to adopt the term ‘Insured Profit’ in future policy wordings.
It has been suggested that the term ‘Gross Margin’ might replace ‘Gross Profit’, but it is unlikely that this would help, because gross margin is another technical accounting term in common usage; and, therefore, it is thought that it could prove equally confusing.
With regard to the specific use of the term ‘purchases’, this could be more specifically defined as ‘purchases of stock, raw materials and components (and/or consumables)’. Some policies already do this, and this brings clarity, albeit there is still the potential risk of the term ‘purchases’, including other things in the accounts. Subcontracted manufacturing processes are the most likely area of difficulty given that the owner of a business may view those costs as purchases in the same way as raw materials. The definition of ‘purchases’ could be extended to include subcontract manufacturing processes.
Given the significant number of businesses that do not use the term ‘purchases’ in their accounts at all, there may be merit in having a slightly wider and more flexible wording to include ‘purchases of stock, raw materials and components (and/or consumables) and other third party subcontracting costs’.
1.2 Gross Profit – Uninsured Standing Charges Clause
1.2.1Current position
Many policies include an uninsured standing charges clause. This will state that if an insured business fails to insure fixed costs, and thereby takes on the risk of part of the gross profit of the business, the policy will only pay a proportion of increased costs incurred to mitigate loss.
Some policies omit (deliberately or otherwise) the uninsured standing charges clause.
1.2.2What is the problem?
The term ‘standing charges’ is not one in everyday commercial use, and the application of the uninsured standing charges clause may not be clear at first reading. To make matters worse, there is seldom, if ever, a definition of the term ‘standing charges’. This also begs the question as to whether there is any relationship between ‘standing charges’ and ‘working expenses’ used in the definition of Gross Profit.
1.2.3What are the consequences?
Difficulties with the term ‘standing charges’ are likely to arise as a consequence of the difficulty in establishing what is variable and what is not. Over the course of a microsecond all costs are fixed (you couldn’t stop spending any money that quickly even if you wanted to); over the course of 100 years, all costs are variable.
It seems almost inevitable that applying the uninsured standing charges clause will prove problematic. The process of debating which costs have been shown to be fixed (although these were assumed to be variable when the sum insured was declared) will inevitably take time. Any lack of clarity over the meaning of ‘standing charges’ will be seized upon when a policyholder, having incurred additional expenditure in good faith to mitigate a loss, finds it will only be partially covered.
1.2.4Potential solutions
The term ‘standing charges’ should be abandoned, because it is not a term in general use and thus has no generally accepted meaning. The issue that the current clause seeks to address is that of working expenses that have specifically been uninsured but which are not truly variable costs.
A previously-circulated proposal suggested referring to ‘the proportion that the insured working expenses bear to all of the working expenses that have not reduced in direct proportion to turnover’.
1.3 Material Damage/Business Interruption Overlap
1.3.1Current position
Business interruption policies typically define Gross Profit as turnover less raw material purchases adjusted for stock movement (with minor variations relating to carriage, bad debts and other costs likely to vary in direct proportion to turnover). As a consequence, all overheads and wage costs are insured as part of the Gross Profit.
This gives rise to two issues.
First, there is the issue of stock. Manufacturers especially, but not exclusively, add overheads and wages to the basic raw material costs in valuing their stock. This is to comply with the terms of the Statement of Standard Accounting Practice 9 (SSAP9), issued by the Institute of Chartered Accountants, in which it is acknowledged that an increasing proportion of fixed overheads should properly be regarded as part of the value of stock while it is in the course of manufacture.
If the stock is destroyed and this also gives rise to a reduction in turnover, there is the potential for the insured to be indemnified twice, in respect of both the overheads and wages, because these are insured under both covers.
This may occur where the stock (inventory) policy provides cover for the cost of raw materials, together with labour and overhead expenditure incurred to create either ‘finished’ or partly finished product (i.e., work in progress) and the related BI policy provides cover for the turnover value of the damaged product, reduced only by the cost of the raw materials.
It may also arise where the stock (inventory) policy provides for finished goods at their sales value and the related BI policy allows only deduction of the raw material costs when calculating the Rate of Gross Profit.
In the profit and loss example above, adopting the insurance definition of Gross Profit would result in the subcontracting and direct labour costs (along with all other overheads and net profit) being insured as part of the business interruption cover. These are the type of costs that would be included in any stock valuation for manufacturers in particular. Were that to be the case, there may need to be a deduction of these amounts at the point of settlement to avoid an over indemnity.
The mere fact that there is both a BI and stock claim running in parallel does not of itself mean that there is definitely an overlap to be dealt with. If damaged stock is not re-manufactured until after the end of the Maximum Indemnity Period, the overheads incurred as part of the stock re-creation process will be those of the subsequent period and no overlap will present itself.
The fact that a stock loss has occurred does not inevitably mean that there will be a BI loss arising for it to overlap with.
Second, the insured’s overheads and wages might be paid as part of the cost of the repair and reinstatement process under the material damage cover, while also being an element of the BI claim in the event of a loss of turnover. For example, the insured’s staff might be paid to carry out cleaning work post incident. If the insured presents a valid claim for their own labour/ overhead costs incurred as part of the material damage recovery costs and simultaneously presents a claim for the same labour and overhead costs under the related BI policy (by virtue of the definition of specified working expenses applicable within the BI policy), there is a risk of the policyholder receiving more than a full indemnity.
1.3.2What is the problem?
Whenever these scenarios arise, policyholders may potentially benefit because elements of their costs are covered by both policies, or by both sections of a combined policy.
Policyholders often argue that they have paid appropriate premiums for both elements of cover and, therefore, they should be entitled to receive the benefit of any duplication in the cover.
There is no clear means under either policy by which any duplicated amounts may
