Business Interruption Insurance

Business interruption insurance policy language often limits claims to the loss of gross profits due to the drop in turnover and any related “increase in the cost of working” necessary to minimise disruption or shortfall in turnover. However, the insured gross profit is not always the same as the gross profit in your management accounts, so it’s critical to know the difference.

Business interruption insurance compensates for cash flow losses. This cash flow will be created by gross profits, which are defined as: (1) net profit plus fixed costs paid during the disruption; or (2) turnover minus variable expenses. Using technique (1) or (2) should get the same result. Note that variable expenses are simply those that the business will not incur due to inadequate sales.

Example: Sales are £100,000, supplies are £40,000, manufacturing labour is £10,000, outsourced distribution is £5,000, Office salaries £5,000 and other administrative expenditures are £20,000. That’s a £20,000 net profit.

In this case, the insurance gross profit is £55,000. (or 55 per cent). 

It consists of:

• the net profit plus office and manufacturing labour; or
• sales minus materials and outsourced distribution. 

To make up for this, the gross accounting profit is £45,000 (or 45%).

The Difference: The manufacturing business is not included in the insurance gross profit business (unless there are zero-hour contracts), but it is included in the accounting cost of sales calculation.

You may have spent additional costs to get the business back up and running and to limit damages. For example, a flood or fire may result in significant clean-up expenditures.

For example, the six-week road closure is claimed as lost gross profits. To calculate the lost profits, you must first estimate the sales that would have been made if the adverse activity had not happened. Then, after calculating sales, you should be able to estimate variable expenses and calculate gross profit. Finally, review your management P&L statements for the last three years to spot seasonal patterns. For example, since June sales have consistently been around 10% higher than May sales for the previous three years, you can safely anticipate that June 2021 sales would have been 10% higher than May 2021 sales if the loss hadn’t occurred.

Predict lost revenue using historical data from management accounts and current economic and industry trends. Subtraction of variable costs yields lost profits. Because employees must be paid during a business interruption, sales labour is not generally subtracted from insurance gross profit.