Many commercial property insurance policies require that policyholders submit a Sworn Statement in a Proof of Loss (also referred to as “Proof of Loss”) in order to receive benefits under the policy. A Proof of Loss provides the insurer with specific information about the incident giving rise to the claim, such as the cause, the nature of any damage sustained, and the financial impact to the business, if any. In the event a policyholder suffers a financial loss as a result of an insured event, it is essential that the policyholder understands how to calculate business income losses covered under its policy so it can attest to that amount in the Proof of Loss. Ultimately, the specific language in the policy will dictate the policyholder’s approach for calculating business income losses, but there are two general approaches typically used by insurance industry experts.
Top-Down or Gross Receipts Method
The first approach is referred to as the “Top-Down or Gross Receipts Method”. Under this approach, the policyholder must (1) calculate the lost sales resulting from covered property damage and then (2) subtract expenses that were saved as a result of not achieving those sales.
(1) Projected Sales – Actual Sales = Lost Sales
(2) Lost Sales – Saved Expenses = Business Income Losses
“Projected Sales” (also referred to as “but for revenue”) is the revenue the policyholder would have earned between the date covered property damage forced the policyholder to suspend its operations and the date when the policyholder resumed, or reasonably could have resumed, normal operations (the “Period of Restoration”) if the insured event had not occurred. To develop a foundation for Projected Sales, the policyholder may consider:
(a) the history of sales in the years leading up to the incident;
(b) the pre-loss average monthly sales achieved in those years;
(c) actual purchase orders and/or contracts that could not be fulfilled/satisfied due to the covered event;
(d) the rate of inflation; and
(e) any other factors that could influence the expected sales volume or price offered for impacted products
These other factors may include seasonality, growth, industry trends, and other outside factors (e.g., political changes, changes in industry regulations, competition, economic forecasts and conditions, etc.).
Sometimes, a covered event may occur shortly before a new product is scheduled to go to market, so there is no history of sales to develop a foundation for Projected Sales. In these instances, insurers may be more reluctant to include Lost Sales for the novel product in the business income loss calculation. While policyholders may rely on existing forecasts/projections to establish a foundation for such Lost Sales, policyholders may also want to submit other documentation showing that the Projected Sales for the new product are not speculative (e.g., communications with customers expressing intent to purchase, documentation demonstrating that the new product is complimentary to existing products offered by the policyholder, reports/analyses showing the new product was favorably anticipated by the target market, etc.).
“Actual Sales” is the revenue actually realized by the business during the Period of Restoration. Depending on the scope of the incident impacting the policyholder’s operations, the policyholder may realize little to no Actual Sales during this period.
Also, policyholders are not always able to immediately achieve sales at pre-incident levels upon resumption of operations. For this reason, many policies provide coverage for a “ramp-up” period (sometimes referred to as “Extended Business Income” or “Extended Period of Liability” coverage). This is the period between the date a business completes repairs and resumes operations and the date business operations recover to the level/capacity which would generate the business income amount that would have been realized if no interruption had occurred. If applicable, these amounts should be included in the claim.
After “Lost Sales” has been determined (by subtracting Actual Sales from Projected Sales), the policyholder should calculate and subtract from Lost Sales the expenses the company saved as a result of not making those Sales. These avoided costs should include both the incremental direct costs (also referred to as “variable direct costs”) and incremental indirect costs (also referred to as “variable indirect costs”) that the business would have incurred had it generated the Lost Sales revenue.
Variable direct costs are the specific incremental expenses that a business incurs directly to manufacture/provide one additional unit of product or service, or to buy a product for resale. Such costs are typically reflected in the “Cost of Goods Sold” section of a business’ Income Statement and may include direct labor, direct materials, manufacturing supplies, commissions, wages for production staff, fuel or power consumption, etc.
Variable indirect costs are expenses associated with multiple operational activities, and which cannot therefore be assigned to specific products or services, but which nevertheless fluctuate with the amount of sales. These could include utilities, insurance, professional fees, certain administrative expenses, advertising expenses, office supplies, postage, and temporary labor.
It is also important to consider whether certain fixed costs, which would be excluded from this analysis, may ultimately become variable if current operations are faced with capacity limitations. For instance, if an existing manufacturing facility was capable of manufacturing 1,000 units of product per month and Projected Sales were expected to exceed this amount at some point during the Period of Restoration, a fixed cost, such as rent, may become variable if it would become necessary to rent an additional facility to expand the production capacity to meet the projected demand.
Bottom-Up or Net Income Method
The second approach for calculating business income losses is the “Bottom-Up or Net Income Method”. Under this approach, the policyholder must (1) determine the Net Income that should have been earned during the period of loss and (2) then add the actual operating expenses that continued during the loss period.
(1) Projected Net Income – Actual Net Income = Lost Net Income
(2) Lost Net Income + Operating Expenses Actually Incurred = Business Income Losses
Some policies contain language indicating that this method should be used in calculating business income losses. For example, the Insurance Services Office Inc. (ISO) BP 00 03 01 10 form states that the insurer will “pay for loss of Business Income that you sustain during the ‘period of restoration’ and that occurs within 12 consecutive months after the date of direct physical loss or damage…” The form defines Business Income as “(i). Net income (Net Profit or Loss before income taxes), that would have been earned or incurred if no physical loss or damage had occurred … and (ii). Continuing normal operating expenses incurred, including payroll.”
“Projected Net Income” is the revenue the policyholder would have earned during the Period of Restoration, including any ramp-up period, if the insured event had not occurred, less all costs that would have been expended to generate that revenue and sustain normal operations, including all direct, indirect, variable and fixed expenses.
“Actual Net Income” is revenue actually realized by the policyholder during the Period of Restoration, including any ramp-up period, less all costs that were actually expended to generate that revenue and sustain normal operations, including all direct, indirect, variable and fixed expenses.
After “Lost Net Income” has been calculated (by subtracting Actual Net Income from Projected Net Income), the policyholder should add to that amount the Operating Expenses the company actually incurred during the Period of Restoration and ramp-up period. Operating expenses are costs a business incurs through its normal business operations, beyond direct materials and labor. These expenses are typically included under the Selling, General & Administrative expenses, Officer Compensation, Depreciation/Amortization, and Interest, sections of a business’ Income Statement rather than the “Cost of Goods Sold” section.
Seek assistance
This blog is intended to provide a high-level overview on business income loss calculations. In practice, such calculations may require more nuance and may be subject to different interpretations depending on the judgment of the professional calculating the loss. For more information, or if you need assistance with your business interruption claim, please reach out to your regular Reed Smith contact or the authors.
