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Managing Consequential Loss Exposures

• As the term suggests, "consequential" losses are


those that result from direct loss. They are also
referred to as "indirect" loss.

• Also, in those situations in which the amount of


the consequential loss is a function of time, some
consequential loss exposures are also referred to
as "time element" exposures.

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Managing Consequential Loss Exposures

• Although the terms tend to be used


interchangeably, not all consequential losses are
time element losses.

• Debris removal losses and losses arising out of


the enforcement of building codes are examples
of consequential loss where the loss is not a
function of time.

18-2
Time Element Exposures

• The simplest example of an indirect time element


exposure is business interruption. When a
factory burns, the owners lose the value of the
factory and its contents.

• In addition, however, they also lose the output of


the factory for the period of time required for
reconstruction.

18-3
Time Element Exposures

• Another consequential loss exposure is "extra


expense," for organizations that cannot suspend
operations, but must continue to provide services
using extraordinary means and at a higher cost.

• The increased cost of continuing operations


when owned property is damaged or destroyed
can result in a reduction in profit or, in severe
cases, an operating loss.

18-4
Importance of Consequential Loss Exposure

• Although the magnitude of a consequential loss


may equal or exceed that of a direct loss,
organizations that would not consider going
without property insurance ignore the business
interruption or extra expense exposure.

• In addition to the failure to purchase insurance,


the amount of insurance purchased under
business interruption and extra expense forms
often bears little relationship to the exposure.

18-5
Controlling Consequential Loss Exposures

• Since indirect property losses are occasioned by


direct property losses, the loss control measures
aimed at preventing and reducing direct loss also
serve to prevent indirect losses.

• In addition to measures that are aimed at


preventing direct loss, there are a number of loss
control measures that aim specifically at
preventing or controlling indirect loss.

18-6
Planning for Indirect Losses

• The most effective loss control technique for


consequential losses is to anticipate such losses
and make arrangements prior to a direct loss for
continuation of operations.

• A determination must be made as to whether it


will be feasible for the organization to continue
operations in the event of damage to or
destruction of its property.

18-7
Planning for Indirect Loss

• Unless specific plans are made where and how


operations will be continued, it may be found that
it is impossible to obtain access to the facilities
required to continue or resume operations.

• Ideally, a specific continuation plan should be


devised, which identifies the requirements that
will exist for continuing operations and the
manner in which these requirements will be met.

18-8
Identifying Bottle-Necks

• In some situations, a key machine is critical to


the entire production process, which means that
the loss of the machine could interrupt the entire
operation.

• When such bottlenecks are identified, it may be


possible to reduce the interruption period by
planning for rapid replacement of the item.

18-9
Planning Replacement Facilities

• It may be possible for the organization to enter


into a reciprocal arrangement with another firm in
the same industry for temporary use of facilities.

• In other cases, it may be possible for the firm to


subcontract with another organization during the
period required to restore the premises.

18-10
Alternate Computer Facilities

• Many organizations make advance provision for


use of an alternate facility in the event the
organization’s data processing equipment is
damaged or destroyed.

• Alternate computer facilities are designated as


“cold sites” or “hot sites,” according to their
configuration.

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Contingent Business Interruption Exposures

• When a contingent interruption exposure relates


to a single supplier, the firm may consider
stockpiling a reserve of the raw materials.

• To the extent possible, alternate sources of


supply should be identified.

• If the cost of obtaining supplies from the


alternate source will be higher, once this has
been determined, insurance may be arranged to
cover the higher cost.

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Redundancy

• Redundancy in production facilities is similar in


effect to stockpiling raw materials; it can permit
continuation of operations when a direct loss
damages production facilities.

• It can be an effective loss control strategy, but


only if the primary and redundant facilities are
not subject to loss in the same occurrence.

18-13
Post-Loss Control - Resuming Operations

• Once a direct loss has occurred, it may be


possible to reduce the amount of the loss by
continuing operations at another location or by
partial resumption of operations.
• Indirect-loss insurance coverages require the
insured to use all reasonable means to resume
operations as soon as possible.
• If it is possible to continue operations even on a
partial basis, the insured is required to do so.

18-14
Expediting Repairs and Reconstruction

• The more quickly reconstruction can be


completed, the more quickly the firm will be able
to resume normal operation.

• In general, this means expediting the resumption


of operations in all ways possible.

• One technique that is increasingly applied to this


problem is Program Evaluation and Review
Technique (PERT).

18-15
Program Evaluation and Review Technique
(PERT)

• PERT is an analytical technique that is used when


a project includes a number of time-critical
events whose performance may determine the
total time required to complete the project.

• PERT analysis can help to expedite restoration


and resumption of operations. This was
dramatically demonstrated in the restoration of
the World Trade Center following its bombing by
terrorists.

18-16
Financing Consequential Losses

The major time-element indirect loss coverages are:


business income (interruption) insurance,
extra expense insurance
contingent business interruption
contingent extra expense insurance, and
leasehold interest coverage.

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Business Income Insurance

• Business income insurance indemnifies business


firms for loss of income during the period
required to restore property damaged by an
insured peril to a useful condition.

• It pays the expenses that continue and the profits


that would have been earned during the period of
interruption.

18-18
Business Income Insurance

• Although a valued form of coverage is available,


most business interruption is written on an
indemnity basis.

• In determining the amount of loss under the


indemnity forms, the insurer considers the
insured's experience before the loss and
probable future experience if no loss had
occurred.

18-19
Perils Insured

• Like direct property loss, business interruption


coverage should provide protection against any
peril that could trigger suspension of operations.

• This includes, among other things, not only the


broad coverage of an open-peril form, but
earthquake and flood as well.
• Boiler and machinery coverage include indirect
loss coverage in the same amounts as under the
general property insurance part of the program.

18-20
Monthly Limit of Indemnity

• Under the Monthly Limit of Indemnity option, the


insured may collect a specified fraction of the
total amount of the insurance during any month
for which the business is totally or partially
interrupted.

• Options are available to permit collection of 1/3,


1/4, or 1/6 of the face amount of coverage.

18-21
120-Day Indemnity Form

• The standard Business Income form can be


converted to a 120-day indemnity form by
electing the Maximum Period of Indemnity option.

• The coinsurance clause is replaced with a 120


day limit on the period for which indemnity is
payable, with no monthly limit on the amount
payable other than the amount of loss.

18-22
Valued Business Interruption Insurance

• Pays a specified amount per day or week or


interruption regardless of the actual loss
sustained.
• A proportional payment is made for partial
interruptions.
• The valued form of business interruption
insurance is most useful when the income is
stable and does not fluctuate over time.

18-23
Business Income (Coinsurance) Forms

Standard forms of business income insurance


• Business Income Coverage (And Extra
Expense) form and the
• Business Income Coverage (Without Extra
Expense) form.

Coverage under either form is subject to a


coinsurance provision. Coinsurance options of
50%, 60%, 70%, 80%, 90%, 100%, or 125% are
available.
18-24
Business Income (Coinsurance) Forms

• If the business is interrupted, payment is made


for the loss of "Business Income," defined as the
net profit that would have been earned (including
or excluding rental income) and the necessary
expenses that continue during the "period of
restoration."

• In determining the amount of loss, the insurer


considers the insured's experience before the
loss and probable future experience if no loss
had occurred.

18-25
Resumption of Operations

• A Resumption of Operations provision requires


the insured to resume operations as soon as
possible, even on a partial basis, using damaged
or undamaged property at the described
premises or elsewhere.

• If operations are not resumed when it is possible


to do so, the insurer will reduce payment for loss
of income by the amount that resumption of
operations would have reduced the loss.

18-26
Expense to Reduce Loss/Extra Expense

• Expense to Reduce Loss provision of Without


Extra Expense form pays for expenses to resume
operations or otherwise reduce the amount of the
business interruption loss.

• Extra Expense provision of And Extra Expense


form, pays for expenses to continue operations
whether or not such expenses reduce the
business interruption loss.

18-27
Programming Business Income Insurance

To determine the appropriate amount of business


interruption insurance it is necessary to determine:
(1) the period of time for which the firm will be
interrupted,
(2) the income that will be lost during that period,
and
(3) the expenses that will be incurred and the
profit that will be lost during the period of
interruption.
18-28
Non
Business Continuing Continuing
Month Income Expenses Expenses Profit
January $15,000 $5,000 $5,000 $5,000
February 15,000 5,000 5,000 5,000
March 15,000 5,000 5,000 5,000
April 15,000 5,000 5,000 5,000
May 15,000 5,000 5,000 5,000
June 15,000 5,000 5,000 5,000
July 15,000 5,000 5,000 5,000
August 15,000 5,000 5,000 5,000
September 35,000 5,000 20,000 10,000
October 35,000 5,000 20,000 10,000
November 45,000 5,000 20,000 20,000
December 65,000 5,000 20,000 40,000
$300,000 $60,000 $120,000 $120,000

18-29
Programming Business Income Coverage

• It has been determined that in the event of a loss,


the period required to restore the building and
the stock would be four months.
• The problem is to determine the maximum loss
that might be incurred by the insured during the
four month period.
• The four months with the highest projected
continuing expenses and profits are September
through December: $160,000.

18-30
Non
Business Continuing Continuing
Month Income Expenses Expenses Profit
January 15,000 5,000 5,000 5,000
February 15,000 5,000 5,000 5,000
March 15,000 5,000 5,000 5,000
April 15,000 5,000 5,000 5,000
May 15,000 5,000 5,000 5,000
June 15,000 5,000 5,000 5,000
July 15,000 5,000 5,000 5,000
August 15,000 5,000 5,000 5,000
September 35,000 5,000 20,000 10,000
October 35,000 5,000 20,000 10,000
November 45,000 5,000 20,000 20,000
December 65,000 5,000 20,000 40,000
300,000 60,000 120,000 120,000

18-31
Determining the Coinsurance Percentage

• Selection of the coinsurance provision is based


on the relationship of the insurance purchased to
the annual business Income.
• In our illustration the annual Business Income is
$300,000.
• The amount of insurance needed is $160,000.
$160,000/$300,000 = .5333

• The coinsurance provision should be 50%.

18-32
Ordinary Payroll

• The insured may elect to exclude payroll for rank


and file workers of cover it only for a limited
period of time using the Ordinary Payroll
Endorsement.

• "Ordinary payroll" is defined as payroll expense


for all employees except officers, executives,
department managers, employees under contract,
and any other employees selected by the insured
and designated in the Ordinary Payroll Limitation
endorsement.

18-33
Dealing With the Problem of Underinsurance

Insurers offer two options to address the problem


of possible inadequate coverage.

The Agreed Value Option

The Premium Adjustment Endorsement

18-34
Agreed Value Option

• Suspends the coinsurance provision and


guarantees that the insured will not suffer a
coinsurance penalty on a partial loss.

• Protects the insured from a coinsurance penalty


when earnings increase more than anticipated.

• The cost of the Agreed Value Option is 10% of the


business income premium.

18-35
Premium Adjustment Endorsement

• A type of reporting form, with a single report at


the end of the year, to determine both the amount
of insurance that was in force during the year and
the premium for the coverage.

• The insured selects a provisional amount of


insurance that is higher than the anticipated level
of protection that will be required. In addition, a
coinsurance percentage is selected.

18-36
Premium Adjustment Endorsement

• At expiration, the amount of insurance in force


during the coverage period is determined by
multiplying the coinsurance percentage selected
by the actual business income of the firm.

• Unlike the Agreed Amount option, there is no


premium surcharge for the Premium adjustment
endorsement.
• The cost is the interest foregone on the premium
for any excess coverage not needed.

18-37
Lag in Earnings After Restoration

• There are some situations in which it can be


anticipated that a firm's income will remain
depressed following restoration of the premises.

• Old customers may have turned to new sources


during the period of interruption, and the process
of rebuilding a clientele may require time beyond
the period of restoration.

18-38
Lag in Earnings After Restoration

• The ISO business interruption forms provide


coverage for a period of 30 days beyond the date
of restoration, under a provision entitled
"Extended Business Income."
• The Extended Period of Indemnity optional
coverage permits the insured to extend this 30
day extension in 30 day increments up to six
months, with 90 day increments thereafter up to
365 days.

18-39
Extra Expense Insurance

• Under some circumstances, it may be necessary


for a business to continue operations after
destruction of its facilities.

• For example, a bank's earnings, which are


derived from loans and investments, would not
be affected by destruction of the bank's
premises, but the bank would need other facilities
to continue to service its accounts.

18-40
Extra Expense Insurance

• Extra expense insurance is an alternative to


business interruption insurance for those
enterprises that can continue operations with
other facilities.

• It provides payment for expenses above normal


costs when such expenses are incurred to
continue operations after damage to the premises
by an insured peril.

18-41
Extra Expense Insurance

• The Extra Expense Coverage Form contains a


schedule of cumulative monthly limits, expressed
as a percentage of the policy limit, and payment
for loss is limited to these percentages.
• The most commonly used schedule permits the
insured to collect up to:
40% of the limit in the first month after damage,
80% during the first two months, and up to
100% for three months or more.

18-42
Extra Expense Insurance

• An insured anticipating a more extended period


of extra expenses can select a smaller monthly
limitation (for example, 10% during the first
month, 20% in the first two months, and so on.

18-43
Indirect Boiler and Machinery Coverages

The Boiler and Machinery Policy may be endorsed


to provide coverage for three consequential loss
coverages:
Business Interruption
Extra Expense
Consequential damage

Consequential damage coverage covers loss to


perishable property that is damaged because of the
breakdown of the insured object.
18-44
Contingent Business Interruption Exposures

1. Contributing Property: when the insured depends


on one or a few suppliers for most of its materials.

2. Recipient Property: when the insured relies on


one or a few businesses to purchase the bulk of its
products.

3. Leader Property: When the insured counts on a


neighboring business to help attract customers.

18-45
Contingent Extra Expense

Contingent extra expense insurance operates in


much the same way as contingent business
interruption, but is designed for the firm that would
incur increased costs as a result of damage to a
contributing or recipient firm's property.

18-46
Interruption of Utilities

• A specialized form of contingent business


interruption insurance covers interruption due to
the suspension of utility service caused by
damage to the utility (or transmission media)
away from the premises.

• The Off-Premises Services - Time Element


endorsement provides coverage when the
insured’s insured's business is interrupted
because of loss of utility services because of
damage by an insured peril.

18-47
Interruption of Utilities

The particular type of utility service for which


coverage is desired must be indicated. There are
five options:
water supply
communication, not including transmission lines
communication, including transmission lines
power supply, not including transmission lines
power supply, including transmission lines

18-48
Leasehold Interest Insurance

• The leasehold interest exposure arises from the


contractual right to the lower-than-market rent,
which would be lost if the property were
destroyed.

• When prevailing conditions make it impossible to


secure similar quarters at less than say, $2500 a
month, the existing contract would create a
leasehold interest loss of $ 1,500 a month for the
remaining period of the lease.

18-49
Leasehold Interest Insurance

• The amount of coverage under leasehold interest


coverage decreases month by month, with the
amount of insurance always about equal to the
insured's interest in the lease.
• In the event of a loss that terminates the rental
agreement, the insured is paid a lump sum equal
to the discounted value of the leasehold interest
for the remaining months of the lease.
• The insured may select a discount rate ranging
from 5% and 15%.
18-50
Rain Insurance

Rain insurance is a consequential loss coverage.

• It does not protect against damage to property,


but against loss of income or the incurring of
extra expenses due to rain, snow, sleet, or hail.

• It is usually sold to cover outdoor events


scheduled for a certain day dependent on
favorable weather for success.

18-51
Rain Insurance

• The coverage may be written on an indemnity


basis to cover the loss of income suffered or
additional expenses incurred, or it may be written
on a valued basis.

• The policy must usually be taken out at least


seven days before the event and is not subject to
cancellation by either party.

18-52

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