20 Dec 2018

No double-dipping is business as usual: understanding "Increased Cost of Working" in Industrial Special Risks claims

By Fred Hawke

A business claiming Consequential Loss of Profits under common types of Industrial Special Risk policies will often make the mistake of treating the reduction in Turnover/Output and the Increase in Cost of Working as separate heads of claim – but they aren't.

Businesses across Australia rely on Industrial Special Risks (Mark 4 and Mark 5) policies to insure them for damage or loss to their physical assets, and the loss of profits that comes as a consequence of that. And when it comes time to make a claim, they can be surprised to find the insurer holds off, or even knocks back the claim. The policy must have been a waste of money, right?

Not necessarily. In an Industrial Special Risks (ISR) policy, there are specific terms – "Gross Profit", "Turnover" (Output if selected) and "Increase in Cost of Working" – which are all precisely defined. If you don't understand what they mean, and how they interact, you won't appreciate just how the Basis of Settlement of a Section 2 (Consequential Loss of Profits) claim works.

This means delving into some of the mysteries of the accountant's art as well as the lawyer's, but at the end of it you should (we hope) have a better appreciation of what you are actually insured for, and how any claim must be prepared.

The key terms in an ISR policy – and what they actually mean

The Basis of Settlement is actual loss of gross profit, due to reduction in turnover and increase in cost of working. 

"Gross Profit" is commonly defined as:

"the amount by which the sum of the Turnover and the amount of the closing stock and work in progress shall exceed the sum of the amount of the opening stock and work in progress and the amount of the Uninsured Working Expenses as set out in the Schedule, the amounts of the opening and closing stocks and work in progress being determined in accordance with the Insured's normal accounting procedures, with due provision for depreciation."

"Turnover" is defined as:

"The money (less discounts) paid or payable to the Insured for goods sold and delivered and for services rendered in the course of the Business."

What this basically means: sales revenue. 

As an alternative to this input, the word "Output" may be substituted and is commonly defined as:

"The sale value of goods manufactured or processed by the Insured in the course of carrying on the Business at the Premises."

What this basically means: the sale value of production.

In either case the shortage (reduction) is calculated as:

"The amount by which the Turnover/Output during a period shall, in consequence of the Material Damage, fall short of the part of the Standard Turnover which relates to that period."

"Standard Turnover (Output)" simply means:

"The Turnover (Output) during that period in the 12 months immediately before the date of the Material Damage which corresponds with the Indemnity Period (appropriately adjusted where the Indemnity Period exceeds 12 months)."

"Increase in Cost of Working" is defined as:

"The additional expenditure necessarily and reasonably incurred for the sole purpose of avoiding or diminishing the reduction in Turnover (Output) which, but for that expenditure, would have taken place during the Indemnity Period in consequence of the Material Damage, but not exceeding the sum produced by applying the Rate of Gross Profit to the amount of the reduction thereby avoided." [emphasis added]

The Rate of Gross Profit is the proportion which the Gross Profit represents of the Turnover, or Output as the case may be, for the financial year immediately preceding the damage – basically, the margin.

What this basically means: you can claim additional costs incurred solely to maintain your business' productivity after the damage, so long as they don't exceed the value of the production saved.

Finally, there's the all-important "trending clause", which normally reads:

"Adjustments shall be made to the Rate of Gross Profit, Annual Turnover, Standard Turnover and Rate of Pay-Roll as may be necessary to provide for the trend of the Business and for variations in or other circumstances affecting the Business either before or after the date of the Material Damage or which would have affected the Business had the Material Damage not occurred, so that the figures as adjusted shall represent as nearly as may be reasonably practicable the results which but for the Material Damage would have been obtained during the relative period after the Material Damage occurred."

Calculating the actual Loss of Gross Profit: enter the economic test

A client with an ISR Section 2 claim will often make the mistake of treating the reduction in Turnover/Output and the Increase in Cost of Working as separate heads of claim. As can be seen from the above definitions, however, they each represent an input into the calculation of actual Loss of Gross Profit during the indemnity period, which is the true basis of settlement. 

The so-called "economic test" of Increased Cost of Working, which is the stipulation that the expenditure must not exceed the amount of Gross Profit saved due to it, means that for every dollar of ICW incurred,  you must prove that you saved more than a dollar of Gross Profit that otherwise would have been lost, during the Indemnity Period, due to the effect of the Material Damage on the Business. 

The "sole purpose" requirement means that costs incurred for wider strategic purposes and which may benefit the business outside the Indemnity Period, such as additional advertising, may be hard to justify as Increased Cost of Working.  They may, however, be able to fit within the definition of Additional Increased Cost of Working, as described below.

So what do you have to prove for an Increased Cost of Working claim?

In short, for an ICW claim you have to prove that:

  • as a result of the Material Damage, during the Indemnity Period you incurred expenditure additional to normal fixed and variable costs;
  • that this had the effect of reducing the diminution in Turnover/Output and consequent loss of Gross Profit, occasioned by the Material Damage;
  • by an amount greater than the expenditure; and
  • this was the only reason that additional expenditure was incurred.

This effectively means that to claim one dollar of increased cost of working, you must prove that you saved at least one dollar and one cent of Gross Profit that otherwise would have been lost due to the Material Damage.  That is, one dollar and one cent of Gross Profit that you:

  • would have earned had the Material Damage not happened;
  • but would not have earning owing to the Material Damage;
  • but for the ICW expenditure.

So the difference between the Gross Profit in the counterfactual scenario where no Material Damage occurred, and the Gross Profit achieved in the actual scenario after the Material Damage, needs to have shrunk, due to the ICW expenditure, by more than the sum of that expenditure. 

Contradictions in the counterfactuals

Here's the challenge for the insured: the greater the difference between the counterfactual Gross Profit and the actual Gross Profit, the harder it becomes to prove a net reduction in the loss resulting from the ICW expenditure.  The more the insured talks up both the actual loss of Turnover/Output and margin attributable to Material Damage and the amount of the ICW, the harder it becomes to demonstrate that the ICW expenditure in fact produced a positive impact greater than its amount.  This is a trap into which insurance claims preparers not infrequently fall.

For example, if you actually achieved four million dollars' worth of Gross Profit in the post-Material Damage Indemnity Period, and you claim one million dollars' worth of Increased Cost of Working, you must show that without that expenditure the actual Gross Profit would have been less than three million dollars. 

The higher the ICW claim, the lower must be the projected Gross Profit in the alternative scenario where that expenditure was not incurred or the higher the  Gross Profit actually achieved.  If, however, the ICW erodes  the margin entirely, so that there is no profit actually made on a unit of production, then that unit becomes part of the Actual Loss of Gross Profit element of the calculation, and ICW cannot be claimed in respect of it.

Increased Cost of Working vs Additional Increased Cost of Working – they're not the same thing

Increased Cost of Working is not to be confused with Additional Increased Cost of Working (AICW), which is commonly defined as expenditure:

"Not otherwise recoverable under Section 2 of this Policy necessarily and reasonably incurred during the Indemnity Period in consequence of the Damage for the sole purpose of avoiding or diminishing reduction in Turnover or resuming and maintaining normal operation of the Business."

This is basically ICW as defined above but:

  • without the economic test; and
  • with the alternative purpose of resuming and maintaining normal operation of the Business and with the impact not limited to the Indemnity Period.

AICW therefore represents a far less constrained calculation of claimable loss than ICW, and can even extend to such matters as additional financing costs, advertising campaigns, product placements and the like, provided they are necessary to re-establish the Business.  It is, however, invariably sub-limited.

Conclusion: you can't claim for a loss of profit and for the cost incurred in avoiding it

For insureds considering making a claim, the most important point to remember is that the effect of the economic test is that there is a trade-off between Turnover reduction and Increased Cost of Working, once the latter exceeds the margin.  

To the extent that ICW incurred in the indemnity period has reduced the diminution of turnover it is claimable, but it has, ipso facto, reduced that element which otherwise would have formed part of the claim.  Axiomatically, the Insured cannot claim both for a loss of profit and for the cost incurred in avoiding it

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Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this communication. Persons listed may not be admitted in all States and Territories.