How to Navigate the Complicated Intersection of Business Income, Extra Expense, & Coinsurance

Immediately following a loss, an insured business is exposed to potential lost revenue, related profits, and business. The insured is typically contractually obligated to mitigate its business income loss through its use of extra expense coverage and other available methods.

The insurance policy usually contains provisions that dictate, sometimes limit, and shape how much of the business income loss will be covered. One of the provisions that come into play but doesn’t typically apply to the extra expense coverage is coinsurance. This separation of provisions related to interconnected coverages (business income and extra expense) adds a layer of complexity to the measurement of the loss calculation.

• Manufacturing business sustains a loss involving an immediate and total suspension in the first month.

• Months two and three of the period of restoration involve a partial suspension of business whereby the insured uses otherwise dormant, retired production machinery to mitigate its loss.

• The use of the older machinery allows the insured to generate a significant portion of revenue, but at a 20% incremental cost premium compared to normal pre-loss levels.

• As a result of the loss and the insured’s mitigating efforts, the business sustains a business income loss in months one through three, while incurring extra utilities and raw material costs in months two through three associated with using older, otherwise retired assets.

The table below summarizes the insured’s loss:

The scenario above presents the issue of the insured’s prudent desire to preserve customer relationships. Consider that the insured’s additional expense amount of $20,000 in month two allows it to generate 80% of pre-loss revenue. However, the insured only mitigates its business income loss by $100,000 due to inefficiencies associated with operating older equipment. The impact of the extra expense mitigation is further diminished by the coinsurance penalty and related collectible percentage, the impact of which is shown below:

The insured’s gross collectible business income losses of $200,000 and $300,000 in months two and three are reduced to $60,000 and $30,000 due to coinsurance, but at the cost of $20,000 and $90,000 in extra costs, respectively.

The following takeaways highlighted by this scenario are important:

1. The business income loss is subject to the coinsurance penalty, but the extra expense is typically not subject to the same provision.

2. The mitigation of the business income loss may be less than the extra expense (if pure extra expense) if coinsurance is involved.

3. The saved cost of goods sold from the first month should be used to offset the corresponding lost revenue in month one and not credited against the extra expenses incurred in months two and three.

Additional less apparent lessons relate to potential other cost savings that are not illustrated above. Labor savings (related to staff laid off) beyond that recognized in cost of goods sold serve to reduce the added raw materials and utility expenses in months two and three.

Additionally, if the insured outperforms the projected revenue despite older equipment, then the actual revenue should be used as the new basis for establishing the projected cost of goods sold.

The result of the excess revenue results is a higher net collectible loss for the insured because of the interplay between the business income loss, extra expense, and coinsurance. The higher revenue figures may also impact the coinsurance penalty driving it higher. Refer to the table below for an illustration of how the higher revenue and related cost of goods sold impact the extra expense loss: 

When measuring the time element losses that involve coinsurance, the importance of understanding and recognizing the added expenses (and true expected normal costs) are critical for an accurate loss assessment.