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 basis or on a Difference basis.
The Additions basis states that the broker must add to the Net Profit all the Standing Charges that
must be insured.
* Net Profit is the total (before deduction of Income Tax) that is generated annually by the business.
* Standing Charges are all those annual charges or expenses of the business that will continue
during any 'shut down' period, e.g. rent, salaries, HPs, lease agreement payments, etc.
The Difference basis requites that the broker 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 business 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 ChargesR(nowadays termed "fixed costs")
Uninsured Working ExpensesR(nowadays termed "variable expenses")
TurnoverR(could be called "income" or "sales" or "revenue")
Notice that the Turnover and Income of Sales and Revenue of the business is made up of NPBT +
Fixed and Variable costs or 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 =Turnoverx 100
Doing the sums
With the assistance of the broker, the client takes their last financial report (Balance Sheet) 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 is the expected Gross Profit.
To this expected Gross Profit, VAT must be added and 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.
Example figures
Fixed Charges R 550 000.00
Variable Expenses R 400 000.00
NPBT R 50 000.00
Turnover 29/02/2008 R 1 000 000.00
Insurance Gross Profit R 600 000.00
Rate of Gross Profit 60%
Turnover increase 15%
Period of Insurance01/03/2008 to 28/02/2009
Expected Turnover R 1 150 000.00
Year after expiry of policy 01/03/2009 to 28/02/2010
Expected Turnover R 1 322 500.00
Insurance Gross Profit R 1 322 500.00 x 60% (Rate of Gross Profit)
Gross Profit Sum Insured R 793 500.00
Plus VAT R 904 590.00
Rounded up to nearest R10 000 R 910 000.00
The premium is calculated on R682 500, or 75% of R910 000.
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.
