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Abstract

LOSS OF PROFIT INSURANCES and ITS INFLUENCES on COMPRNYS' INVESTMENT DECISIONS (Summary)CONTENTS PAGE NO. I. INSURANCE II. LOSS OF PROFIT (BUSINESS INTERRUPTION) INSURANCES 2 1. History 2 a) Chomage and Percentage of Fire Loss Policies 2 b) Time Loss Insurances 2 2. General 4 3. The Insurability of Business Interruption Risks 5 4. Losses Caused by Business Interruption 6 a) Loss of Income 6 b) Additional Expenditure 7 5. Insurance Value 8 S. Indemnity 9 7. Interruption Period, Indemnity Period, Insurance Period 3 8. Types of Business Interruption Insurances 11 a) Machinery Loss of Profits Insurance 11 b> Computer Loss of Profits Insurance 12 i) Insurance of Gross Profit 13 ii) Insurance of Extra Expenses 13 c) Other Forms of Loss of Profits Insurance 13 III. RISK P.ND THE ENTERPRISES 14 1. Physical Threats 14 2. Liability Risks 14 3. Business Interruption 14 4. Loss of Materials and Resources 14PAGE NO. 5. Social Risks 15 6. Political Risks 15 7. Environmental Risks 15 Q. Management Risk 15 IV. EFFECTS OF RISKS ON COMPANIES ACTIVITY 16 V. PROTECTION AGO INST RISKS 17 CONCLUSION 18I. INSURANCE The sense of uncertainty surrounds everything we do in life. find, we will look upon risk as the uncertainty of loss. We can consider Insurance as a risk transfer mechanism.II. LOSS OF PROFIT (BUSINESS INTERRUPTION) INSURANCES 1. History Despite the comment that consequential loss insurance only started to any great degree in the 20th. century, the need for cover had been appreciated by sone at an earlier period. Whilst no detailed evidence remains, it is thought that some companies did issue policies on the basis of a weekly payment in the latter half of 19th century, but we have no real knowledge of the basis of the cover. France is believed to be the first country to have introduced actual Loss of profit Insurance. The first treaties for the so-called Chomage Insurance were signed in France in I860. a) Chomage and Percentage of Fire Loss Policies Chomage means `cessation from work, enforced idleness, silence`: it was similar to cover given by the percentage of fire loss policy which was introduced by the Lloyd's market just before the turn of the 19th century. This type of cover agreed to pay a fined percentage of the amount paid under the fire material damage policy, as a loss of profit. b) Time Loss Insurances The time loss form of policy represented the first effective attempt to recognise that consequential loss insurance must be regarded as having principles of its own, in addition to those governing material damage insurance. fin obvious feature to be taken into account was the time factor. Trading is carried on over a period of time and, broadly, the longer the period of time during which business and plant are out of use, the greater is the amount of financial strain and loss.Time loss policies sought to take this feature into account by regarding the annual profits as earned evenly over the year at a definable rate per working day. The amount of the annual profits of the business was adopted as the sum insured under the policy, and for each working day that the business entirely ceased because of insured damage. In the time loss policy it was usually provided that the amount payable should be either: i) the agreed fraction of the sum insured for each working day, or ii) the agreed fraction of the sum insured as applied to the annual profits, whichever was the smaller. c) With the improvement in the standard of accountancy practice and knowledge, however, interest in the possibility of covering financial losses following fire increased, and in the closing years of the 19th century Mr. Ludovic Mc Lei Ian Mann evolved a cover of an indemnity basis which provided the foundation of the principles contained in the current standard United Kingdom policies, and indeed in those of many other countries. The new policy is clearly a contract of indemnity, undertaking to indemnify the insured for loss of profits due to fire, sustained during a specified period following the fire, measured by the actual diminution in turnover or output as revealed by the accounts of the business.2. General This form of insurance was originally called time loss of profits, or consequential loss, and towards the latter part of the 1970* s `Interruption Insurance`. This last title is appropriate because the policies available deal with the loss of profits of a business or the additional expenditure necessary after some physical property has been damaged. The fire, all risks or engineering policies will deal with.the value of the property damaged or destroyed but not with the losses which reduced sales have brought about during the repair period and thereafter until full sales are restored. These losses come about because: i) certain overhead costs will remain at their full level even though sales are reduced, ii) net profit will be reduced, iii) there may be certain increases in costs incurred to keep the business going in a temporary manner. Realizing a profit and guaranteeing solvency are the goals of a company, only the concerted efforts of the production factors; human labour, plant and machinery make these goals attainable and secure the earning power of a business. Physical loss or damage is a threat to this earning power, as they result in extensive business interruptions and paralyze operating efficiency. The consequence is a shortfall in income, which can be avoided only by insuring against it - that is by taking out a business interruption insurance. As it is impossible for a company to keep its turnover and income at unchanged levels after the occurrence of a physical loss, the target of a business interruption insurance is to secure the company's existence. Business interruption insurance enables a company to absorb the fixed costs, profits and, of course, any extra expenses required to maintain production after a disturbance of the company's operations. The company will not suffer a financial loss in the time until production is resumed.What was explained so far can be summarized as follows: - The aim of business interruption insurance is to secure the company' s solvency. - Solvency is secured by maintaining the flow of goods. In order to translate this into an insurance, the relevant parameters in the flow of goods must be ident if ied. Relevant parametres are, the variable costs, fixed costs, sales proceeds and profits, if any. The parametres influence the flow of goods i.e. the manufacture of products from raw materials to finished products which are either sold or put in stock. The entire process may also be called operational output. 3. The Insurability of Business Interruption Risks The insurability of the business interruption risk is an aspect which should not be forgotten. Any insurance of this risk must be subject to several conditions: - The event leading to the business interruption must have the nature of an accident. - The risk insured must be defined clearly. - The interdependence between the insured risk and other risks must be identifiable. - The distribution of probabilities of insured losses must be known (rating). - The size of a loss, i.e. indemnity period interruption period. sum insured must be determinable. A business interruption is any unforeseen and unplanned disturbance of the business operations, irrespective of the area or part of the business where it occurs.8. Types of Business Interruption Insurances The most common interruption policies are those which cover losses following froms a) fire and special perils; b) engineering breakdown risks; c) computer damage and break- down risks. a) Machinery Loss of Profits Insurance The best way of avoiding interruption as a consequence of a breakdown in machinery is to have access to reserve machinery. However, it is not always possible or economically justifiable since the maintenance of reserve machinery entails charges for interest, depreciat ion, and storage. If the ma intan ence of reserve machinary is too expensive, estimates should be made of the delivery time for a replacement in the event of a breakdown. In such circumtances machinery loss of profits insurance may often be the cheapest form of cover. The insurance covers interruption as a consequence of a breakdown in the reserve machinery. The insured interest in machinery loss of profits insurance is, as in fire loss of profits insurance, the gross profit during the indemnity period The indemnity period is normally 6 or 12 months. Machinery loss of profits insurance is effected either for certain specified machines, i.e. those which are considered most likely to cause substantial interruption if damaged, or for all machinery within a plant. Those machines to be covered by the insurance are determined by considering the importance of the respective machines for the production line. When it is diffucult to determine which machines should be insured, it may be appropriate to cover all machinery in the insurance policy. In this way the insured limits his own assumption of risk to a deductible chosen when the insurance is effected. The size of this deductible is adopted to the structure of the plant, the size of the loss or profits interest etc. U4. Losses Caused by Business Interruption For the company, the business interruption may cause losses of two types: They are a shortfall income on the one hand, and costs for lessening the loss on the other hand» The latter are extra expenses which reduce income further. In considering business interruption losses the nature and purpose of the organization must first be considered. Organizations undertake widely differing types of activity under very different market and general economic conditions. Thus the degree or urgency that may be felt to get back into business following a loss ranges between: <i) Organizations that perform a vital service that must somehow be continued, if at all possible, following the occurrence of the loss causing event (e.g. a hospital) For such organizations interruption losses need to be measured in terms of the additional expenses that will be required to ensure that the minimum acceptable level of operation is maintained. (ii) fit the other extreme are organizations that may suspend operations while the effects of the loss causing event are remedied, and in this case the business interruption loss may be considered in terms of an income loss. Most organizations lie somewhere between these two extremes, and not infrequently the loss of a key process, if not immediately replaced, could bring the rest of the organization to a standstill. Therefore, interruption often involves both additional expenditure and loss of income. a) Loss of Income Any event that disrupts output or destroys completed stocks is likely to cause a loss of business and so of revenue. Some offsetting saving in expenses may be possible, though insufficient to prevent a fall in profits. Consequently the net loss to the organization will comprise the reduction in turnover less any saving in expenses. fls the loss will be experienced over a period, probably extending beyond the time required to restore potential output to its preloss level, it may be measured in terms of its present value.fin indemnity period fining the time for which the insurer is liable also has to be agreed. Agreement of an indemnity period limits the time of active insurance cover. The indemnity period begins with the occurrence of a physical loss or damage and its usual agreed duration is twelve months. Shorter indemnity periods should be agreed only for particular items, such as wages, salaries or agents' commissions. In any case the calculation should be based on the amounts for the entire year. Expiry of the indemnity period is governed by its agreed duration; it was said before that the standard duration is twelve months. For the agreed indemnity is granted in respect of: - the shortfall in income caused by the business interruption, - the necessary costs incurred to lessen the loss. fls the purpose of the business interruption insurance is a protection against a shortfall in income, the indemnity period will not be terminated by the reinstatement of technical operability, that is when the company is able to resume its production. The indemnity period will rather terminate at the time, when the company is able again to realize its old income, so that there is no further economic loss. The condition for the termination of indemnity period is the restoration of the so-called `readiness for commercial operat ion`. When the consequances of a business interruption are overcome before expiry of the indemnity period, the indemnity will, of course, not be granted for the full indemnity period, as the company's earning capacity could be restored before its expiry. 10- setting up emergency operations and continuing production on a temporary basis, - accelerating the further supply of fuels and raw materials, - intensifying advertisement and customer service, - working additional shifts, - buying semi-finished and finished products from other companies. The insurer indemnifies for all extra expenses incurred in order to prevent or lessen the business interruption loss, as far as such expenses reduce the indemnity payable by the insurer. There are even cases, where a business interruption loss consists of nothing else but the incurred to lessen the loss. 5. Insurance Value The purpose of a physical loss insurance is to replace the perished item of property. Therefore, the replacement value of the corresponding item of property is also the insurance value. On the basis of this replacement value the sum insured is then determined. The purpose of the business interruption insurance is to compensate for the loss of income. Therefore, the insurance value is dependent on that amount of earnings of the business, which is realized without disturbance of operations to offset fixed costs and net profits. As in physical loss insurance the standard cover in business interruption insurance is an insurance of the full value. This means that the sum insured must be at least the amounts of the operating income. The Insurance Value = Amount of earnings realized without Disturbance of operations to offset Fixed Costs and Net Profits. Fixed Costs + Net Profits = Gross Profit So, we can say that Gross Profit constitudes the Insurance Value.- setting up emergency operations and continuing production on a temporary basis, - accelerating the further supply of fuels and raw materials, - intensifying advertisement and customer service, - working additional shifts, - buying semi-finished and finished products from other companies. The insurer indemnifies for all extra expenses incurred in order to prevent or lessen the business interruption loss, as far as such expenses reduce the indemnity payable by the insurer. There are even cases, where a business interruption loss consists of nothing else but the incurred to lessen the loss. 5. Insurance Value The purpose of a physical loss insurance is to replace the perished item of property. Therefore, the replacement value of the corresponding item of property is also the insurance value. On the basis of this replacement value the sum insured is then determined. The purpose of the business interruption insurance is to compensate for the loss of income. Therefore, the insurance value is dependent on that amount of earnings of the business, which is realized without disturbance of operations to offset fixed costs and net profits. As in physical loss insurance the standard cover in business interruption insurance is an insurance of the full value. This means that the sum insured must be at least the amounts of the operating income. The Insurance Value = Amount of earnings realized without Disturbance of operations to offset Fixed Costs and Net Profits. Fixed Costs + Net Profits = Gross Profit So, we can say that Gross Profit constitudes the Insurance Value.4. Losses Caused by Business Interruption For the company, the business interruption may cause losses of two types: They are a shortfall income on the one hand, and costs for lessening the loss on the other hand» The latter are extra expenses which reduce income further. In considering business interruption losses the nature and purpose of the organization must first be considered. Organizations undertake widely differing types of activity under very different market and general economic conditions. Thus the degree or urgency that may be felt to get back into business following a loss ranges between: <i) Organizations that perform a vital service that must somehow be continued, if at all possible, following the occurrence of the loss causing event (e.g. a hospital) For such organizations interruption losses need to be measured in terms of the additional expenses that will be required to ensure that the minimum acceptable level of operation is maintained. (ii) fit the other extreme are organizations that may suspend operations while the effects of the loss causing event are remedied, and in this case the business interruption loss may be considered in terms of an income loss. Most organizations lie somewhere between these two extremes, and not infrequently the loss of a key process, if not immediately replaced, could bring the rest of the organization to a standstill. Therefore, interruption often involves both additional expenditure and loss of income. a) Loss of Income Any event that disrupts output or destroys completed stocks is likely to cause a loss of business and so of revenue. Some offsetting saving in expenses may be possible, though insufficient to prevent a fall in profits. Consequently the net loss to the organization will comprise the reduction in turnover less any saving in expenses. fls the loss will be experienced over a period, probably extending beyond the time required to restore potential output to its preloss level, it may be measured in terms of its present value.III. RISK AND THE ENTERPRISES Looking first at the major threats that face most companies we can break them down into the following types: 1) Physical Threats Physical threats include injury and death and all forms of loss or damage to property. The causes of physical loss will usually be common perils, such as fire, explosion, flood, earthquake, physical collision, pollution, contamination, lightning but it may also result from arson, theft, vandalism, rioting, or deterioration of property and damage or loss caused by human error. 2) Liability Risks Liabilities can be divided into claims from customers of the business, from employees of the business and from the public generally. Whilst liability claims can result from the factors mentioned under physical threats one must also consider claims which are related to the product or services provided by the company, the effects of contractual liability to customers, suppliers or others and the effect of national and international regulations and laws. 3) Business Interruption Losses of this kind will follow the physical threats and liabilities already considered. Here it is necessary to consider the effect of the potential loss on the company's production processes on other operations, including such factors as reliance on suppliers, supplies to suppliers, particular reliance on records systems, especially where computers are employed, and so. Other threats include loss of market or goodwill, and industrial action. 4) Loss of Materials and Resources These threats affect the resources or materials essential to the processing of the company's products and include for example paper shortages in a service industry, national and local supplies of energy and labour resources. The origins of these threats will to some extent overlap with those already considered, but in the case of energy, for example, could include the effect of an increase in fuel prices on products in the world market. /H4. Losses Caused by Business Interruption For the company, the business interruption may cause losses of two types: They are a shortfall income on the one hand, and costs for lessening the loss on the other hand» The latter are extra expenses which reduce income further. In considering business interruption losses the nature and purpose of the organization must first be considered. Organizations undertake widely differing types of activity under very different market and general economic conditions. Thus the degree or urgency that may be felt to get back into business following a loss ranges between: <i) Organizations that perform a vital service that must somehow be continued, if at all possible, following the occurrence of the loss causing event (e.g. a hospital) For such organizations interruption losses need to be measured in terms of the additional expenses that will be required to ensure that the minimum acceptable level of operation is maintained. (ii) fit the other extreme are organizations that may suspend operations while the effects of the loss causing event are remedied, and in this case the business interruption loss may be considered in terms of an income loss. Most organizations lie somewhere between these two extremes, and not infrequently the loss of a key process, if not immediately replaced, could bring the rest of the organization to a standstill. Therefore, interruption often involves both additional expenditure and loss of income. a) Loss of Income Any event that disrupts output or destroys completed stocks is likely to cause a loss of business and so of revenue. Some offsetting saving in expenses may be possible, though insufficient to prevent a fall in profits. Consequently the net loss to the organization will comprise the reduction in turnover less any saving in expenses. fls the loss will be experienced over a period, probably extending beyond the time required to restore potential output to its preloss level, it may be measured in terms of its present value.CONCLUSION There are relatively few business which in the event of damage being caused by fire or other perils at their premises or possibly those of their suppliers or customers would not suffer financially either through a loss of trade or the additional expenditure involved during the period following the occurence. As it is known, profit and earning power of an enterprise depend on uninterrupted operations. Should a material damage occur which interrupts operational activities, a loss of the income which is required for the coverage of expenditure and profit attainment may result. In addition, the liquidity of an enterprise may be subject to considerable strain under a long-term Loss- of-Prof it damage. Financial obligations e.g. for investments effected prior to the damage, remain in spite of the interruption of activities. Often, at least temporarily, outside capital is required so as to allow activities to continue. The availability of Loss of profit or Business Interruption Insurance should encourage credit institutions to assist in providing financial support. Thus, Loss of Profit (Business Interruption) insurance plays quite a considerable role in the private as well as in the national economic sector. The social point of view should also be taken into account, i.e. the protection of job security with the uninterrupted payment of wages and salaries even in the case of an interruption of business. The motivation for this decision being that the proprietor of the enterprise must reckon with the possibility of a possible destruction of his company by fire or other perils and that he can avoid consequences of fire or other perils by a Loss of Profit (Business Interruption) insurance. 'Vs. ^ in 18III. RISK AND THE ENTERPRISES Looking first at the major threats that face most companies we can break them down into the following types: 1) Physical Threats Physical threats include injury and death and all forms of loss or damage to property. The causes of physical loss will usually be common perils, such as fire, explosion, flood, earthquake, physical collision, pollution, contamination, lightning but it may also result from arson, theft, vandalism, rioting, or deterioration of property and damage or loss caused by human error. 2) Liability Risks Liabilities can be divided into claims from customers of the business, from employees of the business and from the public generally. Whilst liability claims can result from the factors mentioned under physical threats one must also consider claims which are related to the product or services provided by the company, the effects of contractual liability to customers, suppliers or others and the effect of national and international regulations and laws. 3) Business Interruption Losses of this kind will follow the physical threats and liabilities already considered. Here it is necessary to consider the effect of the potential loss on the company's production processes on other operations, including such factors as reliance on suppliers, supplies to suppliers, particular reliance on records systems, especially where computers are employed, and so. Other threats include loss of market or goodwill, and industrial action. 4) Loss of Materials and Resources These threats affect the resources or materials essential to the processing of the company's products and include for example paper shortages in a service industry, national and local supplies of energy and labour resources. The origins of these threats will to some extent overlap with those already considered, but in the case of energy, for example, could include the effect of an increase in fuel prices on products in the world market. /HCONCLUSION There are relatively few business which in the event of damage being caused by fire or other perils at their premises or possibly those of their suppliers or customers would not suffer financially either through a loss of trade or the additional expenditure involved during the period following the occurence. As it is known, profit and earning power of an enterprise depend on uninterrupted operations. Should a material damage occur which interrupts operational activities, a loss of the income which is required for the coverage of expenditure and profit attainment may result. In addition, the liquidity of an enterprise may be subject to considerable strain under a long-term Loss- of-Prof it damage. Financial obligations e.g. for investments effected prior to the damage, remain in spite of the interruption of activities. Often, at least temporarily, outside capital is required so as to allow activities to continue. The availability of Loss of profit or Business Interruption Insurance should encourage credit institutions to assist in providing financial support. Thus, Loss of Profit (Business Interruption) insurance plays quite a considerable role in the private as well as in the national economic sector. The social point of view should also be taken into account, i.e. the protection of job security with the uninterrupted payment of wages and salaries even in the case of an interruption of business. The motivation for this decision being that the proprietor of the enterprise must reckon with the possibility of a possible destruction of his company by fire or other perils and that he can avoid consequences of fire or other perils by a Loss of Profit (Business Interruption) insurance. 'Vs. ^ in 18III. RISK AND THE ENTERPRISES Looking first at the major threats that face most companies we can break them down into the following types: 1) Physical Threats Physical threats include injury and death and all forms of loss or damage to property. The causes of physical loss will usually be common perils, such as fire, explosion, flood, earthquake, physical collision, pollution, contamination, lightning but it may also result from arson, theft, vandalism, rioting, or deterioration of property and damage or loss caused by human error. 2) Liability Risks Liabilities can be divided into claims from customers of the business, from employees of the business and from the public generally. Whilst liability claims can result from the factors mentioned under physical threats one must also consider claims which are related to the product or services provided by the company, the effects of contractual liability to customers, suppliers or others and the effect of national and international regulations and laws. 3) Business Interruption Losses of this kind will follow the physical threats and liabilities already considered. Here it is necessary to consider the effect of the potential loss on the company's production processes on other operations, including such factors as reliance on suppliers, supplies to suppliers, particular reliance on records systems, especially where computers are employed, and so. Other threats include loss of market or goodwill, and industrial action. 4) Loss of Materials and Resources These threats affect the resources or materials essential to the processing of the company's products and include for example paper shortages in a service industry, national and local supplies of energy and labour resources. The origins of these threats will to some extent overlap with those already considered, but in the case of energy, for example, could include the effect of an increase in fuel prices on products in the world market. /HIII. RISK AND THE ENTERPRISES Looking first at the major threats that face most companies we can break them down into the following types: 1) Physical Threats Physical threats include injury and death and all forms of loss or damage to property. The causes of physical loss will usually be common perils, such as fire, explosion, flood, earthquake, physical collision, pollution, contamination, lightning but it may also result from arson, theft, vandalism, rioting, or deterioration of property and damage or loss caused by human error. 2) Liability Risks Liabilities can be divided into claims from customers of the business, from employees of the business and from the public generally. Whilst liability claims can result from the factors mentioned under physical threats one must also consider claims which are related to the product or services provided by the company, the effects of contractual liability to customers, suppliers or others and the effect of national and international regulations and laws. 3) Business Interruption Losses of this kind will follow the physical threats and liabilities already considered. Here it is necessary to consider the effect of the potential loss on the company's production processes on other operations, including such factors as reliance on suppliers, supplies to suppliers, particular reliance on records systems, especially where computers are employed, and so. Other threats include loss of market or goodwill, and industrial action. 4) Loss of Materials and Resources These threats affect the resources or materials essential to the processing of the company's products and include for example paper shortages in a service industry, national and local supplies of energy and labour resources. The origins of these threats will to some extent overlap with those already considered, but in the case of energy, for example, could include the effect of an increase in fuel prices on products in the world market. /H