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 be deducted from the settlement, thereby restricting the overall ‘global’ figure to a strict indemnity.
1.3.3What are the consequences?
Policyholders may be seen to be claiming a double indemnity for costs incurred, contrary to the principle of indemnity.
If the insured mitigates its losses by using its own labour (often at considerable saving to insurers), it might recover the costs incurred from its material damage insurers. If the labour costs paid are then deducted from the BI claim in order to avoid this so called ‘double indemnity’, the policyholder may feel that it is penalised unjustifiably.
There is no facility for making any adjustments (to reflect the duplicated amounts) within either the material damage or the BI policy. Such adjustments are generally applied to the BI settlement, but these do not fall within any of the clearly-defined elements of the standard UK BI policy wording. Consequently, they are often treated incorrectly as ‘savings’ even though they do not fall within the definition of costs/expenses saved in consequence of the incident, giving rise to the claim.
Notwithstanding this, where one or other element of the cover (MD/BI) is underinsured and average conditions are incorporated, policyholders may be entitled to ‘cherry pick’ the sections of the policy against which the costs that are covered under both sections are allocated.
1.3.4Potential solutions
There are several possible solutions to this issue.
If it is the intention to avoid any double indemnity, a provision could be made in either the material damage or BI policy to make an appropriate deduction. Current practice would seem to be that any adjustment be made under the BI policy, but this could act to the detriment of the insured if the material damage settlement had already been limited by the application of average.
It is possible to amend the wording of the BI policy to enable such costs that have already been paid (after application of average) within the material damage policy or section to be taken into account in the BI settlement. This could be achieved by, for example, including the following clause:
Due account will be taken of any payment already made in respect of insured costs under a related Property Damage policy or section of this policy.
Alternatively, it may be insurers’ intention to pay both the BI and material damage claims on the basis that the insured has paid the full premium for both covers.
The US approach is to exclude BI losses relating to finished stock, which reduces the significance of the overlap in relation to stock but does not address the circumstance where the insured’s own labour undertakes material damage repairs to buildings, plant, etc.
1.4 Material Damage Proviso
1.4.1Current position
The material damage proviso is fused with the operative clause in some policies, and set out separately in others. Regardless, it is invariably not identified in policy wordings as ‘the material damage proviso’ (MDP) – this term is used within the industry to refer to a form of words seen in most policies.
A typical material damage proviso might read:
[The Operative clause will trigger] provided that at the time of the happening of the damage there shall be in force an insurance covering the interest of the insured in the property at the premises against such damage and that payment shall have been made or liability admitted therefore under such insurance.
The main purpose of the material damage proviso stated in Riley4 has been to ensure that sufficient funds are available to facilitate reinstatement, which in turn will mitigate the BI loss. A subsidiary objective is to obviate the need for the business interruption adjuster to duplicate the work of the material damage adjuster in investigating cause and considering the application of any clauses precedent to liability.
1.4.2What is the problem?
It