Time to Call Time on Gross Profit?
As forensic accountants, we frequently assist in quantifying business interruption losses and there is no doubt that, in the UK at least, gross profit policy wordings are the most commonly seen. Although these have been around a long time, confusion over just what has been insured under gross profit policies is still widespread. This was brought home to me by a recent case in which the definition of gross profit became a key issue worth several million pounds. Whilst a satisfactory conclusion was reached in this instance, the issue had the potential to derail the loss settlement process and it set me wondering, why is this such a perennial problem and is there a better solution?
An oft-cited answer to the first question is simply a misunderstanding of the term ‘gross profit’. Consider the duck-rabbit optical illusion. From a first glance at this image, I saw a duck and might assume you did too. However, you are equally likely to see a rabbit and unless we discuss our impressions of the image, we might never discover our differing views. Gross profit is similar in that what an insurer means by it and what a business understands by it, its ‘accounting definition’, may be quite different. It is often only when an incident occurs that the two parties find out there is a discrepancy in what they thought was insured and the potential for a major shortfall in coverage.
Confusion over the term gross profit is a common problem, but it is by no means the only complication we see. A key part of insuring gross profit involves making assumptions about which costs will stop or reduce following an incident. However, when a loss arises, particularly in the case of a partial loss, we often find costs are not saved as assumed per the policy. There can be many reasons for this: oversight and over-simplification may play a role, but the reality is, projecting costs is not straight-forward. Modern businesses and their bookkeeping practices can be so complex that even their owners struggle to interpret their results, experiencing what Warren East, CEO of Rolls Royce, has poetically described as an ‘accounting fog’. Compounding this inherent complexity is the unpredictability of what type of incident will occur and which mitigation strategies will be required; under these circumstances perhaps surprises are to be expected.
These problems are well-known to insurance industry professionals and some potential solutions were outlined in a 2012 CILA review of policy wordings. One popular idea discussed in this publication is to move away from gross profit policies, in favor of revenue-based wordings. The key advantage of a revenue policy is that the sum insured is based on turnover, a term whose meaning is less ambiguous and a figure which can normally be projected with more confidence. Misunderstandings over what is meant by gross profit are avoided, reducing the risk of uninsured losses and potentially streamlining the claims process.
If revenue policies are the solution to gross profit’s problems, it may seem surprising that they enjoy only a minority share of the market. Part of the reason may be an adherence to tradition within the industry; gross profit policies have, after all, been written and sold successfully for many decades. Furthermore, revenue policies do not remove the challenge of predicting which costs are likely to be saved in the event of incident, but shift that responsibility and risk from the business, who understand their costs better, to the insurer. Insurers may understandably be somewhat reticent in doing this, without a compensating increase in premium.
It may also be that there is a limited appetite for revenue policies on the part of businesses who perceive them as being a more expensive option. If additional premium is required by insurers to compensate for the wider coverage provided, businesses may be unwilling to pay this, especially if they lack clarity on the potential benefits of revenue policies or if they discount these benefits because they will only crystallize in the event of a loss.
The traditional gross profit policy is therefore likely here to stay in the UK and, if set up correctly, remains an excellent basis for indemnification. Nevertheless, revenue-based policies do offer an effective solution to some of the potential pitfalls of gross profit policies and, if they were to proliferate, the progress towards loss settlement may be smoother in many cases. Ultimately, whichever type of policy is selected, to fully understand the risks involved and avoid unpleasant surprises from both the insurer’s and business’s perspective, ideally a dialogue is required in which both parties consider potential loss scenarios, the likely impact on the business’s costs and the policy’s response.
