In search of lost profit: Business interruption insurance in disastrous times
The classic form of protection against the financial consequences of natural disasters is property insurance, primarily covering the risk of physical damage or destruction. But that is not all. Insurance for businesses can also protect against the loss of profits and against unanticipated costs of business interruption.
Unfortunately, 2024 has been a year abounding in natural disasters in Poland, ranging from a series of fires over the dry summer, through the biggest floods in years, striking Lower Silesia almost as soon as the summer heat wave subsided. Apart from scattered suspicions of arson, it is hard not to link this year’s events with climate change, which is gradually increasing the risk of natural disasters such as droughts (and thus fires), floods and windstorms. In other words, we must get accustomed to these risks—and ideally protect against them.
The classic form of protection against the financial consequences of natural disasters is property insurance, primarily covering the risk of physical damage or destruction. But that is not all. Insurance for businesses can also protect against the loss of profits and against unanticipated costs of business interruption. The idea behind this instrument is primarily to cover situations of downtime and temporary reorganisation of operations as a result of damage or destruction in the enterprise, for example if a fire consumes a production line or a flood overcomes a logistics facility or shopping centre.
Polish insurers usually refer to these products as “insurance against loss of profit,” but the overall purpose of this instrument is somewhat broader and is best conveyed by the original name in English: “business interruption insurance” (“BI” insurance in short). The notion of “interruption” does cover the loss of anticipated profit, but it is broader, covering costs related to the disruption.
Lost profit covered only if property injured too
In market practice, business interruption is always connected with property insurance in the narrow sense, i.e. with insurance against physical (mechanical) damage or destruction. If a company wishes to take out insurance against lost profit, a policy covering its material property must also be taken out.
But the links between lost profit and physical harm to property go much further. Only physical damage to (or destruction of) insured assets can trigger insurance cover for lost profit and other costs—if the ordinary operation of the enterprise is disrupted as a result of that physical damage. For example, if a production line burns down in a fire, compensation may also cover the profit lost because of the interruption in production, and hence reduced sales. But if instead the fire destroys the plant of a subcontractor or customer (e.g. located in the same industrial zone, as it sometimes happens), leaving the insured’s own production line unharmed, then the insurance will not cover the insured’s lost profit despite the disruption of its supply chain, because the insured’s own property has not been affected. The same result would be reached if the fire destroyed only vehicles or equipment actually used by the insured but not owned by it, such as leased assets.
Difficult adjustments
Calculation and adjustment of the lost profit under a business interruption policy can prove complicated. Historically, it was the difficulties in finding reliable methods of calculating lost profits that hindered the introduction of business interruption insurance. It is no coincidence that such insurance products were ultimately developed in the second half of the 19th century, when the first professional associations of chartered accountants were established in the UK and the US, and with them, standardised accounting rules.
The reason for this connection is that the baseline for calculating lost profit is the “anticipated” or “standard” profit, which is usually calculated based on the booked turnover generated in the periods prior to the loss, e.g. in the immediately preceding 12 months. Having this type of insurance will not necessarily result in fully making up the real level of lost profit, because compensation is based on an abstract, average profit which the insured would have achieved in line with historical data from its accounting books. The specific formulas for calculating lost profit compensation are set forth in the each insurer’s terms and conditions. It’s worth devoting some time to analyse the terms and conditions—ideally along with the company’s finance or accounting department—in order to understand more clearly how much compensation can fairly be expected and whether the particular mechanism is advantageous for the given company, taking into account for example its accounting policies or the allocation of profits and expenses within the corporate group.
The booked level of previous profit also carries over to the sum insured, which is usually equivalent to the anticipated profit for the maximum indemnity period set for the given policy. By doing so, the policy essentially specifies the period for which the insured can claim compensation for lost profits. If for example that is three months, then the sum insured will be set as the standard three-month profit, calculated based on the company’s prior results, e.g. for the last completed financial year.
As mentioned, however, lost profit is not the only element of financial injury that may be covered by a business interruption policy. It is standard for such insurance to cover also the fixed costs that the insured must incur despite the downtime in its operations (e.g. property rent and salaries) as well as the costs of temporary reorganisation of the insured’s operations necessary to resume and allow them to continue despite the loss event.
Right and duty to mitigate losses
This second category basically amounts to the cost of mitigating lost profits by the insured. Polish law makes coverage of such costs mandatory anyway, in particular via Civil Code Art. 826 §4. In this respect, apart from the sum insured, the insured’s ability to obtain compensation is also limited by the reasonableness of the measures taken to “save” the business (but not whether, in hindsight, these measures prove to have been actually effective).
Notably, it is not just that the insured has a right to take efforts to restore its enterprise, but is under a direct obligation to do so (mandated by Civil Code Art. 826 §1). According to the Civil Code, if the insured fails to take such actions, either intentionally or through gross negligence, this releases the insurer from liability for the resulting loss. Some insurers even try to expand these duties on the part of the insured by introducing policy exclusions suggesting that the insurer will not be liable if the insured does not take “immediate” action, or runs short of funds for restoring the enterprise to operation. Generally, such provisions are legally ineffective if they set a higher standard than intentional or grossly negligent failure to act, but they can nonetheless become a point of contention during the loss adjustment process.
Can’t afford to save on insurance?
Obviously, every company must answer this question for itself, looking at its business model and the range of available insurance products. Manufacturers have a different risk profile than service firms, and whether business interruption insurance makes economic sense will also depend on the premium levels and other variables such as the geographical location of the plant or even the company’s adopted accounting rules.
At the very least, businesses should be aware of these insurance products and take them into consideration. Like other insurance products, they provide a unique opportunity to protect against the consequences of unavoidable events, and thus in a certain sense to “cheat fate.” At least up to the sum insured.
Maciej Zych, adwokat, Dispute Resolution practice, Wardyński & Partners
Mateusz Kosiorowski, adwokat, Insurance practice, Wardyński & Partners
