February 2009

The Global Economy’s Impact on Business Interruption & Extra Expense Claims

Gerry Bouwman, CMA and Shannon Rusnak, CPA, CFE, CFFA

Gerry Bouwman

Yet in spite of these troubling uncertainties, life goes on, and in the insurance world, policies are being written, losses are occurring and claims are being made. Those of us responsible for evaluating economic damages during this time of economic turmoil are being asked, "How does the current situation affect the measurement of business interruption and extra expense losses?"

At first glance, the answer to this question may appear to be relatively straightforward: revenues will be down, profits will shrink and the impact far reaching.

Shannon Rusnak

Common Business Interruption Loss Measurements

In general, the following measurements are used to help project what an impacted business’ earning potential would have been but for the loss:

• Comparison to prior year and adjusted for revenue change (increase or decrease)
• Experience just prior to the loss
• Comparison with budgets and forecasts
• Comparison with industry trends

Analyzing Prior Growth

If a retailer incurred a covered loss in August 2008 and is forced to suspend operations through the end of the year, a comparison of revenue levels in the past two years prior to the loss may show significant gains. However, if we apply similar growth projections to the period in which the business was shuttered, it could drastically overestimate the revenues that would have been earned.

The consumer electronics industry is a prime example of a business sector that predicted good to moderate sales levels throughout 2008. On July 22, 2008 the Consumer Electronics Association (CEA) issued a statement that read, "U.S. Consumer Electronics Industry to Reach $173 Billion in 2008, $183 Billion in 2009: CE Shipment Revenues Withstand Lagging Economy." ⁱⁱ

Less than six months later, CEA released revised figures that showed U.S. revenue growth in the consumer electronics industry at $172.1 billion in 2008. Forecasts for 2009 have now been revised down from the original $183 billion to $171 billion.ⁱⁱⁱ

Thus, we may have a consumer electronics retailer that predicted steady revenues throughout 2008 and may have even seen such figures in the first half of the year. However, if that same retailer had a loss in August 2008, its original revenue projections would have been unlikely to come to fruition.

Industry Trends & Past Results

In general, utilizing industry trends and analyzing them before and after the loss should help provide a fairly solid basis for projecting expected revenue levels. However, the continued decline of many commodity prices throughout the fall of 2008 indicates that we should not assume there is a "reasonable floor" on which to base these calculations.

When Hurricane Ike entered the Gulf of Mexico on September 9, 2008, the Baker Hughes Rig Counts, "an important barometer for the drilling industry and its suppliers,^iv reported an annual high for its rig count for that week. Since that time, rig counts have steadily declined, with a significant drop taking place during the first two weeks of 2009.

Supply Chain Issues

There are also instances where the recession is affecting the supply chain. In Canada, the heavy snows of 2007/08 and the beginning of 2008/09 caused an increase in sales for snow blowers throughout the country. If we assumed a loss at a retailer, we might expect to continue to project increasing revenue figures for snow blower sales. However, the Globe and Mail recently ran a story with the headline, "Want a snow blower? Order Now for 2010: Shutdown of U.S. motor-maker leaves many retailers sold out or very low on inventory.^v Thus, while many consumers are still trying to buy snow blowers, the recession has, in fact, resulted in one manufacturer’s inability to produce something currently in high demand, thus leading to reduced sales among snow blower distributors.

While the above examples highlight the need to carefully review past results, industry trends and problems that affect the supply chain, it is important to note that the current financial climate can also result in situations where prior year results may actually understate the potential revenue loss a business may suffer.

Businesses That May Benefit

In January, the retail giant Wal-Mart announced that ASDA, its subsidiary in the United Kingdom:

Experienced one of the company’s strongest Christmas sales seasons, which concluded a quarter of strengthening comparable store sales, without fuel. Sales were strongest in core grocery and George apparel. Traffic was up significantly in the week before Christmas, as sales came later than ever before. ASDA had record sales for a single day on December 23. ^vi

Similarly, on January 27 the Wall Street Journal reported that McDonald’s "reported strong fourth-quarter results" and "same-store sales that rose by 7.2%." The article went on to note that "McDonald’s low prices and efforts to broaden its menu with more chicken, beverage and breakfast items are helping the company grow despite the recession."^vii

While the economy is driving consumers to cut back on discretionary spending such as eating out, this in turn leads them to purchase more basic food items at discount chains such as Wal-Mart’s ASDA. Additionally, when people do opt to dine out, it’s more likely to be at a restaurant like McDonald’s versus a sit-down establishment with higher prices. Therefore, while in many cases the current economic situation would result in decreases in projected revenues, some businesses actually have the potential to benefit from this same turmoil.

Conclusion

When evaluating a business interruption loss in these uncertain economic times, it’s important to consider the following:

• Historical earnings are not necessarily indicative of what earnings would have been but for the loss; analyzing pre-loss trends as a means of projecting normal "but for" revenues could result in misleading projections.
• It is important to analyze benchmark industry indices when attempting to accurately project the loss period revenues but for the loss.
• Considering the financial stability of suppliers who provide materials, goods or services to the affected business as well as the customers’ ability to purchase the necessary items is a key component in measuring loss.

About the Authors

Gerry Bouwman and Shannon Rusnak are Partners at Matson, Driscoll & Damico. They each specialize in economic damage quantification and have handled losses across the world. Gerry is in the Toronto office and joined MD&D 15 years ago. Shannon is in Houston and has been with the firm for over 20 years.

For more information please go to: http://www.mdd.net/ce/contact/partners/bouwman.php or http://www.mdd.net/us/contact/partners/rusnak.php