How to Determine the Sum Insured for Loss of Profit Insurance?
Loss of Profit insurance is a complex field sending a spine- chilling signal to even veteran insurance broker, but when mastering the subject, another income from cross-selling. Providing an insight into this cover explains, in plain layman English, to derive the sum insured.
The accountant terms on gross profit are entirely different from the insurance point of view as the definition relates to Income minus Expenses during shut down period.
Two ways on calculates the Loss of profit insurance either on an Additions or on a Difference basis.
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Addition
The Additions basis insure by adding the Net Profit and all the Standing Charges.
* The total Net Profit (before deduction of Income Tax) generated annually for running a year of business without interruption.
* Standing Charges are those expenses incur regardless whether the business is in operation, e.g. rent, salaries, hire purchases, lease agreement payments, etc.
Difference
The Difference basis deducts those working expenses not required to cover from the Turnover.
* Turnover is the total sales amount received for the business activity undertaken.
* Uninsured Working Expenses are the total of all those eliminated expenses not required any business termination, e.g. purchases, commissions, packaging, outsourcing, contract workers, part-time worker, transport.
Insurance Gross Profit
We establish the insurance Gross Profit figure based on
Net Profit before tax known called it Net Profit before Tax
Standing Charge termed as fixed costs.
Uninsured Working Expenses termed as variable expenses.
Turnover called “income” or “sales” or “revenue”.
Notice that the Turnover of the business comprises Net Profit before Tax + Fixed and Variable costs or expenses.
Rate of Gross Profit
The Loss of profit policy wording is the only wording that actually guides insured on how to calculate a claim and therefore assists in establishing a sum insured. The claim settlement requires that the Rate of Gross Profit applies to the shortfall in Turnover expected by looking backward and adding any future enhanced trends. Briefly to say that businesses rarely change on a successful duplicated operating system to generate further turnover and any supplement to keep up with the inflation upward trends.
However, copying last year operating system means that all the ratios against Turnover will probably remain stable – so the more sales volume means the more increase the operation cost. So a 15% increase in turnover correspondingly 15% increase in the working cost. (This is a minimum percentage to keep ahead of inflation) If not, then the business has not copied last year’s system 100% and the broker needs to prove the reason.
The Rate of Gross Profit is the percentage ratio of the insurance Gross Profit to the Turnover. In other words:
Rate of Gross Profit =Turnover x 100
The broker assists the insured by taking the last financial report (Balance Sheet and profit and loss account and stock) figures for fixed costs, variable costs and NPBT and calculates the Gross Profit, as per the insurance definition. When both agreed on the method to establish the rate of gross profit and will use for future reference provided the rate is correct. Since all business increases their Turnover every year by more than the inflation rate, the client must agree to their expected annual Turnover increase percentage.
So the insured now has a Rate of Gross Profit and an annual expected Turnover increase rate.
Next, the insured needs to calculate their expected Turnover for the year after the expiry of the next period of insurance. This means that the insured looking two years beyond for projection. This turnover applies the Rate of Gross Profit and that is the expected Gross Profit.
Adding the VAT to this expected rate of gross profit and round to the nearest $100.00, inflates twice the figures, but the premium only charged on 75% of this Gross Profit sum insured.
Example figures
Fixed Charges= $5 million
Variable Expenses= $4 million
NPBT= $500 000.00
Turnover 31/12/2016= $10 million
Insurance Gross Profit =$6 million
Rate of Gross Profit =60%
Turnover increased =15%
Period of Insurance 01/01/2017 to 31/12/2017
Expected Turnover =$11.5 million
Year after expiry of policy 01/01/2018 to 31/12/2018
Expected Turnover= $13 225 000.00
Thus Insurance Gross Profit= $13 225 000.00 x 60% (Rate of Gross Profit)
Gross Profit Sum Insured= $7 935 000.00
Plus 6 % Vat ($7 935 000.00 + 476 100.00) = $8 411 100.00
The sum insured calculates on 75% of $8 411 100.00 =$6 308 325.00
It is our broker’s duty to aid the insured on deriving a reasonable sum insured. The insured’s understanding on the calculation is crucial to avoid future dispute when a claim incurs. However, to safely guide the broker from the insured sued the former for professional indemnity. Advisable requesting the insured signs a document stating that they agree with the method used and that the figure is acceptable.
End of Policy Year Adjustment
If the client achieves marginal 15% increase in their Turnover, during the insured period, adjustments require, we arrive at the following figures:
Turnover= $11 500 000.00
Gross Profit =$6 900 000.00 (60% of Turnover)
Plus 6 % VAT ($6 900 000 x 6%) =$7 314 000.00
Initial sum insured of $6 308 325.00 but their real Gross Profit was $7 314 000.00, the sum insured difference is $1 005 675.00, a lesser premium collected. The insured paid a 75% as a deposit premium, providing a correct calculation; the insured had 100% coverage with a 75% of the paid premium.
If the premium rate was 0.10% the client paid a deposit premium of $6308.33 plus an adjustment premium of $ 1 005.68, which totals $7 314.01, instead of a full premium of $8 411.10.
A Mistake did by broker Howard
The broker utmost responsibility duty to decide the insured NPBT figure, Howard does not include NPBT in their coverage. Consequently, wrongly calculate the sum insured on Consequential Loss Policy, arriving at a Rate of Gross Profit of 56.24% which converts into a sum insured of $5 400 000 +6% VAT = $5 724 000.00. Not to forget the deposit premium and end of policy year adjustment for this coverage.
Bearing in mind
Loss of profit insurance works either all the fixed cost items for the Additions basis only or all the variable charges for the Difference basis only.
Not using the above 2 methods, this leads to either the law of average applies or the insurer not agreeing with the client’s calculation of their claim. Also, the Loss adjusters find in a daunting task in finalizing a claim if excluded the charges.
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