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18-1

Managing Consequential Loss Exposures

• As the term suggests, "consequential" losses are those that result from direct loss. They are also referred to as "indirect" loss.

• Also, in those situations in which the amount of the consequential loss is a function of time, some consequential loss exposures are also referred to as "time element" exposures.

18-2

Managing Consequential Loss Exposures

• Although the terms tend to be used interchangeably, not all consequential losses are time element losses.

• Debris removal losses and losses arising out of the enforcement of building codes are examples of consequential loss where the loss is not a function of time.

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Time Element Exposures

• The simplest example of an indirect time element exposure is business interruption. When a factory burns, the owners lose the value of the factory and its contents.

• In addition, however, they also lose the output of the factory for the period of time required for reconstruction.

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Time Element Exposures

• Another consequential loss exposure is "extra expense," for organizations that cannot suspend operations, but must continue to provide services using extraordinary means and at a higher cost.

• The increased cost of continuing operations when owned property is damaged or destroyed can result in a reduction in profit or, in severe cases, an operating loss.

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Importance of Consequential Loss Exposure

• Although the magnitude of a consequential loss may equal or exceed that of a direct loss, organizations that would not consider going without property insurance ignore the business interruption or extra expense exposure.

• In addition to the failure to purchase insurance, the amount of insurance purchased under business interruption and extra expense forms often bears little relationship to the exposure.

18-6

Controlling Consequential Loss Exposures

• Since indirect property losses are occasioned by direct property losses, the loss control measures aimed at preventing and reducing direct loss also serve to prevent indirect losses.

• In addition to measures that are aimed at preventing direct loss, there are a number of loss control measures that aim specifically at preventing or controlling indirect loss.

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Planning for Indirect Losses

• The most effective loss control technique for consequential losses is to anticipate such losses and make arrangements prior to a direct loss for continuation of operations.

• A determination must be made as to whether it will be feasible for the organization to continue operations in the event of damage to or destruction of its property.

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Planning for Indirect Loss

• Unless specific plans are made where and how operations will be continued, it may be found that it is impossible to obtain access to the facilities required to continue or resume operations.

• Ideally, a specific continuation plan should be devised, which identifies the requirements that will exist for continuing operations and the manner in which these requirements will be met.

18-9

Identifying Bottle-Necks

• In some situations, a key machine is critical to the entire production process, which means that the loss of the machine could interrupt the entire operation.

• When such bottlenecks are identified, it may be possible to reduce the interruption period by planning for rapid replacement of the item.

18-10

Planning Replacement Facilities

• It may be possible for the organization to enter into a reciprocal arrangement with another firm in the same industry for temporary use of facilities.

• In other cases, it may be possible for the firm to subcontract with another organization during the period required to restore the premises.

18-11

Alternate Computer Facilities

• Many organizations make advance provision for use of an alternate facility in the event the organization’s data processing equipment is damaged or destroyed.

• Alternate computer facilities are designated as “cold sites” or “hot sites,” according to their configuration.

18-12

Contingent Business Interruption Exposures

• When a contingent interruption exposure relates to a single supplier, the firm may consider stockpiling a reserve of the raw materials.

• To the extent possible, alternate sources of

supply should be identified.

• If the cost of obtaining supplies from the alternate source will be higher, once this has been determined, insurance may be arranged to cover the higher cost.

18-13

Redundancy

• Redundancy in production facilities is similar in effect to stockpiling raw materials; it can permit continuation of operations when a direct loss damages production facilities.

• It can be an effective loss control strategy, but only if the primary and redundant facilities are not subject to loss in the same occurrence.

18-14

Post-Loss Control - Resuming Operations

• Once a direct loss has occurred, it may be possible to reduce the amount of the loss by continuing operations at another location or by partial resumption of operations.

• Indirect-loss insurance coverages require the insured to use all reasonable means to resume operations as soon as possible.

• If it is possible to continue operations even on a partial basis, the insured is required to do so.

18-15

Expediting Repairs and Reconstruction

• The more quickly reconstruction can be completed, the more quickly the firm will be able to resume normal operation.

• In general, this means expediting the resumption of operations in all ways possible.

• One technique that is increasingly applied to this problem is Program Evaluation and Review Technique (PERT).

18-16

Program Evaluation and Review Technique (PERT)

• PERT is an analytical technique that is used when a project includes a number of time-critical events whose performance may determine the total time required to complete the project.

• PERT analysis can help to expedite restoration and resumption of operations. This was dramatically demonstrated in the restoration of the World Trade Center following its bombing by terrorists.

18-17

Financing Consequential Losses

The major time-element indirect loss coverages are:

business income (interruption) insurance,

extra expense insurance

contingent business interruption

contingent extra expense insurance, and

leasehold interest coverage.

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Business Income Insurance

• Business income insurance indemnifies business firms for loss of income during the period required to restore property damaged by an insured peril to a useful condition.

• It pays the expenses that continue and the profits that would have been earned during the period of interruption.

18-19

Business Income Insurance

• Although a valued form of coverage is available, most business interruption is written on an indemnity basis.

• In determining the amount of loss under the indemnity forms, the insurer considers the insured's experience before the loss and probable future experience if no loss had occurred.

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Perils Insured

• Like direct property loss, business interruption coverage should provide protection against any peril that could trigger suspension of operations.

• This includes, among other things, not only the broad coverage of an open-peril form, but earthquake and flood as well.

• Boiler and machinery coverage include indirect loss coverage in the same amounts as under the general property insurance part of the program.

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Monthly Limit of Indemnity

• Under the Monthly Limit of Indemnity option, the insured may collect a specified fraction of the total amount of the insurance during any month for which the business is totally or partially interrupted.

• Options are available to permit collection of 1/3, 1/4, or 1/6 of the face amount of coverage.

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120-Day Indemnity Form

• The standard Business Income form can be converted to a 120-day indemnity form by electing the Maximum Period of Indemnity option.

• The coinsurance clause is replaced with a 120 day limit on the period for which indemnity is payable, with no monthly limit on the amount payable other than the amount of loss.

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Valued Business Interruption Insurance

• Pays a specified amount per day or week or interruption regardless of the actual loss sustained.

• A proportional payment is made for partial interruptions.

• The valued form of business interruption insurance is most useful when the income is stable and does not fluctuate over time.

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Business Income (Coinsurance) Forms

Standard forms of business income insurance

• Business Income Coverage (And Extra Expense) form and the

• Business Income Coverage (Without Extra Expense) form.

Coverage under either form is subject to a coinsurance provision. Coinsurance options of 50%, 60%, 70%, 80%, 90%, 100%, or 125% are available.

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Business Income (Coinsurance) Forms

• If the business is interrupted, payment is made for the loss of "Business Income," defined as the net profit that would have been earned (including or excluding rental income) and the necessary expenses that continue during the "period of restoration."

• In determining the amount of loss, the insurer considers the insured's experience before the loss and probable future experience if no loss had occurred.

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Resumption of Operations

• A Resumption of Operations provision requires the insured to resume operations as soon as possible, even on a partial basis, using damaged or undamaged property at the described premises or elsewhere.

• If operations are not resumed when it is possible to do so, the insurer will reduce payment for loss of income by the amount that resumption of operations would have reduced the loss.

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Expense to Reduce Loss/Extra Expense

• Expense to Reduce Loss provision of Without Extra Expense form pays for expenses to resume operations or otherwise reduce the amount of the business interruption loss.

• Extra Expense provision of And Extra Expense form, pays for expenses to continue operations whether or not such expenses reduce the business interruption loss.

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Programming Business Income Insurance

To determine the appropriate amount of business interruption insurance it is necessary to determine:

(1) the period of time for which the firm will be interrupted,

(2) the income that will be lost during that period, and

(3) the expenses that will be incurred and the profit that will be lost during the period of interruption.

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Non Business Continuing ContinuingMonth Income Expenses Expenses ProfitJanuary $15,000 $5,000 $5,000 $5,000February 15,000 5,000 5,000 5,000March 15,000 5,000 5,000 5,000April 15,000 5,000 5,000 5,000May 15,000 5,000 5,000 5,000June 15,000 5,000 5,000 5,000July 15,000 5,000 5,000 5,000August 15,000 5,000 5,000 5,000September 35,000 5,000 20,000 10,000October 35,000 5,000 20,000 10,000November 45,000 5,000 20,000 20,000December 65,000 5,000 20,000 40,000

$300,000 $60,000 $120,000 $120,000

18-30

Programming Business Income Coverage

• It has been determined that in the event of a loss, the period required to restore the building and the stock would be four months.

• The problem is to determine the maximum loss that might be incurred by the insured during the four month period.

• The four months with the highest projected continuing expenses and profits are September through December: $160,000.

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Non Business Continuing ContinuingMonth Income Expenses Expenses ProfitJanuary 15,000 5,000 5,000 5,000February 15,000 5,000 5,000 5,000March 15,000 5,000 5,000 5,000April 15,000 5,000 5,000 5,000May 15,000 5,000 5,000 5,000June 15,000 5,000 5,000 5,000July 15,000 5,000 5,000 5,000August 15,000 5,000 5,000 5,000September 35,000 5,000 20,000 10,000October 35,000 5,000 20,000 10,000November 45,000 5,000 20,000 20,000December 65,000 5,000 20,000 40,000

300,000 60,000 120,000 120,000

18-32

Determining the Coinsurance Percentage

• Selection of the coinsurance provision is based on the relationship of the insurance purchased to the annual business Income.

• In our illustration the annual Business Income is $300,000.

• The amount of insurance needed is $160,000.

$160,000/$300,000 = .5333

• The coinsurance provision should be 50%.

18-33

Ordinary Payroll

• The insured may elect to exclude payroll for rank and file workers of cover it only for a limited period of time using the Ordinary Payroll Endorsement.

• "Ordinary payroll" is defined as payroll expense for all employees except officers, executives, department managers, employees under contract, and any other employees selected by the insured and designated in the Ordinary Payroll Limitation endorsement.

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Dealing With the Problem of Underinsurance

Insurers offer two options to address the problem of possible inadequate coverage.

The Agreed Value Option

The Premium Adjustment Endorsement

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Agreed Value Option

• Suspends the coinsurance provision and guarantees that the insured will not suffer a coinsurance penalty on a partial loss.

• Protects the insured from a coinsurance penalty when earnings increase more than anticipated.

• The cost of the Agreed Value Option is 10% of the business income premium.

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Premium Adjustment Endorsement

• A type of reporting form, with a single report at the end of the year, to determine both the amount of insurance that was in force during the year and the premium for the coverage.

• The insured selects a provisional amount of insurance that is higher than the anticipated level of protection that will be required. In addition, a coinsurance percentage is selected.

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Premium Adjustment Endorsement

• At expiration, the amount of insurance in force during the coverage period is determined by multiplying the coinsurance percentage selected by the actual business income of the firm.

• Unlike the Agreed Amount option, there is no premium surcharge for the Premium adjustment endorsement.

• The cost is the interest foregone on the premium for any excess coverage not needed.

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Lag in Earnings After Restoration

• There are some situations in which it can be anticipated that a firm's income will remain depressed following restoration of the premises.

• Old customers may have turned to new sources during the period of interruption, and the process of rebuilding a clientele may require time beyond the period of restoration.

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Lag in Earnings After Restoration

• The ISO business interruption forms provide coverage for a period of 30 days beyond the date of restoration, under a provision entitled "Extended Business Income."

• The Extended Period of Indemnity optional coverage permits the insured to extend this 30 day extension in 30 day increments up to six months, with 90 day increments thereafter up to 365 days.

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Extra Expense Insurance

• Under some circumstances, it may be necessary for a business to continue operations after destruction of its facilities.

• For example, a bank's earnings, which are derived from loans and investments, would not be affected by destruction of the bank's premises, but the bank would need other facilities to continue to service its accounts.

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Extra Expense Insurance

• Extra expense insurance is an alternative to business interruption insurance for those enterprises that can continue operations with other facilities.

• It provides payment for expenses above normal costs when such expenses are incurred to continue operations after damage to the premises by an insured peril.

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Extra Expense Insurance

• The Extra Expense Coverage Form contains a schedule of cumulative monthly limits, expressed as a percentage of the policy limit, and payment for loss is limited to these percentages.

• The most commonly used schedule permits the insured to collect up to:

40% of the limit in the first month after damage,

80% during the first two months, and up to 100% for three months or more.

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Extra Expense Insurance

• An insured anticipating a more extended period of extra expenses can select a smaller monthly limitation (for example, 10% during the first month, 20% in the first two months, and so on.

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Indirect Boiler and Machinery Coverages

The Boiler and Machinery Policy may be endorsed to provide coverage for three consequential loss coverages:

Business Interruption Extra Expense Consequential damage

Consequential damage coverage covers loss to perishable property that is damaged because of the breakdown of the insured object.

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Contingent Business Interruption Exposures

1. Contributing Property: when the insured depends on one or a few suppliers for most of its materials.

2. Recipient Property: when the insured relies on one or a few businesses to purchase the bulk of its products.

3. Leader Property: When the insured counts on a neighboring business to help attract customers.

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Contingent Extra Expense

Contingent extra expense insurance operates in much the same way as contingent business interruption, but is designed for the firm that would incur increased costs as a result of damage to a contributing or recipient firm's property.

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Interruption of Utilities

• A specialized form of contingent business interruption insurance covers interruption due to the suspension of utility service caused by damage to the utility (or transmission media) away from the premises.

• The Off-Premises Services - Time Element endorsement provides coverage when the insured’s insured's business is interrupted because of loss of utility services because of damage by an insured peril.

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Interruption of Utilities

The particular type of utility service for which coverage is desired must be indicated. There are five options:

water supply

communication, not including transmission lines

communication, including transmission lines

power supply, not including transmission lines

power supply, including transmission lines

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Leasehold Interest Insurance

• The leasehold interest exposure arises from the contractual right to the lower-than-market rent, which would be lost if the property were destroyed.

• When prevailing conditions make it impossible to secure similar quarters at less than say, $2500 a month, the existing contract would create a leasehold interest loss of $ 1,500 a month for the remaining period of the lease.

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Leasehold Interest Insurance

• The amount of coverage under leasehold interest coverage decreases month by month, with the amount of insurance always about equal to the insured's interest in the lease.

• In the event of a loss that terminates the rental agreement, the insured is paid a lump sum equal to the discounted value of the leasehold interest for the remaining months of the lease.

• The insured may select a discount rate ranging from 5% and 15%.

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Rain Insurance

Rain insurance is a consequential loss coverage.

• It does not protect against damage to property, but against loss of income or the incurring of extra expenses due to rain, snow, sleet, or hail.

• It is usually sold to cover outdoor events scheduled for a certain day dependent on favorable weather for success.

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Rain Insurance

• The coverage may be written on an indemnity basis to cover the loss of income suffered or additional expenses incurred, or it may be written on a valued basis.

• The policy must usually be taken out at least seven days before the event and is not subject to cancellation by either party.