Risk Managers' Forum

Valuing business interruption exposures

Challenges include predicting loss duration and covering unknown risks

By Rich Rudolph, Ph.D., CPCU, ARM

Every economic activity creates a net income exposure. Organizations may suffer a loss of revenue or may incur additional new expenses or an increase in existing expenses when their normal activities are disrupted. Sometimes it can be a real challenge to identify the source of the net income exposure, but it's even harder to properly value the net income exposures once identified.

The traditional focus of net income exposure valuation is the net income, the so-called "bottom line" of the income statement. However, this net income value may not be the "real" net income value the organization faces. Determination of net income is affected by the type of accounting methodology used. An organization will often use Generally Accepted Accounting Principles (GAAP) for one purpose, Internal Revenue rules for another purpose, and management accounting principles for their own internal use. All three can result in different net income results. Which one is the "real" net income?

One problem of valuing the net income exposure is determining which source of financial information should be used. Using a financial statement can be a good first start, but only if you know the type of accounting system under which the financial statements were prepared. Financial statements created by following Generally Accepted Accounting Principles present standardized information in standardized formats, but these rules may not reflect the real net income exposure the organization faces.

For example, the income statement may be affected by an inventory valuation method (such as FIFO or LIFO) to achieve a desired asset valuation on the balance sheet that affects the cost of goods sold and net income. Simply using the GAAP net income or "bottom line" for valuation purposes may not cover the "real" net income exposure.

Tax accounting rules will also affect the "bottom line," primarily from non-cash expenses like depreciation. The concept of depreciation recognizes that an organization should set aside funds to replace property and equipment that is subject to wear and tear, but the tax rules define how much wear and tear can be deducted and when, and those financial effects will be reflected in the net income figure on the GAAP income statement, not necessarily on the "real" net income exposure.

These problems may be addressed by using internal or management accounting statements, the statements that management uses in the day-to-day operations of the firm. Management statements present the financial information in the manner the managers of the organization use in making decisions and are more likely to reflect the "real" net income exposure, not the net income figure that is calculated under generally accepted accounting principles or tax rules.  However, many organizations regard their internal financial statements as being highly proprietary and are unwilling to release this information. Further, some users of financial statements insist on GAAP-prepared statements because they have less confidence in the validity of the content of management statements because these statements are not audited and do not have an opinion letter from a CPA.

Another problem is measuring the extent of the interruption or disruption. Since insurance contracts are annual, it is easy to focus on an annual amount of net income exposure. However, most interruptions are not 12 months in length. Further, the interruption is frequently more of a disruption, or a decrease in activity rather than the total cessation of activity. The challenge here is to attempt to determine the duration of the interruption or disruption and the extent of the interruption or disruption.

For example, an organization may face a total interruption for three weeks followed by a partial interruption for three months as recovery begins to talk place. Or the organization may face a disruption that affects operations resulting in a 30% reduction in revenue or a 20% increase in expenses. These types of estimates are very challenging to generate, with the only real methodology being a table-top exercise or group discussion that results in a consensus opinion of the likely length and extent of interruption; and even with a consensus opinion, managers tend to be overly optimistic regarding recovery estimates.

For an interesting and revealing read, The Black Swan by Nassim Nicholas Taleb addresses the reasons why managers and "experts" tend to have overly optimistic opinions regarding their areas of "expertise" and their reliance on mounds of data.

Net income losses also have a tendency to follow a variation of Murphy's Law: The loss will occur at the worst possible time. For organizations that have seasonal variations in activity, either sales or production, the estimation of the value of the interruption must consider when the interruption would occur. Naturally, the most conservative estimate would assume the interruption would occur at the worst possible time.

Related to the timing issue is the possibility that losses will extend beyond one year. For example, wineries, distilleries, and cheese producers require the passing of time for their production cycle. While the physical facility may be restored to operations, the usual cessation point for determining the claims value of the interruption, the real net income loss is extended because the aging process cannot be rushed simply because the facility is reopened. More commonly, organizations that are landlords may find that tenants exercise their lease option to terminate in the event of a significant loss, and when the property is ready to reopen, the landlord finds that it takes many months to re-let, waiting for tenants who have other leases that must run out before they will lease space in the newly reopened property. These scenarios will require purchasing insurance amounts in excess of the annual net income amount and a careful review of the insurance policy and possible negotiation of amendatory language for an extended period of indemnity beyond the customary restoration of operations.

Assessing exposures

Perhaps one of the most daunting tasks for the risk manager is to assess the array of business interruption exposures that the organization does not know it has. It is challenging enough to adequately identify and assess the myriad of business interruptions that are obvious to the risk manager; however, it is even more so, and potentially more devastating to the organization's survival and recovery hopes, to identify other organizations' exposures that will impact the risk manager's organization when the risk manager does not know they exist. While many of these quasi-unknown exposures might easily be handled, even if accidentally, by a contingent business interruption exposure, the proper valuation of these exposures is problematic. However, an unplanned financing of an unknown exposure is never a positive event in the harried life of a busy risk manager.

While both the usual business interruption and contingent business interruption coverages work for many exposures, these coverage forms are closely tied to the direct damage coverage's perils, exclusions, and restrictions. For example, a magnet store for a shopping center is a routine contingent exposure, but the loss of the sole bridge accessing the complex, a bridge owned by a municipality, state, or the federal government, will be even more devastating to the shopping center than the loss of the magnet store. Added to that is the problem of covering traditionally excluded or restricted perils, such as flood, earthquake, tsunami, or even acts of civil authorities. A recent example of the impact of "unknown unknowns" was the destruction of automotive parts by the earthquake in Japan and its ripple effects on auto dealers and repair facilities in the United States and other parts of the world.

In short, business interruption exposures are a paradox, both easily identified and totally unknown, both easily quantified and totally unquantifiable, yet the successful handling of business interruption exposures, a natural by-product of every economic transaction, is key to the survival and success of any organization.

The author

Richard G. Rudolph, Ph.D., CPCU, ARM, ARP, APA, AIAF, AAM, entered the insurance industry in 1972 as a sales representative for a major insurance company. In 1992 he joined a risk manage­ment consulting practice which now bears his name. He is a national faculty member for The National Alliance for Insurance Education & Research. For more information on The National Alliance's CRM program, go to:  www.TheNationalAlliance.com.