Fire insurance is a common insurance, covering material damage to buildings, furniture, machinery, stock etc, due to the insured perils. But if the loss takes place in a a manufacturing organization, besides the loss due to insured perils caused to machinery, stocks and the building, the manufacturing activity and consequently the profit due to the stoppage of production and selling the final product will be also severely affected. This loss can be covered by a lesser known policy called the ‘Loss of Profit Insurance’ or the ‘Consequential Loss policy’.
The trading loss caused due to stoppage of business can be considered under the following three heads:
- Net Profit- This may be understood as the margin of Income over all the expenses connected with the particular business of the insured.
- Standing Charges- These are the fixed overhead expenses which continue despite the stoppage of production, like Salaries of permenant staff, interest payable, taxes etc.
- Increased cost of working- This is the cost incurred by the insured who would like to keep up the production and sales inorder to reduce the loss incurred by getting it done by renting a temporary premises, payment of overtime expenses, hiring of machinery or outsourcing production.
The distinction between the fire insurance and the Loss of profit insurance is that the subject matter of Fire Insurance is Property, whereas the subject matter of Loss of Profit insurance is the business of the Insured, which is the earning capacity of the property.
Basis of profit insurance: Business is conducted on the principle that income should exceed the expenditure so that a profit is earned. If the turnover is stopped or reduced, profits are affected. Therefore the loss of profit is determined and measured with reference to the reduction in turnover and this is the basis adopted in Profits Insurance. Turnover is defined as the money payable to the insured for th goods sold and delivered and for services rendered in the course of business at the premises. In simple terms it refers to ‘Sales’.
Turnover consists of the following three elements,
- Variable Charges: These are expenses incurred in production of goods such as purchase of raw materials etc. which vary in proportion to the volume of business
- Standing Charges: These expenses are fixed in amount irrespective of the volume of business or production. They cannot be reduced in proportion to the reduction in business. For eg, salaries interest, loan installments etc.
- Net profit = TURNOVER – (VARIABLE COST + STANDING CHARGES)
Standing charges and Net profit contribute to the Gross Profit in business.
After a loss, the variable cos, may get reduced but the standing charges continue at the same level and Net profit will be affected. All the elements bear a constant relationship to the whole which can be expressed in a percentange. For example, the variable cost may be 70% of the turnover. The proportion of Gross profit (Standing Charges & Net Profit) may be 30% of the turnover. The proportion of Gross Profit to the Turnover during a particular period (usually the last financial year) is known as the rate of Gross Profit. This is the earning capacity of the business expressed in a percentage. Accordingly the loss in this policy can be measured by comparing the previous financial years Rate of Goss Profit to the reduction in current year’s turnover to the previous year.
Indemnity Period: The Profits policy provides indemnity in respect of the loss during the indemnity period which is selected by the insured. It can vary from 3 month to 3 years depending upon the insured’s assessment of the time it would take to re start the normal business activity from the same premises, after the loss. It depends upon the nature of business, alternate premises available, etc. the fire should occur within the policy period but the indemnity period may go well beyond the policy period.
The Sum insured: This must be computed from the Insured’s accounts, i.e. the trading P&L accounts. The first is to determine what are the standing charges of the business; next is to arrive at the Net profit; The total is the Gross Profit and the Sum Insured to be taken under the policy. This is ascertained from the previous financial year’s accounts and due adjustments to be made for the future gross profits expected to be earned.
Since the loss of profits policy provides for the reduction in gross profit during the indemnity period, if the indemnity period selected is say 24 months, then the sum insured should be twice the Gross Profit arrived as above.
Losses not Payable:
- Claim under Loss of profits policy is admissible only if the claim under the Material damage policy is admissible
- under-insurance under the material damage policy
- difference in value of stock at the time of loss and subsequent replacement
- deterioration of undamaged stock after loss occurred
- failure to recover debts of pre-damage trade owing to destruction of records
- fine, damages and or penalties under contracts arising from breach of contract in consequence of damage
- third-party claims
- loss of good will / loss of market
- cost of preparation of documents for consequential loss claim (auditors fees for extracting and certifying particulars of profit) Can cover auditors fees at an additional premium)
- litigation costs connected with insurance claims