Material World

Ensuring that your business assets are insured adequately can be an onerous task, and an ongoing challenge. There are misconceptions around what should be insured and for how much. Even if a policy is set up with adequate limits initially, these limits must be regularly reviewed to ensure cover remains appropriate and take into account changes in your business, such as new items of machinery, or else the condition of average can mean that you receive significantly less than you expect in the event of a claim.

In this bulletin, Nick Balcombe and Jonathan Samuelson of specialist claims managers Harris Balcombe LLP highlight some of the common pitfalls and provide ten top tips on keeping your Material Damage and Business Interruption insurance fit for purpose, should the worst happen.

Buildings

Insure buildings for rebuild/reinstatment value, not market value

One common pitfall is when buildings are insured at their market value, as opposed to their rebuild/reinstatement value. It is often thought by policyholders, that the market value of their building will be an accurate indication of what it would cost to rebuild, in the event that the building was totally destroyed. Often they do not appreciate that there is a difference between the two figures. Frequently the market value is derived from a valuation prepared for a bank or building society for loan security purposes. Thus the market value may be on a forced sale basis. To add further complications a cleared site could have a greater market value than the original building.

The actual costs of rebuilding are often significantly higher than the market value of the property and serious under insurance issues can arise when the wrong figure is used. When a policyholder says they have had a valuation of the building carried out, it is essential that the type of valuation is ascertained and that the correct – rebuild/reinstatement – value is used to set the sum insured. A number of insurers are now offering policy wordings that exclude the under insurance average clause for buildings, where a valuation is carried out by one of the insurers approved valuers and is then updated every three years. Take all areas into account, not just the main building

and include professional fees including demolition

Another major issue with setting the sum insured for buildings relates to what is included within the definition of buildings. Normally a policyholder will assume that the building consists only of the main structure. However, for sum insured purposes the value needs to include not only the main structure of the building but also the external car parking and other hard standing areas, roads, fencing, walls and anything else on the site as a whole. The value will also need to include the cost of demolishing the entire structure, including removing the floor slab and foundations, as well as all the professional fees associated with rebuilding such as architects, surveyors, planning experts and so forth. These professional fees can add up to 15% of the figure excluding these professional fees.

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July 2013

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Ten top tips to avoid the pitfall of under-insurance

Insure plant and machinery for what it would cost you to replace it now with new equipment

The majority of plant and machinery policies are written on a “new for old” basis. This means that the sum insured needs to be on the basis of what it would cost to replace all of the plant and machinery with brand new equipment, even in circumstances where the equipment that was damaged or destroyed in an incident was originally bought second hand. Often the sum insured is based on the original cost of the plant and machinery when it was originally purchased. That may have been many years previously and the costs for a new piece of equipment may be very much higher. Even worse is the situation where the sum insured is based on the written down value of the piece of equipment after depreciation has been deducted from the original cost – perhaps over many years. This can lead to a situation where some pieces of equipment are valued at nil in terms of the written down value and if that figure is then used as the basis for the sum insured it is easy to see how major problems may arise.

If it would never be the intention of a policy holder to replace certain items of equipment with brand new replacements then the basis for the insurance cover – at least for those items of plant and machinery – should be on indemnity which would mean that the second hand value would be the sum insured. This would allow the policyholder to purchase a second hand replacement and to have the insurance cover in place to meet that cost.

Don’t overlook the cumulative cost of small items

Whilst hopefully, all of the major pieces of plant and machinery will be included within the cover, what is often forgotten are all of the small pieces of equipment such as hand tools or racking. Other items that are frequently forgotten are jigs and patterns. All of these items, whilst they may have fairly low individual values, will add up to a significant sum in the event that they are totally destroyed. They all need to be included in the overall sum insured, as they form part of the value at risk. Often these smaller items never find their way into the fixed asset schedule, as they are not treated as fixed assets when they are acquired but are expensed within the profit and loss account. Nonetheless, for insurance purposes, they form part of the plant and machinery and need to be included in the sum insured.

Remember to highlight new purchases

Most policies include a “capital additions” clause which will allow the sum insured to be increased to take account of equipment that may have been acquired since the previous policy renewal. There is normally an upper limit on capital additions – typically 10% of the overall sum insured. However, if a major piece of equipment has been acquired since the last renewal and the insurer has not been notified a 10% capital additions clause may be hopelessly inadequate.

It is essential that you let your Broker know of any major pieces of equipment or new depots or locations that are taken on, or acquired after the date of renewal, so that they can be added to the policy.

Use the insurance definition of Gross Profit

The definition of Gross Profit is still a leading cause of problems in Business Interruption policies. The issue has gained a much higher profile in the last year or two as a result of the Business Interruption Policy Wording Review, carried out by the Chartered Institute of Loss Adjusters and the Insurance Institute of London. The under insurance problems that arise in Business Interruption cover have also led to the problem being designated as one of the key 2013 BIBA (British Insurance Brokers Association) Conference themes.

The accounting definition of Gross Profit is different, completely different, to the insurance definition of Gross Profit. The accounting definition will show Gross Profit after the deduction of purchases and typically, production wages. Frequently, other costs are also deducted such as repairs, depreciation and so forth. The insurance policy definition of Gross Profit is sales, less purchases adjusted for opening and closing stock. Sometimes carriage, packaging and freight are also deducted but not always. Thus a business which has a high production wage cost and which has based the Gross Profit sum insured for insurance purposes on the Gross Profit figure that appears in the accounts is going to have a very unpleasant surprise in the event that there is a significant Business Interruption claim. Under insurance averaging will seriously reduce the amount that will be paid by insurers.

It is absolutely essential that the policyholder is aware of what the Gross Profit definition for insurance purposes means. Some insurers, notably Aviva, have started to abandon the use of the term “Gross Profit” and now use “Insured Profit”. The purpose of this is to encourage the policyholder to query what Insured Profit means. By doing so, it will hopefully, ensure that the correct figure is included in the sum insured, i.e. Sales less Purchases.

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Consider a Declaration Linked Basis

It is also essential that the sum insured takes into account the trend of the business. Is the business growing? Have new branches been opened? Has a competitor recently closed down? Furthermore, a loss may occur right at the end of the policy year so the forecast for how the business is likely to perform actually needs to stretch out well beyond the actual policy period and through to the end of the year after the policy period (assuming a 12 month maximum indemnity period – see below). One way of dealing with the difficulties in forecasting how the business is going to perform and dealing with potential under insurance issues at the same time is to arrange cover on a Declaration Linked Basis. This requires an estimate of the likely Gross Profit to be given at the renewal and this is then confirmed subsequently once the actual figures are known. If the estimate was too high then there is a pro rata return of premium and if the estimate was too low an additional premium is payable. However, most importantly, there is no under insurance clause within the policy wording and thus under insurance averaging cannot be applied. Furthermore, there is an automatic uplift of up to 33.33% that can be added to the sum insured in the event that the estimated figure was too low. However, this is not a way of deliberately under insuring by under estimating the sum insured. Insurers are likely to claim that there has been a Material Misrepresentation in the event that the estimated figure is significantly different to what the actual insurable amount should have been. A material misrepresentation would entitle insurers to repudiate not just the Business Interruption element of a claim, but the entire claim including all of the material damage claim as well.

Factor-in your purchasing commitments

With the increase in businesses that import their products, in particular from China, consideration needs to be given as to whether it would be more appropriate to insure turnover rather than Gross Profit. Importing from China (and many other countries particularly in the Far East) involves a commitment that cannot be turned off. Thus, if there has been some catastrophic loss at a UK based production facility such that no products can be produced until the facility is reinstated and where a number of components are coming from a Chinese factory, it will not be possible to tell the Chinese factory to suspend the supply as the UK facility is not operating. The Chinese factory will supply what has been ordered and will expect to be paid for those goods. Indeed, it is likely that they will have already been paid under a trade finance agreement.

In those circumstances, it would not be appropriate to assume that purchases will vary in direct proportion to sales and that a significant loss of sales would result in a reduction in purchases. It would be much more sensible in this situation to insure the whole turnover.

Example: A similar situation arose in a claim that Harris Balcombe LLP recently dealt with for a potato crisp manufacturer, who suffered a catastrophic fire at one of their factories. That company forward purchases potatoes by agreeing with individual farmers that they will take the entire crop of potatoes that the farmer is able to produce. It was not possible for the crisp manufacturer to subsequently go back to the farmer and say that they did not need the potatoes now as the factory had burned down. The farmer had a contract to supply the potatoes and, accordingly, the crisp manufacturer was obliged to take delivery of the potatoes and pay for them. Fortunately, they were able to dispose of the potatoes in the market although, as a forced seller, they incurred a significant loss. They were insured for loss of Gross Profit and were thus unable to recover the loss incurred in disposing of the potatoes that they could no longer use.

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Allow sufficient time for recovery

It is a common misconception that a building that is totally destroyed can be rebuilt exactly as it was previously without the need to apply for planning consent. In fact, planning consent is always required when a significant part of any building has to be rebuilt. The normal planning period, even when the Planning Officers are supportive, is approximately four months. Thus, with a 12 month maximum indemnity period, one-third of the available cover is likely to be used up simply going through the planning procedure.

Insurers will, on any significant loss, appoint Forensic Scientists and probably Forensic Accountants as well to investigate the cause of the loss and to look into the financial health of the policyholder. They will also want to ensure that all of the warranties and conditions have been complied with and that no previous statements made by the insured when the policy was put in place were inaccurate. This process can take several weeks and until liability has been accepted by insurers there will be no financial assistance from the insurers by way of interim payments and so forth. Orders for replacement machinery cannot be placed because there will be no funds from insurers to pay deposits.

Sophisticated machinery is generally not available “off the shelf” and has to be ordered and manufactured. This is a process that can take many months.

Stock often has a lengthy lead time – particularly if it is coming from China or elsewhere in the Far East. Furthermore for seasonal stock it is generally not possible to order “out of season”. Thus for a clothing wholesaler who has lost a warehouse full of winter coats in a flood they will not be able to go back to the manufacturers in China and order a further supply of winter coats because those manufacturers will already be manufacturing for the spring/summer of the following year. The knock on effect of being unable to supply for one season will usually carry on to the following season and quite possibly the season after that as well. Accordingly it is highly likely that cover of just 12 months will be utterly inadequate to provide a full indemnity for losses.

Manufacturers who supply multiple grocers will find that if they are unable to supply for any reason their products are likely to be de-listed by the retailer. To re-gain those listings may take several years. A maximum indemnity period of just 12 months will be insufficient to provide cover, whilst efforts are made to relist the products.

Extend cover to include suppliers premises

It is not just an incident at a policyholders own premises that can cause a problem. If a key supplier suffers a serious incident, such that they are unable to supply what has been ordered the knock-on impact for the policyholder may be just as serious. Harris Balcombe LLP acted for a major food manufacturer who purchased most of their printed packaging film from a large printer whose factory was totally destroyed in a catastrophic fire. Not only were all of the printing presses destroyed but the warehouse in which printed and finished stocks of packaging film were held for the policyholder was also totally destroyed along with all of the stock. The final piece of this catastrophe

jigsaw was that all of the gravure rollers which held the art work in colour separations for each of the separate packaging images were also destroyed. Fortunately the policyholder had the benefit of a “suppliers extension” to the Business Interruption policy. The business suffered very serious losses as it took many weeks to remake all of the gravure rollers and then find suitable printers all around the world, who were capable of manufacturing the printed packaging film. Once sufficient stocks had been obtained the food factories were able to, once again, commence production.

Without the benefit of a suppliers’ extension the losses suffered by the policyholder would have been totally uninsured.

Some suppliers will not be classed as critical as the product that they supply will be readily available from other suppliers. However there will be some products that are totally dependent on that particular supplier and that will take a very long time to source from a different supplier.

About Harris Balcombe LLP

Harris Balcombe LLP has been providing loss assessment services for over 150 years. Negotiating with insurers becomes a whole lot easier when you have the right expertise on your side. That’s why we directly employ Chartered Accountants, Chartered Surveyors, Chartered Loss Adjusters and Loss Assessors to act on our clients’ behalf. Our website www.harrisbalcombe.com provides plenty of information about our expertise, but please don’t hesitate to pick up the phone to find out how our claims management team could help you.

About Oval Insurance Broking

With offices across the UK, Oval Insurance Broking (Oval) is the specialist insurance and risk management partner of choice for thousands of organisations and individuals across a range of disciplines and industry sectors.

From general insurance to sector-specific requirements, the strength of Oval lies in designing bespoke, dynamic and keenly competitive risk solutions that fit your needs exactly. Our skilled specialists take the time to understand those needs, simplifying risk to deliver a consistently innovative, high standard and high performance service that adds value, capability, agility and competitive edge to your business.

Would you like to talk?For more information about minimising the risk of under-insurance on your insurance programme, or to discuss any other risk and insurance need, please speak to your usual Oval contact, or call:

0800 612 6223

or Email: ib-enquiries@theovalgroup.com

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