Calculating the BI GP Sum Insured

Business Interruption cover is a complex field, and many business insurance intermediaries have dreaded calculating the Gross Profit sum insured for a commercial client. Graham Wood of ITS Insurance Services (Pty) Ltd (Incorporating the Insurance Technical School) provides insight into this cover and explains, in plain English, how the calculations are made.

The starting point to correctly calculating the Gross Profit (GP) sum insured for Business Interruption (BI) cover is to understand what is being covered. While accountants also use the term gross profit, the definition of GP in insurance is entirely different. In the insurance industry, the definition relates to Income less Expenses that will not continue during shut down periods.

Basis

The BI cover is issued either on an Additions or on a Difference basis.

The Additions basis states that the client must add to the Net Profit all the Standing Charges that must be insured.
* Net Profit is the profit (before deduction of Income Tax) that is generated annually by the business.
* Standing Charges are all those annual charges and expenses of the business that will continue during any 'shut down' period, e.g. rent, salaries, HPs, lease agreement payments, etc.

The Difference basis requires that the client deducts from the Turnover all the Working Expenses that do not need to be insured.

* Turnover is the total annual amount received or due the business for the activity undertaken.
* Uninsured Working Expenses are the total of all charges/expenses of the business that will NOT continue during any 'shut down' period, e.g. purchases, commissions, packaging, etc.

Insurance Gross Profit

The client needs to establish only four financial figures to be able to establish their insurance Gross Profit figure.

These are:
Net Profit (before tax) R
(known as NPBT)
Standing Charges R
(nowadays termed "fixed costs") costs"
Uninsured Working Expenses R
(nowadays termed "variable expenses") 
Turnover R
(could be called "income" or "sales" or "revenue" )

Notice that the Turnover / Income / Sales / Revenue of the business is made up of NPBT + Fixed and Variable costs / expenses.

The policy wording goes further by detailing Closing and Opening Stock figures, but for the purposes of establishing the basics of arriving at a reasonable sum insured, we will not deal with these now.

Rate of Gross Profit

The BI policy wording is the only wording that actually tells the client how to calculate a claim and therefore assists in establishing a sum insured. The claim settlement requires that the Rate of Gross Profit is applied to the shortfall in Turnover expected by looking backwards and adding trends. Put simply, it says that businesses rarely change a successful operating system and will continue to generate turnover by copying last year and adding enough to keep ahead of inflation.

However, copying last year means that all the ratios against Turnover will probably remain the same - so the more sold means the more spent. So if the Turnover increases by 15% (this should be a minimum percentage to keep ahead of inflation) then the other three figures are likely to also increase by 15%. If not, then the business has not copied last year's system 100% and the broker needs to establish why.

The Rate of Gross Profit is the percentage ratio of the insurance Gross Profit to the Turnover. In other words:

Gross Profit

Rate of Gross Profit = Turnover x 100

Doing the sums

With the assistance of the broker, the client takes their last financial report (Income Statement) figures for fixed costs, variable costs and NPBT and calculates the Gross Profit, as per the insurance definition. The client can now establish the Rate of Gross Profit and both agree that this rate is correct, and that it will probably remain so for the immediate future. Since every business must increase their Turnover every year by more than the inflation rate, the client must agree to their expected annual Turnover increase percentage.

So the client now has a Rate of Gross Profit and an annual expected Turnover increase rate.

Next, the client needs to calculate their expected Turnover for the year following the expiry of the next period of insurance. This means that the client is looking two years ahead. To this projected Turnover they apply the Rate of Gross Profit and that becomes the expected Gross Profit.

To this expected Gross Profit, VAT must be added and the total rounded up to the nearest R10 000. The figures have been inflated twice, but the premium is only charged on 75% of this Gross Profit sum insured.

Whose responsibility?

It is not the broker's duty to do the calculations, it is the client's duty. The broker purely assists the client to understand how to arrive at a reasonable sum insured. However, the broker must ensure that the client signs a document stating that they agree with the method used and that the figure is acceptable.

End of Policy Year Adjustment

If the client achieves a 15% increase in their Turnover, during the period of insurance, and the policy is adjusted as required, we arrive at the following figures:

Turnover R 1 150 000.00
Gross Profit R 690 000.00 (60% of Turnover)
Plus VAT R 786 600.00

The client has paid a premium on R682 500 but their actual earned Gross Profit was R786 600. The adjustment premium charge is then only charged on the difference of R104 100. Premium adjustments are limited to one third of the deposit premium, so provided the calculations were done reasonably correctly, the client will get 100% cover for less than 100% premium.

In this example, if the premium rate was 0,10% the client would have paid a deposit premium of R682.50 plus an adjustment premium of R104.10, which totals R786.60, instead of full premium of R904.59, which means the client enjoyed 100% Gross Profit coverage for less than the full premium.

Sasria

This provides an additional reason why the broker must find out what the client's NPBT figure is: Sasria does not include NPBT in their coverage. So, if we undertake the same calculation for the Sasria Consequential Loss policy, we arrive at a Rate of Gross Profit of 55% which converts into a sum insured of R727 375 + VAT = R829 207.50, which is rounded up to R830 000. Do not forget the deposit premium and end of policy year adjustment, which must be done for the Sasria cover as well.

Keep in mind

Remember that all Business Interruption and Sasria Consequential Loss Schedules must record either all the fixed cost items (for the Additions basis only) or all the variable charges (for the Difference basis only).

Do not omit these titles. Failure to do so can lead to either the application of average or the insurer not agreeing with the client's calculation of their claim. Loss adjusters also have extreme difficulty in finalising a claim if charge items are not mentioned.

Our next article will look at the Occurence vs the Claims Made Liability policy wording.