Events in recent years, such as the COVID-19 pandemic, the war in Ukraine and now the resultant cost of living crisis, have left businesses operating in a prolonged period of uncertainty. As forensic accountants, we are regularly instructed by our insurer and law firm clients to both review business interruption or loss of profit claims and quantify such losses. Our role is to measure the economic impact of the incident, be that something physical such as a fire, storm or flood, or something less tangible such as a data breach, political unrest or the impact of professional negligence.
Our aim, when reviewing and calculating such losses is to identify which losses result directly from the incident. To do this, we must consider how the business would have performed had it not been for the incident versus how it has actually performed. In such uncertain times, it is more important than ever when considering projected ‘but for’ financial performance to understand what non-incident related factors would have impacted the business in any event.
Key Issues Impacting Businesses
Examples of key issues impacting businesses currently include an increase in business costs, supply chain issues and customer demand.
Increasing business costs
Businesses are having to deal with increased costs of sales, including the cost of raw materials and increased production costs due to significant hikes in energy prices. Where a business imports raw materials or essential components, difficulties in obtaining shipping containers and delays at the port are resulting in additional costs and production delays.
In addition, both labour shortages and the soaring cost of living is resulting in businesses having to pay higher wages.
A highly geared business may also be impacted by increasing interest rates, either where loans are subject to variable interest rates or if existing fixed-rate deals are coming to an end.
Supply chain issues
A business may also be impacted by how its main suppliers are faring in the current climate. For example, if there are supply chain issues slowing down the delivery of items to the business, this may put pressure on production lead times and therefore impact sales. Additionally, if a key supplier goes out of business, it may take time for the business to find an alternative supplier.
Customer demand
Depending on what sector a business operates in, inflationary pressures on the end consumer, given the soaring cost of living and reduced disposable income, will impact sales. This might reduce demand or force down prices as consumers become more price-conscious, meaning that higher costs cannot be passed on and profit margins become squeezed.
Historical performance v actual performance
Given the above, it will not be sufficient to assume ‘but for’ projections will be in line with historical financial performance. Consideration should be given to:
any available budgets/forecasts prepared just prior to the incident
performance of the industry sector as a whole, and specific competitors during the interruption period
other specific factors unrelated to the incident, known to be impacting on the business
It is important to prepare a projection that takes into account all the non-incident related factors impacting the business. In doing this, the difference between the projected ‘but for’ financial performance of the business with the actual financial performance, should reflect only the losses arising directly from the incident giving rise to the claim.
Adequate business interruption insurance
Once losses have been quantified, it is also important to check if the insurance cover provided by the business interruption policy in question is sufficient.
For example, where the increases in business costs are passed onto the customer by charging higher prices, sales may be greater than anticipated, which, depending on the type of policy in place, could render sums insured to be inadequate. Whilst declaration-linked policies will typically provide an automatic uplift to the sum insured at the time of the claim, traditional policies stating a set sum insured, may be subject to the principal of average. In such an instance, the amount paid out by insurers will be adjusted to reflect the underinsurance.
Additionally, underinsurance can occur where the indemnity period (the length of time the insurer is obligated to make payments to cover losses insured under the policy) is insufficient. Typically, this will be stated in the insurance policy as a number of months e.g., 12, 24 or 36 months. If it is likely to take two years to reinstate particular business premises after an incident, and the indemnity period is stated in the policy as only 12 months, the business would be 50% underinsured.
Look at the whole picture
When considering business interruption and loss of profits claims, it is important to look at the whole picture. It is not sufficient to compare historical performance with actual performance and assume all of the losses stem directly from the incident giving rise to the claim. Instead, it is important to gain a full understanding of the business in question, what drives the business and what are the key business risks.
If you would like to find out more about how we are able to assist you in reviewing business interruption or loss of profit claims and quantifying such losses, please contact Caroline Bedford on 0113 2211 332 or 07469 850632 or via caroline.bedford@armstrongwatson.co.uk.
