December 7, 2012
The most vexing issue for policyholders and insurers in business interruption claims is determining how to measure the policyholder’s covered actual loss of income. Unlike property damage, which became evident as soon as the storm passed, business interruption claims can take weeks or months to develop and require specialized accounting and forensic expertise to prove. The policyholder must prove what the performance of the business would have been had the catastrophic damage not occurred.
A. The Predicates of the Business Interruption Insurance Claim.
Typically, the insured’s economic performance during a period of time—usually six months—preceding the interruption of business is the best measure of how the insured’s business would have performed during the period of interruption. Indeed, most policies contain language expressly authorizing the use of past economic performance evidence to prove business interruption losses.
If the parties agree that previous economic performance is an adequate substitute for proof of the insured’s actual loss, calculating that loss is simply a matter of applying generally accepted accounting principles. The insured’s recovery will be equal to the projected gross earnings the insured lost. Accountants define gross earning as sales revenue (the dollar value of sales) less cost of sales (the economic inputs to the business that are required to produce the revenue).
In calculating the cost of sales that must be subtracted from sales revenue, the important distinction is between “variable” and “fixed” or “continuing” costs.
Costs that do not fluctuate with the level or volume of production or sales activity are commonly known as “continuing” or “fixed” costs.
Costs that rise and fall with production or sales volumes are known as “variable” costs. It is only the non-continuing or variable costs that can be saved during an interruption of business operations, and thus must be deducted from the insured’s recovery. For example, the use of raw materials, energy, and supplies may be stopped or greatly reduced in the event of a business interruption.
However, employee payroll and certain overhead costs such as rent are likely to continue and thus cannot be deducted from the insured’s recovery.
B. Business Reality.
Attempts to resolve the insured’s loss based on past history often collide with business reality. Many businesses do not operate at a constant level. By their nature, businesses are regularly changing and adapting in order to increase sales and income. These changes and adaptions are likely to become more pronounced in the dramatically changed economic conditions of a post-catastrophe economy. We will examine the complexities of valuing business interruption claims in the context of a widespread catastrophe briefly in our next post and in detail in a Webinar sponsored by West Legal Ed Center on December 17, 2012, “Business Interruption Claims Arising Out of Superstorm Sandy,”