underwriters believed it created a moral hazard. Companies might profit from the coverage, actually ending up better off during the time of interruption than they would have been if it was business as usual.
This is a valid concern. Careful underwriting of a company’s business plan is necessary to counter this possibility. The form should be used as a tool to craft coverage that is suited to companies in their developmental stages, and careful review of the company’s business plan is necessary. It should not be used just because a company is operating at a net loss.
Another potential problem with the valued form is that insureds assume the burden of setting the limit of coverage. Even though this method does not rely on the insured’s internal financial data when adjusting the loss, it does require careful preparation of a business income worksheet by the insured when the coverage is underwritten. Special attention must be given to the amount of anticipated continuing expenses, as well as any extra expense that might be incurred. The insured must realize that the limit established for each unit of recovery (day, week, or month) is the maximum amount recoverable during each recovery unit.
[…]Another reason to possibly avoid using the valued form is, in the event of a partial suspension of business, the form pays a percentage of the per unit limit. It is important that companies understand that the amount paid each day will be decreased proportionately when a partial shutdown occurs. This percentage is equal to the value of lost production or income divided by its normal value prior to the loss. The formula for a partial suspension is as follows:Lost Production x Working Day Limit = Partial Loss Payment
Normal ProductionAs an example, a company may lose $50,000 in production during a month that normally would generate production valued at $200,000. If the recovery limit in this situation is $5,000 per day, the partial suspension would be adjusted as follows:
$50,000 = 1 x $5,000 = $1,250 recovery per day
200,000 4The partial loss formula would be triggered when only a portion of the business is suspended because of a loss. It also comes into play as a company begins to resume operations after a total suspension.
