Business Interruption Services for Private Equity Firms

HOST: Welcome to The Drawdown, a podcast by Cherry Bekaert's Private Equity Practice. In each episode, we explore the latest trends in the private equity sector, as well as challenges and opportunities in the investment environment.

HOST: I'm J.C. Tuthill, Managing Director with Cherry Bekaert's Forensic & Dispute Advisory Services team. Today we will address the importance of business interruption insurance coverage, how it works, whether your portfolio companies have adequate coverage, and the process that should be followed in the event of a loss.

HOST: Business interruption coverage can cover losses resulting from weather events such as hurricanes, tornadoes, fires, and earthquakes, as well as other interruptions like power outages or actions by civil authority. Specific coverages may include cyber attacks or pandemics, but those are the subject of another episode.

HOST: I'm joined today by LORI SMITH, partner in the Forensic & Dispute Advisory Services practice, and JOHN COLLIER, Managing Director. Lori and John are both CPAs with combined experience in the forensic field of over 50 years. Let me begin by welcoming Lori and John.

LORI SMITH: It's good to be with you, J.C. Thank you for having us.

HOST: John, please share the most significant business interruption issues facing businesses resulting from natural disasters and other casualty losses like hurricanes.

JOHN COLLIER: Business interruption insurance is extremely complicated, and business leaders and portfolio managers often misunderstand it. Among the most significant issues are either the lack of coverage or inadequate coverage, which can result in a company going out of business because it is underinsured and significantly impaired financially. Therefore, we recommend that business leaders, including private equity portfolio managers, understand how business interruption insurance works.

HOST: Lori, can you share how business interruption insurance defines what insurers will pay claimants for their lost profits associated with a covered event?

LORI SMITH: Typically, a business interruption policy states that the insurer will pay for the actual loss of business income sustained due to the necessary suspension of operations during the period of restoration. Business interruption coverage is part of a business's property insurance policy and is not triggered until there is a covered cause of loss. A covered cause of loss is a suspension of business operations caused by direct physical loss of or damage to property at the premises described in the policy.

LORI SMITH: This means a business cannot claim a business interruption loss without an insured loss, such as damage to its insured property under the policy. If there's no claim for property damage or another provision of the policy that provides coverage, the business interruption coverage does not apply.

HOST: John, how can business leaders and portfolio managers understand the business interruption coverage they have, either at the fund level or within their portfolio companies?

JOHN COLLIER: The first place to look is the declarations page, usually at the front of an insurance policy. It summarizes the types and dollar limits of coverage. You'll also find deductibles and waiting periods that may apply before the business interruption loss calculation can begin. Other important items on the declarations page include whether there's a coinsurance clause, which could limit the amount of a claim if the property is underinsured.

HOST: Lori, who calculates the claimant's business interruption loss?

LORI SMITH: The insurer will typically hire a forensic accounting firm to calculate a claim, but that firm does not represent your fund or your portfolio company as an insured. You should hire your own forensic accountant experienced in calculating business interruption losses to represent your interests and calculate your loss independently. This process should begin before the insurer's forensic accountants begin their work to ensure all facts and circumstances are identified to provide maximum coverage under the policy and that all attributable losses are considered.

LORI SMITH: Collaborate closely with your forensic accountant to ensure both of you are aware of all applicable provisions of the relevant policy or policies and the facts in support of them to maximize the claim under the terms of the applicable policy. Important coverage you may have is claims data coverage, which pays for the cost of your forensic accountant to compile your claim. Not all policies offer this coverage, and where possible it should be negotiated up front by your insurance agent before the policy is issued. Where claims data coverage is not available, your forensic accountant may seek and recover certain forensic accounting fees as part of extra expense coverage.

HOST: John, can you explain what types of losses are generally covered by a business interruption policy?

JOHN COLLIER: Lost profits are often defined as the net profit or loss before income taxes that would have been earned except for the impact of the insured event, plus continued normal operating expenses. This may include or exclude ordinary payroll, depending on whether the policy provides for ordinary payroll. Lost profits should not include revenues that would have been earned due to an increase in the business resulting from the covered cause of loss.

JOHN COLLIER: Another method calculates lost profit as lost revenues during the period of loss minus the non-recurring expenses, or saved expenses, that do not continue during the period of loss. If done properly, both methods should result in the same amount.

HOST: John, you mentioned ordinary payroll. Please explain what ordinary payroll coverage is and how it can impact a claim.

JOHN COLLIER: Ordinary payroll means payroll expenses for employees excluding officers and executives, department managers, and contract employees. Ordinary payroll coverage will pay the cost of employees, other than those excluded, if the company wants to keep them employed and paid during the period of loss.

HOST: Lori, how does the insurer determine the period of loss during which they will calculate a claimant's lost profits?

LORI SMITH: The period of loss is often stated on the declarations page and is based on policy provisions agreed upon between the business's insurance agent and the insurer at issuance. It's typically comprised of two periods: the initial period of restoration and an extended period of indemnity. The initial period of restoration is often limited to a 12-month period that extends from the date of physical loss or damage until the property is restored or a limited number of months allowed by the policy, whichever occurs first.

LORI SMITH: The extended period of indemnity follows the initial period of restoration for an additional number of days allowed by the policy. The purpose of the extended period is to allow the business to return to its level of operations prior to the event, to reopen and ramp up operations.

HOST: John, in addition to lost profits, what will insurers pay in terms of extra expenses?

JOHN COLLIER: Most business interruption policies reimburse claimants for extra expenses—expenses incurred that were necessary to avoid or minimize the suspension of business during the period of restoration. These are expenses that would not have been incurred absent the loss at the described premises or temporary replacement premises. Examples include generators to keep power on and other expenses to keep the business running and mitigate the loss.

HOST: Lori, what happens if there's no damage to property at the insured premises and coverage is not triggered, but the business cannot resume operations because of an official civil authority action that prevents returning to the premises?

LORI SMITH: Civil authority coverage can apply in such cases. For example, our offices were in downtown New Orleans during Hurricane Katrina. The city flooded, the government declared a state of emergency, and issued an action of civil authority preventing access to described premises. Many policies provide civil authority coverage for a certain period, often 30 consecutive days.

HOST: John, do business interruption policies cover lost profits due to utility failures?

JOHN COLLIER: In some cases they do, when coverages apply to on-premises or off-premises power failures. These are technical and tricky coverages, so they must be carefully explored and clearly defined in the policy to avoid coverage issues after a loss.

HOST: Lori, can you explain dependent property coverage?

LORI SMITH: Dependent property coverage applies when a business sustains lost profits because another property is damaged. For example, a doctor's office may incur lost profits because the hospital where the doctor operates is closed due to a casualty. This coverage is often overlooked by businesses and agents, resulting in uninsured losses.

HOST: John, insurance policies are complicated and often not clear-cut. How do you deal with that?

JOHN COLLIER: It is important to read the defined terms and have the entire policy available, including all endorsements, riders, and exclusions. These are legally binding changes that can add, modify, or exclude coverage. Identify these areas and read them carefully, as the coverage you think you have may not be the coverage you actually have once you consider riders, endorsements, and exclusions. Policy exclusions specify events or risks not covered and can vary by policy and carrier.

HOST: John, do you have steps to set forth for our listeners when a company has a business interruption, whether it's a fire, hurricane, tornado, or earthquake?

JOHN COLLIER: First, take a proactive approach by working with your insurance agent and forensic accountants to understand insurance needs and seek the best possible coverage before a loss occurs. When a loss occurs, immediately report it to your insurance agent; they will report it to the insurer on your behalf.

JOHN COLLIER: Next, mitigate your losses and minimize downtime and lost revenues. Engage forensic accountants immediately to assess and calculate the claim, and authorize them to work with the adjuster and the insurer's forensic accountants. Company management should cooperate with the insurer and adjuster, providing necessary information in coordination with your forensic accountants. Before management answers insurer questions, ensure they understand the implications of their answers so they are accurate and consistent with coverage. If in doubt, seek advice from the agent, forensic accountants, and counsel. Finally, file a proof of loss with the assistance of this team.

HOST: Thank you, John. Those steps are helpful.

HOST: This concludes our episode. Thank you, Lori and John, for joining us, and thank you for listening. If you have questions about this episode, please reach out on our website, cbh.com.

HOST: Thank you for listening to The Drawdown, Cherry Bekaert's Private Equity Podcast. The views presented by our guests do not necessarily represent the views of their respective firms.

HOST: For more information on how Cherry Bekaert serves as a guide forward to private equity funds and their portfolio companies through accounting, tax, and advisory services, please visit cbh.com.