Do I need business interruption insurance? A two-step decision
Natural disasters in 2011 caused a record $350 billion in damages –the equivalent of wiping out the entire market value of General Electric (GE), Ford Motor Co. (F), Hewlett-Packard Co. (HPQ) and Kraft Foods Inc. (KFT) combined. But on top of the insured property losses, companies affected by the Midwest flooding, Japan’s earthquake and tsunami, and flooding in Thailand experienced major disruptions in supply chains and production, hurting results at such companies as Honda, Acer and Arch Coal Inc. (NYSE: ACI).
Most large, multinational corporations know that disasters like those in 2011 could cause significant disruptions to their supply chains and production, so they often hedge their risk with business interruption insurance coverage, said Drew Olson, a manager in the Insurance Claims Services Practice at BDO Consulting.
And most small and mid-sized companies have property policies that include some coverage for business interruption, typically a nominal amount, Olson said. But smaller businesses sometimes struggle with the decision to increase their limits or expand the scope of coverage through policy endorsements, he added.
Business interruption, or BI, coverage provides payment for lost profits when a business suffers losses from an insurable peril. According to the Insurance Information Institute, BI insurance covers not only profits you would have earned but also operating expenses, like electricity, that continue even when business activities are halted.
But Olson says the unique risks of smaller and mid-sized companies mean it’s even more important for those businesses to assess the need for additional BI coverage.
“Smaller and mid-size companies that are centralized in location far too often receive their supplies from a small number of suppliers and have a few main customers that drive their business,” he said. Without adequate insurance to protect their risk following a catastrophic event, it could end up destroying the company, he added.
Furthermore, fixed expenses tend to make up almost a quarter of privately held business’s costs, according to an analysis of financial statements by Sageworks, a financial information company. This figure can vary, depending on the industry, but across all industries, day-to-day costs such as rent, utilities, selling and administrative costs and other overhead represented 23.46 percent of sales in 2011.
“Because these overhead costs are not easily reduced, they can add up quickly and have the ability to cause losses when sales are halted,” said Sageworks Chief Operating Officer Nicole Wolfgang. “In the case where business interruption insurance will cover these costs until the business can again operate, it may be able to help businesses avoid damage to their profits and profit margins.”
Policy prices vary and are tied to the risk of a fire or other disaster damaging your premises, according to the Insurance Information Institute. For example, all other things being equal, a restaurant might have a higher price than a real estate agency because of the greater risk of fire, and because a real estate agency could more easily operate out of another location, the group says.
But generally, you can deduct premiums for business interruption insurance as an ordinary business expense, according to the IRS website.
Olson suggests these two steps to help you decide whether business interruption insurance is right for your business:
1. Gauge the risk culture at your firm. Does senior management prefer to transfer risk or retain it? For example, less risk adverse companies may choose very high deductibles or prefer to reinvest corporate profits rather than pay insurance premiums. One-on-one discussions with the risk manager, treasurer or members of the C-suite can help assess the level of risk that senior management desires.
2. Incorporate stress tests. To evaluate your exposure to business risk from catastrophic events, involve employees from operations, supply chain and sales, and then identify potential stress points among suppliers, customers and geographies. Key data to examine before this discussion: top 10 customers by revenue, top suppliers by procurement spend, and locations that are vital to the continuity of the business. “With the key stakeholders present, the data should be evaluated, and the risk manager or treasurer should mediate the discussion and assist the group in identifying the potential risks to the company,” Olson said. “Armed with an understanding of the risk to operations, the risk manager and/or treasurer can then turn to their broker in obtaining insurance that protects the company in an informed and strategic way.“
Additional Resources:
Planning for Business Interruptions, by ICW Group. http://www.icwgroup.com/earthquake/earthquake-planning-business-interruption.html
Supply Chain Management: When the Chain Disintegrates, by Marsh Inc. http://marsh.com/DisasterRecovery/Content/articleType/ArticleView/articleId/4099/Supply-Chain-Management-When-the-Chain-Disintegrates.aspx
Hurricanes: Managing Service Interruption Risks, by Marsh Inc. http://marsh.com/DisasterRecovery/Content/articleType/ArticleView/articleId/5260/Hurricanes-Managing-Service-Interruption-Risks.aspx
Disaster Planning for Retailers, by BDO Consulting.
