Considerations for business interruption loss quantification
Businesses across the globe are facing significant challenges as they try to return to pre-pandemic production levels and sales activity.
Bottlenecks in the supply chain—caused by shortages in labour, shipping containers, distribution, and warehousing—have become commonplace and are a primary reason for disruption and business losses. Combined with other major global events, this has led to inflationary pressures on commodity prices, resulting in continuously increasing costs of raw materials, construction supplies, and other building materials.
As companies explore how to respond to customer demands, they are also hunting for ways to recover from losses caused by supply chain issues and to better protect themselves in the future. While recovery and future business resiliency planning will certainly need to include revisiting procurement contracts, organizations must also closely examine their insurance contracts.
How can insurance help mitigate supply chain risks?
Supply chain disruptions may not be sufficiently covered under traditional insurance policies such as property or general liability insurance. However, there are various types of insurance that may respond to supply chain issues, such as contingent business interruption (CBI) and specialized supply chain insurance (SSCI).
CBI covers supply chain disruption caused by significant partners, suppliers, or customers. To qualify for a claim, the insurance policy may require a list of the insured’s dependent businesses. In this case, a disruption at an unlisted partner may not be covered. Furthermore, CBI will only protect the insured if the third-party entity it depends on has suffered physical damage caused by a covered peril, such as a fire or flood. It will not cover losses caused by disruptions to transportation infrastructure, political disruptions, or bankruptcy of your partner/supplier.
Generally, SSCI covers the gaps left by CBI insurance and responds to various potential risks and exposures such as natural disasters, production issues and industrial accidents, strikes, labour shortages, and other employment and labour issues.
A key differentiator between traditional property coverage and CBI and SSCI coverage is that the latter two respond to supply chain issues even in the absence of physical damage to the insured that is typically the cornerstone of a property policy coverage to qualify for any business interruption losses.
To make sure your business is adequately protected, it’s important to discuss coverage considerations with your insurance advisors on a regular basis.
No matter what type of coverage your business has, there are certain issues that require special consideration. Below, we discuss some of the key considerations that companies need to pay particular attention to when deciding how to mitigate their losses, including the impact to business interruption loss claims and the appropriate indemnity period.
Obligation to mitigate loss
Regardless of the type of policy, when an insured event takes place, the policyholder has a duty to mitigate its losses. Insurance is not meant to be a windfall.
Strategies a business can use to mitigate the impact of production losses include:
Let’s take a closer look at these strategies:
Quantifying financial losses related to manufacturing requires the understanding that a loss of production may not necessarily result in a loss of sales. For relatively short production losses (i.e., a few weeks to a month), production can often be made up after repairs are completed, subject to capacity limitations. If this makeup allows the business to meet customer orders, sales are considered to be delayed and not lost. But does that mean you don’t have a business interruption claim? Not necessarily.
Even if sales are ultimately made up, if the sold goods cost more to produce than they would but for the supply chain issues, the business will now experience lower profit margins. The business will need to make a claim on the difference in the decreased margin as part of its business interruption loss claim in order to put itself in the same position had no insured event had taken place.
What does your business need to do? In these situations, it’s necessary to analyze production costs both pre- and post-incident. Any increase in costs should be clearly identified and documented. If the increases are a result of the delay to fill sales, then the amounts are considered to be part of the insurance claim.Temporarily outsourcing production can be an effective strategy to maintain sales levels and strong relationships with customers. A key benefit is that you’ll be able to deliver products on time even when the business is impacted by an insured event. The downside is that you will likely experience lower margins as now you’re paying someone else a premium to purchase finished material/goods. Typically, the additional costs that would be incurred from subcontracting or purchasing finished goods is claimed as an extra expense or an increased cost of working (ICOW).
Due to current market conditions, subcontracting and purchasing finished goods may be more expensive than previously contemplated. As a result, the business may have additional exposure to extra expenses and/or ICOW—which can be an issue if there isn’t enough coverage for these in place .
What does your business need to do? To calculate the value of these mitigating strategies, it’s important to analyze all available options to determine which mitigation strategy makes the most sense and whether incurring the extra expenses is sufficiently justified to mitigate any losses.Ultimately, this is a business decision that needs to consider not only the impact to the insurance claim, but to the business’s reputation, continuity, and future success.
Typically, the longer the business is impacted by an incident, the larger the business interruption loss.
For example, due to the pressures on the global supply chains, it’s becoming common for businesses to expect longer wait times to repair damaged production equipment. The global shortage has businesses scrambling to source replacement parts that will allow them to get back up and running with minimal impact. As a result of these types of delays, machines may be out of commission longer, which in turn leads to longer periods of time where the business experiences sales or profit losses.
There are certain types of coverage, such as coverage for ordinary payroll, for which the duration of the period covered may require some reconsideration. Often businesses obtain ordinary payroll coverage for a period of 90 days or less, however, you should review your supply chain issues and timing to determine if that is appropriate for the current environment.
Consider engaging the expertise of an insurance loss consultant to assess the range of the indemnity period appropriate for your business. A consultant can conduct a modelling exercise to project potential loss profits that may be faced under different scenarios in relation to the expected timeline to procure the necessary items to get back to normal operations.
How BDO can help
There are various considerations to think about when dealing with supply chain issues and how to manage the related risks. This article has covered some of the more common mitigation and indemnity period issues we often face when quantifying insurance claims. It’s important to note that these considerations apply equally in both first-party insurance claims, where a covered event has caused physical damage to a production facility, and to claims related to supply chain under CBI and/or SSCI.
To help protect your company amid changing business realities, we recommend you discuss these issues in a more fulsome manner with your insurance advisors to ensure your coverage responds to your needs, whether it relates to supply chain risks or any other business risks.
Our BDO team has extensive experience in helping businesses identify and mitigate risk. We’re available to answer your questions and discuss your organization’s options for business coverage in more detail.