Double trouble: Disaster can strike businesses twice

This article was first published in Solicitors Journal, July 2014.

ASOS, the well-known online fashion retailer, was forced to suspend its website and stop taking orders after a fire at the firm's distribution warehouse last month. It suffered the same fate when its former warehouse in Hemel Hempstead was damaged by the explosion at Buncefield oil depot in 2005. After that incident, the firm suspended its shares and had to refund 19,000 orders.
 
When fire, flood or other catastrophes damage or destroy business premises, the owners' attention turns, sometimes for the first time, to how the business will continue trading. It may have to move premises quickly, obtain new supplies and notify staff and customers. In this instance, there is no substitute for a well-thought-out disaster recovery plan, which usually includes establishing multiple lines of communication, staff training, insurance for the physical damage and for any loss of business during a period of interruption, and identification of alternative accommodation.
 
If the business is relatively small, it is usually possible to agree with another similar business to share accommodation in the period immediately following a major incident; larger businesses may find this more difficult to achieve.

ARPI cover

Fortunately, there is a substantial market for insurance covering reinstatement of business premises and for consequential financial loss including losses caused by interruption to business, with £1.5bn paid out in 2011 for
 property damage.
 
The most popular type of insurance is all risks property insurance (ARPI), rather than insurance for specified perils. Its popularity appears to be based on a belief that it covers all eventualities. However, many ARPI policies provide the same level of cover as those for specified perils because of the exclusions.
 
When taking out ARPI cover, it is important to identify the physical property and the legal interest intended to be insured. It may include car parks and rights of way to the premises, as while the risk of physical damage caused to such property may be low, consequential disruption may be substantial.
 
It is also important to ensure damage and consequential losses caused to adjacent property are insured, as fire or flood can spread rapidly destroying other premises. The Buncefield explosion and fire in 2005 measured 2.4 on the Richter scale and led to hundreds of homes being evacuated and business premises being so badly damaged that they were rendered completely unusable, leading to claims of over £700m.
 
Damage under an ARPI policy is limited to physical loss or damage and does not include consequential loss, such as loss of profits and increased costs of working as a result of an incident. It is important to note that it may also exclude loss, destruction or damage that is caused or facilitated by the dishonesty of employees, directors or partners of the business.

Indemnity measure

Reinstatement is the usual starting point for quantification of loss or damage to property (excluding damage to stock and materials) to a condition substantially the same as, but not better or more extensive than, its condition when new. Stock and materials encompass raw material used in production, work in progress and finished units and are subject to fluctuation in quantity and value throughout the insurance period.
 
Thus, to obtain appropriate cover, a business must first state the sum that it wishes to be insured for. The premium based on this will be provisional and subject to adjustment at the end of the period to over-/under-valuation of the stock at the outset.
 
Business interruption insurance usually provides cover for loss of profit consequent on or caused by an insured peril. Under ARPI, this is where the interruption to the business is caused by damage to property used 'at the premises' for 'the purposes of the business'.
 
With some policies, businesses can also claim for a delayed loss in circumstances even where the business is able to continue trading following an interruption because it has reserves of stock.  In this situation, sales revenue may not be affected for a considerable period. Thus, not only is it important to describe the premises with care  but also to fully describe the business being conducted at the premises.
 
This can raise difficulties as it may be hard to show that the damaged property causing the interruption was for business purposes. For example, if a building is empty at the time of the incident, it might not be considered to be 'in use' for the purpose of the business. It may also be difficult to establish other types of losses are indemnified. These include off-site work, such as IT support contractors.
 
Claims difficult to establish also include denial of access as a result of damage to other properties in the vicinity, loss of attraction – for example the impact of oil pollution to the tourist industry in the Gulf of Mexico following the Deepwater Horizon oil disaster – and to suppliers, customers or related business.

Claim notification

Questions must be answered after a disaster:

• At the premises, has there been damage to property used by the insured for the purpose of the business?
• Is the damage the result of the peril which is insured?
• Has the business been interrupted as a result of the damage?
• Will a loss result from the interruption?

If so, there may be a claim under an ARPI policy and it is important to notify the insurer immediately, even if no disruption has yet occurred. In Loyaltrend Ltd [2010] Lloyd's rep IR 466 at 476, the judge said that the date of the incident had to refer to the material damage causing the interruption and not the interruption itself.
 
The insurer will usually appoint a loss adjuster who assesses the claim and may recommend to the insurer that an on-account payment is made, which may include payment for the immediate cost of relocation to other premises and the cost of measures taken to minimise business interruption, such as the purchase of stock and recruitment of temporary staff.
 
Unfortunately, most policies do not define when or in what circumstances a payment on account will be made to a business. However, where cover for the incident has not been accepted by the insurer, it is unlikely that it will make a payment on account, even if expressed to be without prejudice.

Gross profit

Insurance cover for gross profits requires the insured to estimate the amount of the future gross profit in the indemnity period. If the actual profit lost is greater than the profit insured, the insurer's liability will be proportionately reduced  – reflecting the fact that the risk to the business was underinsured and the insurer has taken on a greater risk than agreed.
 
The alternative is to take out a declaration linked policy that pays out actual gross profit  lost by allowing the insured to pay a retrospective increase to reflect the actual loss subject to an over cap, which is usually 133.3 per cent of the declared gross profit.
 
Whatever the basis of the insurance, the assessment of loss will usually involve comparing the actual period of disruption with an equivalent period in the previous 12 months to reflect seasonal changes. The method of assessment means that there is likely to be a period of business interruption before the insured is paid out under the policy.
 
Therefore, if prompt assessment of a claim is required, the business will need to make management and audited accounts for the 12 months prior to the event available to the insurer. If the business is substantial, it may also be necessary to maintain records of gross profit and gross revenue for each team or department as they may have different profit margins and may have been affected by the incident differently.
 
Some policies specify payment based on the average gross profit to avoid the insured being over- or under-indemnified for the loss suffered by different parts of the business. Confusion can occur about the basis of the insurance for business interruption as while gross profit is the usual measure of the indemnity, it can be for net profit.
 
A convenient way to identify the difference between gross and net profit is that the latter is gross profit less fixed charges, or it is turnover less variable costs. This means that an indemnity based on gross profit should provide enough money for the business to cover its standing charges and still retain a net profit, despite the business interruption.

Financial healthcheck

Enquiries into the financial health of the business and its directors can be made to ascertain whether the fire may have been intentional and the records available are accurate. When seasonal goods, such as air conditioning units or fashion items are damaged, it may be impossible to buy new stock in time to continue trading without interruption.
 
It is worse if financial records of trading and stock have been destroyed in the incident preventing a stock reconciliation to establish an accurate measure of loss. While this may be a natural and inevitable consequence of the incident, the business will be expected to take reasonable steps to preserve remaining information.
 
Care must be taken regarding some of the standard exclusions for this insurance type, including exclusions for valuables, electronic data, property in transit and interruption to research and development.
 
An exclusion for other circumstances (trends) may enable the insurer to reduce its liability if it can establish that turnover or gross profit would have fallen over the period.