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Making Something out of Nothing: Business Interruption Claims and the Start-up Enterprise

Measurement of business interruption losses, under normal circumstances, is mathematics combined with fact gathering to establish proper assumptions in measuring the loss.  Historical records can be analyzed to determine the experience of the business had the insured loss not occurred.  We can examine the historical revenues of the business and identify specific revenue trends which are then utilized to project going forward during the indemnity period.

However, what is to be done when the insured business has only recently commenced operations, or in some cases, had not yet commenced operations?  No historical records or limited historical records would be available in order to develop projections during the period of indemnity.  This necessitates a different approach in the loss measurement process.

Given the current financial climate, it is unlikely that a business would be able to obtain start-up financing without the aid of a business plan.  The business plan should contain the projections of the business for a period of several years following the start-up of the business and may also contain monthly projections in the first year.

It is important to ensure that the business plan provided by the insured is one that has been developed and reviewed for financing purposes.  Therefore, one approach in measuring an economic loss of a new business is to inquire if the company prepared a business plan complete with financial projections.    If verification cannot be provided that the business plan provided was reviewed by the lender, then appropriate caution should be taken when relying on the information.

It may be that the business had commenced operations prior to the loss, and although it may only represent a small window of time, the actual results of the business in this period prior to the loss can be compared to the projected results per the business plan.  This comparison allows for an understanding of the reliability of the business plan as a predictor of the results of the insured’s business during the indemnity period.

Furthermore, if the insured has revised their business plan following the inception of the business, this may give further indication as to the future results.  At all times, the business plan and revisions should be discussed with the insured’s representative to understand the assumptions included in the plan and to determine why any changes have occurred.

Appropriate caution should be taken in not assuming that the results immediately after the business commenced operations will be indicative of results that would have been experienced throughout the indemnity period.  Depending on a variety of factors, it is not uncommon for certain business to experience slow growth while marketing plans are put in place or sales are slower than expected due to seasonality issues.  Similarly, a business may open with strong revenues based on the initial “buzz” of the new business, that may eventually decline if the business fails to grasp the loyalty of potential customers.  As an example within Canada, Krispy Kreme Donuts opened with much fanfare only to have sales dwindle and stores close as market penetration could not be sustained.

In addition to the business plan and another opportunity to gain insight into a start-up business, it would be prudent to review the any available industry statistics.  As an example, Industry Canada has developed the SME (small and medium-sized enterprises) Benchmarking Tool.  This reference database contains average income statements for specific businesses by province and differentiates by revenue range as the expenses of a business can be substantially different depending on revenue levels.  This tool is helpful in developing a gross profit/gross earnings/business income rate where no historical financial statements are available and is a strong tool to benchmark against the financial projections

Statistics Canada also publishes a wide variety of monthly statistics by business sector detailing revenues and number of businesses operating.  These statistics are also valuable in assessing the reasonability of projections and expectations.  If industry revenues were on the decline or the number on entrants in a particular sector was increasing, these circumstances may forecast that the new business may have had difficulty growing or that the market was expanding and new opportunities existed.

Unfortunately, not all attempts at new businesses are successful and therefore, the average success rates of new business should be factored in, especially when dealing with lengthy indemnity periods.  Statistics Canada, in its publication “Failure Rates for New Canadian Firms:  New Perspectives on Entry and Exit”, examines the failure rates of businesses and the reasons for such failures.  In the context of a business interruption insurance claim, the following considerations are important:

  • Failure rates can vary substantially by province.  For example in the “Accommodation, Food and Beverage Service Industry”, only 66% of new businesses will survive to their second year in the Atlantic Provinces whereas in Ontario 79% of new businesses will survive to their second year.
  • Failure rates can vary substantially by type of business.  For example, in British Columbia only 69% of businesses in the “Fishing and Trapping Industry” survive to their second year versus 82% of businesses in wholesale trade.

It may be prudent to consider a failure rate with a new business if you are facing a lengthy indemnity period, however, for shorter periods, the application of such a contingency may not be appropriate unless the business was already experiencing financial uncertainty at the time of the loss.

The above steps will assist in evaluating the business interruption loss but should always be undertaken in conjunction with a detailed interview of the insured’s representative.  The insured may be able to provide guidance with respect to the future results of the business which can then be examined in further detail.  Typical situations would be the retention of new customers with the promises of future orders or events that have been booked in the future and email communication may be readily available to support this opportunity.  Assertions such as this, which can be documented, will speak to the revenue growth and opportunity of the business.  Furthermore, the insured will likely be in a position to shed light as to why actual results may not have reached expectations if they are falling short of business plans and/or revenue projections.

As in any business interruption loss and irrespective of the age of the business, it is important to focus on the basic principles of business interruption loss measurement:  understanding the insured’s business, and understanding the insured’s business sector.  New businesses will also be impacted by the same economic forces that impact established businesses in the same industry.

While measuring business interruption losses for a new business does present unique challenges, the above tools and approaches will allow you to focus a little more on the math and strengthen the assumptions made in projecting where a business may be heading.

By Matt Mulholland. Published in Claims Canada – Oct/Nov 2012 issue.

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