Calculating business income loss claims can be tricky. Toachieve an accurate outcome, claim professionals must understandwhat makes a business tick and be comfortable working with businessrecords. An added complexity is the inherent difference betweenaccounting terms and insurance policy language, especially as theyrelate to business income terminology.

From an accounting perspective, business income losscalculations are dependent upon a number of factors. Even thoughthese factors can be complicated to resolve, claim professionalscan become more confident and more proficient in adjusting thistype of claim by familiarizing themselves with four key elements:the period of restoration; sales projection; mitigation; andexpense projection. A clear understanding of these elements and howthey impact business income loss calculations will go a long waytowards the efficient resolution of these losses.

Restoring Order

The period of restoration is important because it defines thestart and the end dates of the damage measurement period.Typically, this begins on the date the property is physicallydamaged and ends on the date that the property should be repairedor replaced. A variety of factors can impact the period ofrestoration. Paying close attention to them will reducemisunderstandings with the insured about periods of time that maynot qualify for business income loss recovery.

First and foremost, it is critical that every consultantinvolved in estimating the repair period — the contractor, theengineer, and the architect — has the same scope of work in mindfollowing the loss event. It is far easier to compare estimateswhen the information on which they are based is the same. A clearlydefined scope of repairs will help establish when the propertyshould be repaired or replaced.

Additionally, the insured will often choose to make improvementsor expand facilities while the business is closed for repairs. Thiscan cause a delay in the resumption of operations and is typicallyexcluded from the insured period of restoration. Before finalizingimprovement plans, the insured should understand that theadditional time to complete any expansion is excluded from theperiod of restoration. If the insured decides to move forward withimprovements, then it is imperative that the adjuster frequentlycheck with the contractor and ascertain whether the project isprogressing as originally planned. Any variances in the originaltime estimates should be investigated and resolved as soon aspossible. This will limit potential problems during the finalsettlement process.

Next, careful planning not only can mitigate the insured'sbusiness income loss but also minimize the suspension ofoperations. For example, certain situations may allow forreplacement and installation of critical equipment well before thebuilding is completely repaired or rebuilt. Even a partialresumption of operations can dramatically reduce the insured'sbusiness income loss.

Lastly, many standard commercial insurance policies include anextended period of indemnity beyond the period of restoration.Extended periods are typically limited to 30 days and beginimmediately after the period of restoration ends. However,occasionally a gap may exist between the end of the period ofrestoration and the beginning of the extended period. For example,if an insured decides to make improvements that delay thecommencement of operations, then the extended period of coveragewould not begin until the date when the property was actuallyrepaired or replaced and operations resumed. This means that theactual date could be weeks or even months after the period ofrestoration.

Fair Forecasting

The sales projection is often an area of disagreement andspirited debate between policyholders and insurance companies. Twokey considerations that impact the sales projection are seasonalityand trend analysis. To support a projection, it is crucial topresent a forecast that falls within a reasonable range. Thisforecast would reflect what the business would have done, asopposed to what the business could have done. The former has abasis in fact, while the latter is merely possible.

It is also important to review the insured's sales history. Theamount of data needed to project sales is contingent upon thelength of the loss period and other situational factors. One commonmethod is to determine either the increase or the decrease in sales(expressed as a percentage) prior to the loss. This will be basedon a comparison of the same months from the prior year. Forexample, consider the sales trend analysis shown in Figure 1 (seefigure links provided at end of article).

After a base period is established, the next step is to applyeither the percentage increase or the decrease to the loss period.Continuing with our example and assuming a four-month loss period,the projected sales might look something like those listed inFigure 2.

At first glance, this appears to be a straightforwardcalculation. However, a credible sales projection is one that canbe explained in real terms, not just in terms of the math. Itshould also be consistent with the experience of the business andchanges in market conditions. For instance, the applicability ofthe 10 percent sales growth explained to forecast sales in 2007depends on what you might find during your investigation. Theprojected increase might not be appropriate if, at the end of 2006,the business lost its largest customer, new competition appeared,it closed or sold an unprofitable segment, or its employees went onstrike. It is critical to exercise good judgment in formulatingsales projections. In short, without common sense, salesprojections are merely mathematical computations.

Another method employed to project sales is a pre-loss monthlyor daily average. When a business is stable — exhibiting no growthor declining trends — and is not seasonally dependent, a pre-lossmonthly or daily average can be used to anticipate sales. Anexample of a business where this methodology would be appropriateis an established dental practice that is closed for one week. Notethat this method tends to work best when the loss period isshort.

Budget numbers can be a useful source to project sales as longas the reliability of the budgeted sales has been confirmed.Compare pre-loss budgeted monthly sales for a period of time to theactual sales for the same period. If the ratio between actual andbudgeted sales is consistent over a span of several months, thenusing the budget for the loss period may be a reliable approach. Toproject sales, you would apply the computed ratio to the budgetedsales for the suspension period.

Duty Calls

Mitigation involves efforts on the part of the insured to reducethe business income loss. When considering mitigation, you mustaddress several questions:

• What measures (if any) were taken to reduce the loss?
• Could anything have been done to mitigate the loss?
• What is the financial impact of the mitigation?
• Is it possible to make up the loss during the post-loss periodeither through normal or stepped-up operations?

Often, the insured's actions to reduce the loss are centered onprotecting long-term business interests rather than reducing theclaim to the insurance company. Even though most policies have aduty-to-mitigate clause, many insureds will do everything they canto resume operations, even partially, as soon as possible.Occasionally, however, an insured will not attempt to mitigate theloss when clear alternatives exist. In the early stages of theclaim, it is wise to reference the specific policy language, whichexplains the obligation to mitigate and the consequences if thisrequirement is not met. Furthermore, most business income policiesallow for extra expenses that serve to reduce the business incomeloss that would otherwise be payable.

Projecting Expenses

Based primarily on historical information, the process ofprojecting expenses involves identifying both fixed and variableexpenses. Projected expenses are subtracted from projected sales todetermine the likely net income or loss of the business had theloss event not occurred.

The main records used to anticipate expenses include federalincome tax returns and monthly income statements. If thesedocuments are not available, other records may be helpful, such asmonthly profit-and-loss statements; trial balances; generalledgers; and budgets/business plans. Records for the two yearspreceding the loss event are typically reviewed. However, there arecertain circumstances in which two years of history proves to beinsufficient. Without an adequate history, it can be difficult toascertain if the pre-loss period being analyzed provides areasonable basis for projecting expenses.

To compute the business income losses, the continuing normaloperating expenses are added to the projected net income (or loss).Calculating continuing expenses appears to be relativelystraightforward endeavor. In reality, however, this can involve avariety of complex matters, including cash/accrual accountingissues as well as identifying and extracting expenses that havebeen submitted as property damage claims or other claims.

Before you get too far along in your analysis of continuingexpenses, you may want to spend some time with the insureddiscussing the nature of their business expenses and how the lossmight impact them. A valuable tool to use in your discussion is theinsured's last income statement or a similar document that wasprepared prior to the loss incident. Carefully examine each expenselisted on the income statement and think of pertinentconsiderations. Your questions to the insured might resemble thefollowing:

• What would you normally expect this expense to be, a monthlyaverage for fixed expenses or a percentage of sales for variableexpenses?
• How do you think this expense will be impacted by theloss?
• What type of documents can you provide to support continuingnormal operating expenses?

Make sure you understand what specific documents are availableto support the insured's claim. Not only will this question clueyou in to the possible limitations of the insured's accountingsystem, but it will also point you in the direction of possiblesolutions early in the loss evaluation.

Russ Matheson, CPA, CFE, is a director in the Seattle officeof RGL – Forensic Accountants & Consultants. He may be reachedat [email protected].