Understanding Business Interruption Values Can Be Critical to Your Company

Understanding the values at risk and overall loss of income exposures can be critical to an organization’s finances, operations, and overall success. Companies affected by Superstorm Sandy experienced significant interruptions to their operations, affecting financial returns and exposing business interruption (BI) insurance coverage limits during the adjustment process. These limits often resulted in complicated and protracted insurance claims, some of which have yet to be paid.

This experience reinforced the importance of thoroughly understanding an organization’s income exposures. As Marsh clients and prospects work to renew their property programs, they are now faced with uncertainties regarding the need for BI insurance and the amount of coverage that is necessary to indemnify their businesses in the event of a loss. Understanding BI values can help organizations determine:

• The amount of coverage needed.
• Risk retention and transfer options, including captive solutions.
• Appropriate limits.

Marsh Risk Consulting’s Financial Advisory Services (FAS) Practice provides three levels of company- and industry-specific analyses — a basic 12-month valuation required by underwriters, an anticipated maximum business interruption loss (AMBIL) calculation, and a contingent business interruption (CBI) exposure study – all of which provide important information for internal decision making.

Basic 12-Month BI Value Calculation

To get started and to satisfy underwriters’ demands, a basic 12-month valuation is necessary. FAS often assists Marsh clients with this basic valuation, as both clients and underwriters feel more confident with a financial statement-based study provided by an independent party. This approach provides transparency into which operating costs and expenses an organization intends to insure along with the profits of the business. The resulting BI value percentage — the product of dividing the calculated value by the annual net sales — gives an organization a quick metric to determine the estimated loss that would be sustained per dollar of lost net sales, a powerful tool when considering the costs and potential mitigations of business continuities.

Although most organizations go through some process to present their BI values to underwriters, it is by no means the same exercise for each. The industry, complexity of the organization, and existence of transfer pricing between domestic and/or foreign affiliates, among other issues, can complicate the process. Another complicating factor is that formal accounting may be misaligned with an organization’s risk. This is often deceiving, as the risk to the organization rests predominantly at the physical location where business activities occur, which is not necessarily the same as the operating location or segment where income is booked.

In conducting past studies, FAS experience is mixed as to whether the calculated BI value is greater or less than the amount previously reported by a client. However, a constant benefit for risk professionals of knowing their values is being an informed decision maker and purchaser in the insurance marketplace. For example:

• If an organization is overinsured based on the results of the study, the reduction in necessary BI limits should result in premium savings.
• If an organization is underinsured based on the result of the study, it now has the information necessary to avoid or mitigate the experience and consequences of a financial loss far in excess of purchased limits through the purchase of additional insurance or an expanded risk management program.

Anticipated Maximum Business Interruption Loss (AMBIL) Calculation

The next level of analysis involves the preparation of an anticipated maximum business interruption loss (AMBIL) calculation. An AMBIL calculation is a values reporting tool, which considers realistic repair/ replace timelines and existing capabilities to mitigate the maximum potential losses to an organization’s supply chains by utilizing inventory, redirection of product, and outsourcing, among others. As such, the AMBIL calculation presents a realistic measure of an organization’s values at risk.

There are many reasons why an AMBIL calculation, which considers the unique characteristics of a company, might differ from the traditional 12-month BI valuation. The most easily understood difference involves geographic spread of risk. With a traditional BI values presentation, the addition of each location’s calculated value would be presented to the underwriters. But, the AMBIL calculation considers events that would have a wide regional impact, possibly affecting multiple operating locations, and focuses on only those locations in the affected region as outlined by the loss scenario. An AMBIL calculation also:

• Quantifies the expected reduction in potential BI from existing business continuities and reduces the reported value accordingly.
• Considers realistic repair and/or replacement timelines.

A recent engagement highlights how each aspect of an AMBIL calculation assisted a hospital group in purchasing the proper amount of property insurance. The hospital group operated a main campus and remote health centers. Marsh Risk Consulting’s engineers determined that the replacement timeline for the main hospital property was approximately 2 ½ years. However, based on the hospital group’s geographic spread of risk and its ability to set up temporary operations for certain medical services, business could continue, in part, during reconstruction. Therefore the potential maximum loss to the main campus was only slightly higher than the 12-month BI value despite the elongated repair period.

Contingent Business Interruption (CBI) Exposure Study

The AMBIL calculation does not necessarily account for the potential impact on an organization’s business from the suppliers and customers on which it depends. Expanding the BI analysis to the next level to include contingent business interruption (CBI) exposures is a smart and often necessary step.

Recent CBI events, notably the Japan earthquake and Thailand floods, highlight the need for increased visibility into the supply chain and understanding of key vulnerabilities so that appropriate coverage can be obtained and any potential outages or shortages are reacted to quickly and appropriately. Some of the CBI vulnerabilities have included:

• Insufficient CBI limits.
• Little or no indirect CBI coverage.
• Coverage provided for only the location where the loss occurred, leaving other global losses without coverage.
• Frequently inaccessible causation and other claim information required by the insurance adjusters, since the physical damage or other causes of loss did not occur at the policyholders’ operating locations.

Underwriters have responded to these recent, unprecedented CBI events by demanding detailed CBI exposure information prior to providing increased or equivalent levels of coverage. CBI coverage can no longer be a simple add-on to the insurance policy. Assessment and quantification of an organization’s direct and indirect exposures must be part of the process when establishing CBI limits and securing adequate coverage from the markets. This analysis provides insight into customers’ and suppliers’ risks to enable the creation of continuity strategies, a competitive advantage especially when there may be limited options in the marketplace. When quantifying CBI exposures, it is important to remember that:

• The sum of the parts can be greater than the whole, since two different suppliers can put the same dollar at risk.
• To avoid duplication and the overreporting of values, the focus should be on the maximum contingent exposures, usually from key suppliers and customers.
• CBI exposures can never exceed the BI value of a total shutdown over the same time period.
• Supply chain mapping and natural hazard exposure analyses help to support CBI quantifications.

Using a pre-loss exposure analysis — whether at a basic, AMBIL, or CBI exposure study level — to understand your values at risk provides the certainty needed as a buyer of property insurance and a manager of risk. These calculations are often an eye-opening experience, bringing new insight to the local and global risks inherent in your business.

For more information on Marsh’s pre-loss exposure analysis capabilities, contact your Marsh representative.