Business Interruption

A Unique Assessment of Commercial Damages

Business interruption is a form of commercial damages that may include both breach of contract and torts. While it is not common for financial experts to be hired in business interruption situations, some claims require their expertise. Unlike a traditional lost profit analysis, business interruption calculations are unique. Any expert asked to make such an analysis should consider lost profits (projected revenue for the loss period less saved expenses), non-saved expenses that are ongoing during the interruption, and extra or expedited expenses the business has to incur to reopen. This article addresses the work in estimating a business interruption claim and provides a case study on how two experts handled such an analysis.

[su_pullquote align=”right”]Resources:

Commercial Damages and Lost Profits

Appraisal, Umpiring, and Resolution of a Business Interruption Claim

Rebuttal of the Business Interruption Claim The Insurance Company’s Challenge

How Policy Language Impacts the Determination and Resolution of a Business Interruption Claim

Calculating Business Damages

Business Interruption— Understanding the Unique Issues of BI Damage Calculation and Developing a Niche Practice

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Business interruption is a form of commercial damages that may include both breach of contract and torts.  While it is not common for financial experts to be hired in business interruption situations, some claims require their expertise.  This article addresses the work a financial expert may be asked to perform for a business interruption claim and provides a case study of how two experts handled such an analysis.

On its face, the concept of business interruption is straightforward.  The claim is an attempt to protect a business and/or business owner against physical damage to the business property that would deprive the business of the use of the property to produce income.[1]  In other words, if a business is damaged and cannot operate or its production has been limited, a claim may be made for lost profits and additional costs related to the damage to the business.

Business interruptions may be caused by natural or manmade disasters.  Storms, wild fires, earthquakes, or other forms of natural disasters may damage a business or a business’ supplier to the extent that conducting normal business is impossible.  Some business interruption may be caused by internal problems like flooding from a burst pipe or a fire from faulty wiring.  Or, the negligent act of a third party may damage business property.  This too may result in business interruption.

Litigation is seldom involved when businesses recover their losses through insurance coverage.  However, if the property damage and interruption was caused by a third party, litigation is more likely with either the damaged business or its insurance company, through subrogation, seeking recovery of the losses from the alleged damaging party.

Insurance Coverage

Many businesses have business interruption insurance.  This coverage is often added to the commercial property insurance coverage.  It could also be part of the business owner’s policy or commercial package policy.  Business interruption coverage is, therefore, not a standalone policy but additional to the standard property and casualty coverage protecting the business.

“Standard property insurance covers physical damage and losses—furniture destroyed in a fire, or a storm-damaged office building, or stolen equipment…But what about losses resulting from a business’s inability to operate because of the property damage?  For this type of loss, a business needs business interruption insurance.

Generally, business interruption insurance will cover:

Revenue lost due to closure.

Fixed expenses, such as rent or utility costs.

Expenses of operating from a temporary location.”[2]

In assessing losses under business interruption coverage, any loss estimate must fall under the terms of the insurance contract.  As an example, some policies will only cover losses for a set period (e.g., twelve months).  Any estimates of losses beyond that point would not qualify as an allowed claim under the coverage.

“Unlike other lost profits cases, the conditions under which the entity can make a claim for business interruption coverage is dictated by the terms of the insurance policy, not the legal theory upon which the claim is based.  The policy will also dictate when the coverage starts (i.e., at what point the insured can begin calculating interruption) and when it ends.  Further, it will indicate the methodology for calculating the claim.”[3]

Direct Property Damage and Time Element

Almost all policies require that a claim be made for damage to the business property prior to the claim for business interruption.  This is because it is damage to the physical property of the business that causes the loss of income and incurring of ongoing expenses.

Some business interruption coverages contain riders that allow for claims when damage to one or more of the business’ suppliers prevents the delivery of products or materials resulting in the interruption in the covered business’ operations.

With any business interruption claim, there is a time element.  “Time element coverages, as the category implies, include insurance for loss items that consider the dimension of time.  The policyholder can recover losses of this type only during a defined period, referred to as the period of indemnity.”[4]

The time definition in most policies is intentionally vague.  It includes wording along the lines of “the loss period will run from the occurrence of the loss and continue to the restoration or replacement of the damaged or lost property.”

Most coverages are triggered only when the actual interruption occurs.  “However, there may be measurable income loss both before and after the interruption that is caused by damage to covered property, such a loss of income may fall outside the coverage provided by the policy.”[5]

This was highlighted in American States Insurance, Co. v. Creative Walking, Inc.  “The insured’s claim for lost income was limited to the 13-day period in which the insured’s business was suspended after a water main break, despite the longer lasting slowdown in business.”[6]

General Loss Claims

Losses claimed under business interruption coverage generally fall under three categories: actual losses, continuing and non-continuing expenses, and expedited and extra expenses.

The following is an example of commonly used coverage language.

“If such loss occurs during the term of this policy, it shall be adjusted based on actual loss sustained by the insured directly resulting from such interruption of business, consisting of the net profit which is thereby prevented from being earned, and all charges and expenses only to the extent that these must necessarily continue during the interruption of business and only to the extent to which such charges and expenses would have been earned had no loss occurred.”[7]

To calculate lost profits, the business’ lost revenue during the loss period is projected and then the avoided expenses that would have been required to generate that revenue are deducted.  But, the traditional lost profit models may not be appropriate for a business interruption analysis.

As Patrick Gaughan noted, “Several different profit margins are regularly used in financial analysis.  Among the most frequently cited are the gross margin, defined as sales minus costs of sales divided by sales, the operating margin, defined as earnings before interest and taxes (EBIT) divided by sales, and the net margin, defined as earnings after taxes divided by sales…Although these margins are the ones most often cited in financial analysis, none of these necessarily coincides with the precise margin that is used in business interruption lost profits analysis.” [8]

The calculation of lost profits for a business interruption claim is different because the damaged business will have ongoing expenses that have not been avoided but are a part of the lost profit assessment.  These ongoing expenses are a part of the business interruption claim.  They are included in a separate analysis.

Continuing expenses are those that necessarily continue during the loss period.  These may differ from traditional fixed costs and include variable costs.  As an example, a business may choose to pay some employees while the business is not operating.  Their wages and benefits, while not considered part of fixed costs, may be included in the business interruption losses because it is important for the business to retain a qualified and experienced staff for when its operations reopen.

Most businesses will seek to reopen as soon as possible.  This may cause a business to incur additional costs while expediting its reopening.  An example of these extra charges is the cost to airfreight materials to a damaged manufacturer who normally uses truck or rail delivery.  In addition, overtime may be needed to rebuild damaged inventory.  This too would be additional expenses that the business would not have incurred were it not for the interruption.

As a part of any loss analysis, a financial expert must work to avoid double counting.  The same is true when assessing business interruption.  Should a business’ inventory be damaged (e.g., by fire and smoke damage), a property damage claim will be filed.  The business’ property or content coverage will, more than likely, pay for the value of the lost inventory based on a formula in the coverage.  This is the same inventory which would have generated the revenue the financial expert has estimated as lost.  Any lost profits calculated from this business interruption must take into consideration the payment for lost inventory; otherwise, the inventory will have been “sold” twice.

Losses for Business Interruption Litigation

If a financial expert is hired to assess business interruption damages caused by a third party, the analysis of losses may be the same period as claimed under business interruption coverage or expanded.  While the expert will continue to assess lost profits, non-saved expenses, and extra or expedited expenses, the length of loss period may go beyond the coverage period to address the entire loss to the business.

Theoretically, an analysis of these losses may result in a closed end, open end, or infinite loss period.  For closed end loss periods, the loss ends when the business returns to its pre-interruption levels of revenues and profits.  For open periods, the loss continues into the future.  Projected pre-interruption revenues continue to exceed actual post-interruption revenues.  And, although the current revenues may exceed actual pre-interruption revenues, they do not equal the projected revenues “but for” the interruption.  Should a business be forced to close as a result of the property damage and/or interruption, the loss is infinite.  As with other commercial damages situations, a business valuation should be performed to determine the value of the destroyed business.

For more practical applications, experts generally rely on one of two forms of the “but for” approach to assess lost profits.  “If the defendant’s alleged acts have impacted the business only a limited period, then the plaintiff’s subsequent performance can be important evidence to support its lost profits during the affected time.”[9]  This analysis looks at the performance of the business “before and after” the interruption.  The losses are shown to have occurred in a middle period (between the before and after periods).  The assumption is that if the alleged wrongful act had not occurred, the business would have performed during the middle period as it did in the “before and after” periods.  In other words, “but for” the interruption, the business would have performed as usual during the loss period.

There are occasions when the business interruption will last longer than a few weeks or months.  For these longer periods, the “before and after” approach may not capture the impact of the loss.  “In a business interruption case, losses are measured until such time as the sales or profits of the plaintiff’s business have recovered.  In a growing business, this may not necessarily be the time when the plaintiff’s revenues reached the pre-interruption levels.  If it can be established that plaintiff’s revenues would have grown absent the actions of the defendant, then the recovery period may be when the post-interruption actual revenues reach the forecasted ‘but for’ revenues.”[10]

Case Study

I have been hired to perform loss estimates in several business interruption matters.  Most of these matters involved litigation against a third party who had caused a fire that damaged the business’ property and ultimately its operations.  One of these cases involved a grocery store located in rural Texas that was damaged by a fire.[11]

The store was in a farming and ranching community of 1,000 people located on the edge of the Dallas Fort Worth metroplex.  It was a mature store, having operated in its location for more than ten years.  The grocery store had limited competition from two local convenience stores.

After the fire that damaged the business property, the business sought payment under its business interruption insurance.  During the initial assessment of the loss, the insurance company determined the claim was legitimate.  After a conversation with the business owner and reconstruction professionals, the insurance adjuster determined the store would be closed for six months.  She applied a “before and after” analysis to estimate the business’ loss.

Unfortunately, the store did not reopen in six months.  When I was contacted, the work to reopen the store was ongoing and the interruption period had just past twelve months.  The owner expected to open in a “few months,” but feared it would be nearly two years before the store was fully operational.

For this analysis, two calculations were made.  The first was for lost profits.  The second was for continuing (non-saved) expenses which included one category of extra expenses.

A review of the grocery store’s income statements and post damage monthly checking statements showed a long list of ongoing expenses.  This list of continuing expenses included, but was not limited to, accounting and professional fees, advertising, charitable contributions, dues, insurance (property and health), rent, security, payroll taxes, telephone, utilities, worker’s compensation, direct labor.

The insurance adjuster and I agreed the business had both saved and non-saved expenses in some categories.  This list included postage, direct labor, payroll taxes, and office expense.  In addition, we agreed the store had extra expenses in regard to security which had increased during the rebuilding period.

The business’ records allowed for the allocation of cost of goods sold between six grocery departments (grocery, meat, produce, floral, deli, general merchandise).  Therefore, based on these allocations, a gross profit was determined for each department.  When totaled, the sum was the lost gross profit for the grocery store.  This amount was then reduced by saved expenses to estimate the lost net profits.

In addition, there were non-saved expenses plus the increased (extra) security expenses.  Non-saved expenses were the largest loss component being approximately eight times the estimated lost profits.  These ongoing expenses were added to show the economic loss incurred by the grocery store.

The insurance company had used a “before and after” analysis when assuming a six-month business interruption.  With the interruption running into two years, my analysis was based on a projection of lost revenue including growth factors for sales and expenses.  The increase in revenue was based on the economic growth of the area during that twenty-four-month period.  Expenses were assumed to grow at the inflation rate over the same period.

There were some nuances in the styles applied by the insurance adjuster and me.  The insurance adjuster estimated lost revenue less costs of goods sold to arrive at the lost gross profits.  From that amount, she deducted saved expenses.  She did not include ongoing expenses as a deduction in her calculation.  Therefore, she included the ongoing expenses the business was having to pay during the business interruption period in her lost profits figure.

My calculations also showed projected lost revenue less cost of goods sold to arrive at a lost gross profits figure.  From that amount, I deducted all the general expenses required to generate those revenues.  This included saved and non-saved costs.  This resulted in a lesser lost profits figure than the one estimated by the adjuster.  I then added to this amount the cost for the ongoing expenses including the additional security costs.  My final figures included lost profits and ongoing expenses, just as the adjuster.  We just approached the problem from different angles.

In the end, my first twelve months’ loss was approximately $22,000 greater than the adjuster’s annualized loss figures (based on her six-month estimates), $299,271 to $277,282.  Because of my growth assumptions, the second twelve months’ loss was slightly greater than the first twelve months’ loss.

Experts for both sides were deposed and the two sides settled prior to trial.  As with most cases, the settlement remains confidential.

Conclusion

Business interruption is a form of commercial damages.  Although normally part of an insurance claim along with a claim for damaged property, financial experts may from time to time be hired to estimate the losses relating to an interruption event.  The expert’s calculations may be used in conjunction with the claim filed with the insurance company or a lawsuit against a third party that allegedly caused the property damage and business interruption.

Any expert asked to make such an analysis should consider lost profits (projected revenue for the loss period less saved expenses), non-saved expenses that are ongoing, and extra or expedited expenses the business has to incur to reopen.

Although the assignment to estimate a business’ losses due to business interruption may seem straight forward, it calls for a detailed analysis of several prior year’s income or profit and loss statements along with income, profit and loss and/or checking statements since the damaging event occurred.

Ultimately, the three sets of losses are totaled to sum the loss incurred by the business in regard to its operations.  These losses are separate from property damage claims made by the business.  However, the expert must be aware if an insurance claim has been or will be made for damaged or lost inventory.  Any payment for the value of the damaged inventory must be considered in the lost profits analysis to avoid double counting.

An expert should be aware, this analysis may be time consuming, but can be rewarding for the damaged business because it means all of its losses will be considered and reviewed.  Even though the business interruption loss period may be brief, the financial expert should also consider the economic, business, and competitive environment in the damaged business’ market during the loss period.  In this way, the expert may provide a well-rounded assessment that provides defensible, reasoned, and detailed loss estimates.

[1] Litigation Services Handbook, 5^th Ed. Roman Weil, Daniel Lentz, David Hoffman, John Wiley & Sons, 2012, page 11.2.

[2] Covering Losses with Business Interruption Insurance, Insurance Information Institute.

[3] The Comprehensive Guide to Lost Profits and Other Commercial Damages, Vol. 1, 3^rd Ed., Nancy Fannon, Jonathan Dunitz, BVR, 2014, pages 197–198.

[4] Weil, Lentz, Hoffman, page 11.3.

[5] Fannon, Dunitz, page 441.

[6] Am. States Inc., Co. v. Creative Walking, Inc., 16 F.Supp. 2d 1062 (E.D. Miss1998), (aff’d, 175 F.3d 1023 [8^th Cir. 1999]).

[7] Safeguard Storage Props, LLC v. Donahue Favret, 60 So. 3d 110 (La. App. 4 Cir. 2011).

[8] Measuring Business Interruption Losses and Other Commercial Damages, 2^nd Ed., Patrick Gaughan, 2009, page 201.

[9] Fannon, Dunitz, page 246.

[10]Gaughan, page 66.

[11] IGA Foodliner, Inc. et. al., v. Benchmark Insurance Company, et. al., 08-05-349, (Wise County, TX).

Allyn Needham, PhD, CEA, is a partner at Shipp, Needham & Durham, LLC, a Fort Worth-based litigation support consulting expert services and economic research firm. Prior to joining Shipp, Needham, & Durham, he was in the banking, finance, and insurance industries for over twenty years. As an expert, he has testified on various matters relating to commercial damages, personal damages, business bankruptcy, and business valuation. Dr. Needham has published articles in the area of financial economics and forensic economics and provided continuing education presentations at professional economic, vocational rehabilitation and bar association meetings.

Dr. Needham can be reached at (817) 348-0213, or by e-mail to aneedham@shippneedham.com.