Insurance Claims for Loss of Stock and Loss of Profit

1. Introduction
2. Meaning of Fire
3. Claim for Loss of Stock
4. Claim for Loss of Profit

---

1. INTRODUCTION

Business enterprises get insured against the loss of stock on the happening of certain events such as fire, flood, theft, earthquake etc. Insurance being a contract of indemnity, the claim for loss is restricted to the actual loss of assets. Sometimes an enterprise also gets itself insured against consequential loss of profit due to decreased turnover, increased expenses etc.

If loss consequential to the loss of stock is also insured, the policy is known as loss of profit or consequential loss policy.

Insurance claim can be studied under two parts as under:-

• Claim for loss of stock
• Claim for loss of profit

For purposes of insurance, fire means:

1. Fire (whether resulting from explosion or otherwise) not occasioned or happening through:

1. Its own spontaneous fomentation or heating or its undergoing any process involving the application of heat;
2. Earthquake, subterraneous fire, riot, civil commotion, war, invasion act of foreign enemy, hostilities (whether war be declared or not), civil war, rebellion, revolution, insurrection, military or usurped power.

2. Lightning.

 

3. Explosion, not occasioned or happening through any of the perils specified in 1 (a) above.

1. of boilers used for domestic purposes only;
2. of any other boilers or economizers on the premises;
3. in a building not being any part of any gas works or gas for domestic purposes or used for lighting or heating the building.

The policy of insurance can be made to cover any of the excepted perils by agreement and payment of extra premium, if any. Damage may also be covered if caused by storm or tempest, flood, escape of water, impact and breakdown of machinery, etc., again by agreement with the insurer.

Usually, fire policies covering stock or other assets do not cover explosion of boilers used for domestic purposes or other boilers or economizers in the premises but policies in respect of profit cover such explosions.

Fire insurance being a contract of indemnity, a claim can be lodged only for the actual amount of the loss, not exceeding the insured value. In dealing with problems requiring determination of the claim the following point must be noted:

(a) Total Loss: If the goods are totally destroyed, the amount of claim is equal to the actual loss, provided the goods are fully insured. However, in case of under insurance (i.e. insurable value of stock insured is more than the sum insured),the amount of claim is restricted to the policy amount.

(b) Partial Loss: If the goods are partially destroyed, the amount of claim is equal to the actual loss provided the goods are fully insured. However, in case of under insurance, the amount of claim will depend upon the nature of insurance policy as follows:

1. Without Average clause: Claim is equal to the lower of actual loss or the sum insured.
2. With Average Clause: Amount of claim for loss of stock is proportionately reduced, considering the ratio of policy amount (i.e. insured amount) to the value of stock as on the date of fire (i.e. insurable amount).

Amount of claim = Loss of stock × sum insured / Insurable amount (Total Cost)

One should note that the average clause applies only where the insured value is less than the total cost and not when goods are fully insured.

1. Where the stock records are maintained and such records are not destroyed by fire, the value of the stock as at the date of the fire can be easily arrived at.
2. Where either the stock records are not available or where they are destroyed by the fire, the value of stock at the date of the fire has to be estimated. The usual method of arriving at this value is to build up a Trading Account as from the date of last accounting year. After allowing for the usual gross profit, the figure of closing stock on the date of the fire can be ascertained as the balancing item.
3. Where books of account are destroyed, the task of building up the Trading Account becomes difficult. In that case information is obtained from the customers and suppliers have to be circularised to ascertain the amount of sales and purchases.
4. After the insurance company makes payment for total loss, it has the same rights which the insured had over the damaged stock. These are subrogated1 to the insurance company. In practice, in determining the amount of the claim, credit is given for damaged and salvaged stock.
5. Frequently salvaged stock can be made saleable after it is reconditioned. In that case, the cost of such stock must be credited to the Trading Account and debited to a salvaged stock account. The expenses on reconditioning must be debited and the sales credited to this account, the final balance being transferred to the Profit & Loss Account.

Loss of Stock

Amount of loss of stock is calculated as under:
Value of stock on the date of fire                           xxxx

Less: Value of Salvaged stock                                xxxx
Amount of loss of stock                                         xxxx

Particulars	Amount
Value of salvaged stock	xxx
Add: Expenses on re-conditioning	xxx
Less: Sales	xxx
Profit / Loss	xxx

---

4. CLAIM FOR LOSS OF PROFIT

When a fire occurs, apart from the direct loss on account of stock or other assets destroyed, there is also a consequential loss because, for some time, the business is disorganized or has to be discontinued, and during that period, the standing expenses of the business like rent, salaries etc. continue. Moreover, there is loss of profits which the business would have earned during the period. This loss can be insured against by a "Loss of Profit" or "Consequential Loss" policy ; there must be a separate policy in respect of the consequential loss but claim will be admitted in respect of the policy only when the claim on account of fire is also admitted under other policies.

The Loss of Profit Policy normally covers the following items:

1. Loss of net profit
2. Any increased cost of working.

In every business, there is some standard by which its activity or progress can be accurately judged: it may be sales affected or the quantity of goods (or services) produced. To measure the loss suffered by a firm due to fire, it is necessary to set up some standard expressed in such units to represents the volume of work. There should be a direct relation between the amount of standard and the amount of profit raised. A comparison between the amount of the standard before and after the fire will give a reliable indication of the loss of profit. The most satisfactory unit of measuring the prosperity (and therefore profits) is usually turnover:

A claim for loss of profits can be established only if :

1. the insured’s premises, or the property therein, are destroyed or damaged by the peril defined in the policy; and
2. the insured’s business carried on the premises is interrupted or interfered with as a result of such damage.

Further, a claim for loss of profits cannot arise if the claim for loss of property as a result of the fire is not admitted. It is also possible that the business of the insured may suffer because of fire in the neighbourhood, not causing damage to the property of the insured, say by closing the street for some time. Such eventualities may be covered by agreement with the insurer on payment of extra premium. If fire does not affect the volume of business, there can be no claim for loss of profits.

Also, it does not mean that if there is a large property claim, there will be necessarily a large claim for loss of profit or vice versa.

The following terms should be noted:

Gross Profit is the sum produced by adding to the Net Profit the amount of the Insured Standing Charges, or, if there be no Net profit, the amount of the Insured Standing Charges less such a proportion of any net trading loss as the amount of the Insured Standing Charges bears to all the standing charges of the business.

Net Profit is the net trading profit (exclusive of all capital receipts and accretion and all outlay properly chargeable to capital) resulting from the business of the Insured at the premises after due provision has been made for all standing and other charges including depreciation.

Insurable Standing Charges: Interest on Debentures, Mortgage Loans and Bank Overdrafts, Rent, Rates and Taxes (other than taxes which form part of net profit) Salaries of Permanent Staff and Wages to Skilled Employees, Boarding and Lodging of resident Directors and/or Manager, Directors’ Fees, Unspecified Standing Charges [not exceeding 5% (five per cent) of the amount recoverable in respect of Specified Standing Charges].

Insurance policies covering loss of profit contain the following considerations usually:

Rate of Gross Profit: The rate of Gross Profit earned on turnover during the financial year immediately before the date of damage plus / minus adjustment for current year changes in price level.

GP Rate applicable for the year = GP Rate of last Financial Year +/- Adjustment for changes in purchase and sale prices in the year of fire.

 

Annual Turnover: The turnover during the twelve months immediately before the damage.

Standard Turnover: The turnover during that period in the twelve months immediately before the date of damage which corresponds with the Indemnity Period.

It is to this corresponding turnover of previous year, further adjustment shall be made as may be necessary to provide for the trend of the business and for variations in or special circumstances affecting the business either before or after the damage or which would have affected the business had the damage not occurred, also known as Adjusted Standard Turnover. Accordingly, this shall represent, as nearly as may be reasonably practicable the results which (but for the damage) would have been obtained during the relative period after damage.

Indemnity Period: The period beginning with the occurrence of the damage and ending not later than twelve months thereafter during which, the results of the business shall be affected in consequence of the damage. Thus, it is a period during which business is disturbed due to fire and is not greater than 12 months.

Memo 1: If during the indemnity period goods shall be sold or services shall be rendered elsewhere than at the premises for the benefit of the business either by the insured or by others on the Insured’s behalf, the money paid or payable in respect of such sales or service shall be brought into account in arriving at the turnover during the indemnity period.

Memo 2: If some of the standing charges of the business are not being insured by this policy then in computing the amount recoverable hereunder as increase in cost of workings only that proportion of the additional expenditure shall be taken into consideration which the sum of the Net Profit and the insured Standing Charges bear to the sum of the Net Profit and all standing charges.

Amount Recoverable as increase in cost of workings = Increased Cost of Working X (GP on Adjusted Annual Turnover) / [(GP on Adjusted Annual Turnover) + Uninsured Standing Charges]

Alternative Formula: Amount recoverable as increase in cost of workings = Additional expenditure x [(Net Profit + Insured Standing Charges)/ (Net Profit + All Standing Charges)]

Memo 3: This insurance does not cover loss occasioned by or happening through or in consequence of destruction of or damage to a dynamo motor, transformer, rectifier or any part of an electrical installation resulting from electric currents, however, arising.

The student should note the following:

1. The word ‘turnover’ used above may be replaced by any other term denoting the basis for arriving at the loss of profit e.g., output.
2. Insured standing charges may include additional items, by agreement with the insurer.
3. Net profit means profit before income tax based on profit.
4. Depending upon the nature of business, the indemnity period may extend beyond 12 months (it may be as long as 6 years). Indemnity period shall not be confused with the period of insurance which cannot be more than one year.

The insurance for Loss of Profit is limited to loss of gross profit due to:

1. reduction in turnover, and
2. increase in the cost of working.

The amount payable as indemnity is the sum of (a) and (b) below:

1. In respect of reduction in turnover : The sum produced by applying the rate of gross profit to the amount by which the turnover during the indemnity period shall, in consequence of the damage, falls short of the standard turnover, i.e., gross profit on short sales.
2. In respect of increase in cost of working: The additional expenditure [subject to the provisions of Memo (2) given above] necessarily and reasonably incurred for the sole purpose of avoiding or diminishing the reduction in turnover which, but for that expenditure, would have taken place during the indemnity period in consequence of the damage. The amount allowable under this provision cannot exceed the  sum  produced  by  applying the rate of gross profit to the amount of reduction avoided by the additional expenditure, i.e., gross profit on (additional) sales generated by increased cost of workings.

Thus, to summarize, in case of Loss of Profit, the claim shall comprise of:

1) Gross Profit on Short Sales (i.e. loss of profit) and

 

2) Claim with respect to Increased cost of Working which shall be the least of the following:

1. Actual amount incurred i.e. increased cost of working
2. Increased Cost of Working X (GP on Adjusted Annual Turnover) (GP on Adjusted Annual Turnover) + Uninsured Standing Charges
3. GP on the additional sales generated because of increased cost of working

The amount payable arrived at as above is reduced by any sum saved during the indemnity period in respect of such amount of the insured standing charges as may be ceased or reduced in consequence of the damage (because those were anyways avoided or not required to be incurred)

Average Clause: Insurance policies provide that if the sum insured in respect of loss of profit is less than the sum produced by applying the  rate of gross profit to  the annual turnover (as adjusted by the trend of the business or variation in special circumstances affecting the business either before or after the damage or which would have affected the business had the damage not occurred), the amount payable by the insurer shall be proportionately reduced. This is nothing but application of the average clause.

The turnover of a business rarely remains constant and where there has been an upward or downward trend since the date of the last accounts and upto the date of the fire, the "standard turnover" should be appropriately adjusted, as per definition given above.

Similarly, where the earning capacity of the business has changed, the rate of gross profit may not represent a correct indication of the lots and mutually agreed rate may be used for the computation.