Top 5 Mistakes with Business Income Claims

by Chad Thompson

files/pages/blog/blog-images/Other/Oops.jpgKeeping with my theme of fives (see The Accounting Fives), I've decided to write about the top 5 mistakes in business income loss claims. Insurance companies view certain business income loss claims as straightforward. As such, they tend to handle these claims internally. While certainly not intentional, mistakes sometimes arise. These mistakes ultimately overstate the loss. It is true that there are some mistakes that understate the loss; however, insureds are usually quick to recognize if the business income settlement appears too low. Accordingly, mistakes that understate the loss are usually just temporary. By contrast, insureds don't often see problems with settlements in excess of their expectations. This is not because they are trying to be sneaky. Rather, insureds may believe the "overage" is just a product of the insurance policy.

I've traveled around the country providing business income loss training for commercial insurance adjusters. In each of my sessions, I train participants to avoid the the top 5 mistakes discussed below.

1. Not using "net" income

The policy generally defines business income as the combination of net income and continuing, normal operating expenses. Net income represents the bottom line number after all expenses and costs. Mistakes arise when one uses gross profit or sales instead of net income. This is the most common mistake I see. In addition, it has a potentially greater impact on overstating the loss than any of the other mistakes discussed here.

This is an easy mistake when one is not versed in accounting. One may conclude that gross profit (sales minus cost of sales) is net income, since the costs of the product or service were deducted. Further, one may see a report that reflects "net sales" and believe this is tantamount to net income.

The impact of this mistake is extraordinary. I selected a sample of my recent business income loss calculations involving a relatively short loss period. On average, using gross profit plus continuing expenses overstated the loss by 197%! Even more staggering was the impact of sales plus continuing expenses. This ill-conceived method overstated the loss by an average of 413%!

2. Paying continuing expenses twice

Business expenses are the basis for several elements of an insurance claim. For instance, the insured's employees may spend time cleaning up after a fire. This clean-up labor expense may be covered and paid under the property portion of the claim (expenses to rebuild or restore property). If the insured also has a business income loss claim, this same labor expense may mistakenly be included as a continuing expense, and paid twice.

This is the second most common error I see. The potential for this error arises anytime the insured has other claims in addition to a business income loss claim. For instance, a valuable paper claim might include employee labor. An extra expense claim might include costs for the insured's machinery and equipment used to clean up or mitigate a loss. If these machinery and equipment costs include depreciation, lease payments, or repairs, odds are they will be picked up again in the business income loss claim as continuing expenses.

3. Paying for unproductive labor

In this case, an insured admits that the business did not lose sales, but incurred payroll expense even though employees could not work for a certain period of time. A claim for "lost payroll" usually follows. The business income loss policy states that business income includes continuing normal operating expenses, including payroll. Consequently, the adjuster may believe the claim for lost payroll is reasonable. However, there is no stand-alone coverage for payroll. It is a component of the business income loss, provided the insured suffers a business income loss. An insured incurs a business income loss only if there is a loss of sales. Therefore, from a policy standpoint, the claim for "lost payroll" is not covered.

This also makes sense from a practical standpoint. Payroll is a business expense. Business expenses are paid from a company's sales proceeds. Therefore, if the company did not lose sales, it is able to continue paying employees as normal, eliminating the need for an insurance reimbursement.

4. Errors in sales projections

A business income loss evaluation starts with a determination of lost sales. When the proper amount of scrutiny is not applied, mistakes abound. A common approach for non-accountants is to project sales using the corresponding period from the prior year. The problem with this approach is that sales are almost never identical from year-to-year. Factors such as trends, economic conditions, changes in business practices, inflation/deflation and the weather among other items have the potential to affect the comparability of a given day, week or month from one year to the next. If these kinds of factors are not considered, the sales projection is likely erroneous.

The errors in sales projections don't always involve prior year comparisons. Errors also arise when inappropriately using current year data to project sales for another period within the same year. For instance, one may use August's average daily sales for an apparel retailer to project September sales. August sales may be high due to back-to-school shopping, which would not occur at the same pace in September. Similarly, if one used June and July sales for an ice cream vendor to project sales for August and September, that projection would also likely be overstated due to the change in seasonal demand.

The solution to these problems lies in understanding the business and its sales patterns. Obviously, small claims do not require detailed and exhaustive sales analysis; however, they do require acknowledgment of issues that affect comparability of sales from one period to another.

5. Paying continuing expenses in excess of what was used to determine net income

This is the most technical of all of the top 5 mistakes. Given its nature, an example provides the best explanation. If a business pays, say $6,000, each year for property taxes, the monthly average is $500. So, for a one-month business interruption, one would deduct $500 in determining net income for the month. Since this expense would likely continue during the one-month period (i.e. no abatement), $500 would also be included in continuing expenses. Thus, $500 is deducted as part of determining net income, but is added back as a continuing expense.

If the affected month just happens to be the month that the insured pays its annual tax bill, the insured may present the bill for $6,000 and want to increase continuing expenses by $5,500 - the difference between the $500 included in continuing expenses and the $6,000 bill. If the insured is then paid $5,500, that's $5,500 too much! Increasing the expense to $6,000 is incorrect since the annual tax bill relates to more than one month. However, if the insured insists on including the extra $5,500, net income would have to be decreased by the same amount. Thus, there were be no net change to the combination of net income and continuing expenses (one decreases and the other goes up by the same amount).

This problem is brought to bear by the use of "cash basis" accounting. Cash basis accounting involves recording revenue when it's received, as opposed to when it's earned, and recording expenses when they are paid, instead of when they are incurred. While cash basis is not acceptable under generally accepted accounting principles, it is widely used by small businesses. As you can see, there is a large potential for this 5th mistake!

So there you have the top 5 mistakes with business income loss claims! These mistakes highlight the intricacies of such claims, along with the benefit of forensic accountants.

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