Abstract
The increasing number of catastrophes world over and quite a few devastating fire accidents witnessed in India, have thrown open the need for the adequacy of the sum insured, both under material damage and business interruption. A key component of the financial management of any corporate, would be to ensure that the assets are protected adequately in the event of any accident which can threaten the existence of the organisation. The article brings on table certain key suggestions which can guide a corporate to get their values at risk reasonably accurately.
During the last couple of years, the world has witnessed a good number of catastrophes ranging from the mass destructions caused by floods in Thailand, earthquakes of New Zealand and Japan, to the not so devastating recent twin quakes in Japan and Italy.
A number of major fires have wrecked havoc in corporate India. All these and many more such incidents of the past have thrown open a plethora of questions to insurers and insured alike. The more common ones which plague the mind of many are:
— Have we got the sum insured right?
— Do we have the right Business Interruption cover in place?
The Importance of Sum Insured
Insurance is a contract between two parties where the insurer, in return for a consideration by way of premium, undertakes to compensate the other party up to a particular fixed sum subsequent to the happening of an accidental event. A proposer wanting to insure his assets, has to decide on the value of the assets for which he wants to insure his property.
This value known as “sum insured” in insurance parlance is very important for the insurers as well as the insured. The importance of this term can well be judged from the following facts:
Sum insured denotes the maximum liability of insurers at the time of claim
— The “sum insured” represents the value on which the premium under the policy is to be determined. The applicable rate is applied on this “sum insured” to arrive at the chargeable premium under the policy which is the “consideration” under the insurance contract.
— The “sum insured” also represents the value for which the customer wishes to insure his assets.
— The “sum insured” also represents the maximum liability of the insurance company in the event of an accident.
Let us understand from the following examples, how an improper fixing of sum insured can be painful for the insured…..
— Insuring the assets for a value lesser than its market value can result in the individual/corporate body being penalised at the time of loss.
Following a loss, the loss assessor or representatives of insurance companies’ carry out the valuation of the attached property as on the date of loss. Subsequently, if the value of the property as on the date of loss is found to be more than the “sum insured” on which the premium has been charged, the risk is said to be “under insured”. Under such circumstances, the assessed loss is reduced in the proportion of the sum insured and the value of the property as on date of loss, thereby often forcing the insured to bear a substantial portion of the loss himself
Under –insurance means a situation when the sum insured is less than the value of the assets insured as on date of loss.
If the value of an affected building as on the date of loss is found to be INR 10,000,000 as compared to the available sum insured of
INR 5,000,000, the assessed loss of INR 2,500,000 would be reduced to INR 2,500,000* 5000000/10000000 = INR 1,250,000.
— At the same time, over insuring the assets does not result in any benefit to the insured, since the maximum benefit under the policy is the sum insured or the actual value of the property as on the date of loss, whichever is less. Thus, insuring a property worth INR 10,000,000 for INR 15,000,000 does not entitle the insured in the event of a loss to a claim of fifteen million. Insurance contract is based on the principal of indemnity and the reimbursement in the form of claim cannot exceed the actual value of the property under any circumstances.
The facts highlighted above aptly describe why it is imperative to adopt a scientific approach to the fixing of the sum insured. While the customer has every right to arrive at a figure to insure his assets, the following suggestions might make the task a lot simpler. The methods of fixing the sum insured cannot be generalised and neither can there be a unanimous approach to this aspect of insurance. Yet, an attempt has been made to simplify the procedure based on certain suggested and tried methods of fixing the sum insured.
Sum insured for fixed assets like building, plant and machinery, furniture, fixtures etc.
Certain common errors seen in the industry while arriving at the sum insured for fixed assets have been highlighted below. These can have a drastic effect on the final assessed amount of loss, in case of an insured event operating.
— Insure the assets on “book value” or capitalised cost.
— Insure after depreciating the capitalised cost.
— Insure on depreciated value with “Reinstatement value clause” incorporated under the policy.
Reinstatement value represents the new replacement cost of similar type of assets…whereas the depreciated value or market value accounts for the depreciation for the period of use of the assets and also the appreciation due to inflation.
Once a policy is issued to cover the assets on “reinstatement value”, the loss settlement is done without taking the depreciation into account. This enables the owner of the assets to replace the property without straining his resources. The market value or the depreciated value accounts for the depreciation due to age / usage.
How to arrive at the sum insured for Building?
The more common methods of arriving at the new replacement cost (Reinstatement value) of buildings are as under:
— The total covered area of the building is multiplied by the prevailing CPWD/PWD rate (for the area) per square metre, to arrive at the new construction cost. The area of the building can be arrived at after carrying out actual measurement or by referring to the sanctioned plan. Any improvements made on account of superior material such as marble flooring/vinyl flooring etc need to be quantified and added to the previous cost to arrive at the correct cost of the building. It is important to note that the cost of the land is not to be taken into account, as land is not insurable.
— Yet another method followed (mainly for old buildings) would be to escalate the original cost of the building through cost rise index published by National Building organisation to arrive at the current cost. However, all the improvements carried out during the years would have to be added to the cost arrived at.
The market value or the depreciated value for the building can be arrived at by suitably depreciating the new replacement cost arrived at (as mentioned in the previous paragraphs). The depreciation applicable cannot be standardised and would vary from building to building depending on the construction, age and the usage. On a very rough basis, the life span of a building of modern construction is considered to be of 50 – 75 years and thus depreciation of 1.5% -2% per year is applicable.
How to arrive at the sum insured for Plant and Mechinery?
The easiest way of arriving at the New replacement cost of the machinery is to consider the “Supplier’s quotation as on date of taking insurance”…
However, this method is time consuming and becomes quite laborious in case of organisation having multiple units with huge asset base. Further, for old set ups it is not always easy to get the supplier’s quotation for the current value of such old machinery.
One of the most scientific methods of arriving at the value to be insured for plant and machinery would follow the subsequent steps.
— The purchase cost or if the purchase invoice are not available then the capitalised cost as per books of accounts, is taken as the basis.
— These costs for every machine in the unit are escalated using suitable Index (In India, for indigenous materials, Index periodically published by Reserve Bank of India…RBI Index is considered) to arrive at the current day new replacement cost. The escalation is done in the ratio of current RBI Index for the category of the machine and the RBI index prevailing at the time of purchase/ capitalisation of the machine. A sample calculation using a hypothetical data is given below, for understanding.
It may not be practically as easy as it may look from the tabular computation. The exercise needs to be done for each class of machine and for every capitalisation/ purchase / modifications done during the year.
If the capitalised cost is taken as a basis, care should be taken to ensure that cost of transportation and installation are deducted from the cost capitalised, before escalating the same as per indices. These costs should be subsequently added proportionately.
The market value or depreciated value of the machinery is arrived at by deducting intrinsic depreciation from the new replacement cost arrived at, as above. The rate of depreciation applicable cannot be standardised and certainly this would not be the accounting rate of depreciation. The depreciation depends upon the age of the machinery, nature of machinery and usage. The life span of a machine would depend on its nature and usage. The same machine used for longer hours in an industry which is prone to corrosion, will have a higher rate of depreciation than when used for lesser hours and some other industry. More than often, the maintenance of the machines also plays a role in deciding the depreciation applicable.
The same list of machines as shown in the hypothetical example above, if insured on market value, the reasonable sum insured would be as per Table: 2 given below. For the purpose of calculation, depreciation rate has been considered @5% per year (for ease of calculation, the month of purchase has not been considered):
Does that really mean that a 20 year old machine or a pipeline need not be insured at all, since the depreciated value is “zero” after considering 5% depreciation per year………?
Quite often it is observed that the maintenance of the assets is such that, even after these have lived through their life span, yet they are performing satisfactorily. In such a situation, it is not possible to write off such machines/assets as scrap, because in insured’s books these are still considered as performing assets. The valuation of such machines is done on the basis
“Residual value/ life concept”.
Insurances are done by capping the depreciation at a reasonable level and the balance is considered to be its residual value e.g. the interstate oil pipelines running across the length and breadth of the country might have been installed 40-50 years back and certainly these pipelines as on date have completed their respective life span. However due to their immaculate maintenance and periodic up gradations, they still perform. It is thus possible that while insuring these assets, the sum insured are taken at 75% (assumed) of their replacement cost, considering 25% as the residual value.
Deviations for Imported machinery:
The basic methodology remaining the same, the imported machinery would have some additional factors to be considered:
— Instead of RBI index, the escalation would have to be done with the help of some International indices, the most common of them being “Marshall and Swift equipment cost Index”.
— The original capitalised cost will be escalated inflated with the help of the international index and the value so arrived at would be in foreign currency.
— The conversion would then be done at the current exchange rate, and custom duty as prevailing on the date of taking insurance, would be added to the same.
Organisations having a mix of imported as well as indigenous equipments would have to carry out separate workings for both the categories of assets.
Sum insured for stocks
Stocks are insured on the basis of the prevailing rate in the market. The maximum quantity of stocks at risk during the past one year is multiplied by the prevailing market rate without profit, to arrive at the sum insured.
Stocks of fluctuating nature can be insured on “declaration basis” too, wherein initially a provisional sum insured is fixed by the above method. Subsequently, monthly declarations of actual value of stocks lying on a particular date are required to be advised to the insurance company before the expiry of the succeeding month. At the end of the year, based on the declarations made, the final premium is calculated on the average of the stocks lying throughout the year.
A Word of Caution!
The efforts in the previous paragraphs were to guide a customer to arrive at a sum insured, which would be reasonably close to the actual value at risk. However, it needs to be kept in mind that the value so arrived, would be the one as on the date of taking the insurance policy ….does it take care of the possible inflation in prices during the course of the year?
It is imperative to build in a cushion to take care of the inflationary trend during the course of the year … let us not forget that the loss might happen on the last day of the year and the sum insured arrived at the inception, may not be adequate. This is particularly true for insurance taken on Reinstatement value basis.
Property insurance covers in India have a provision of opting for “Escalation clause” which provides for an automatic increase in the sum insured during the course of the year to the extent of the selected %.
Demystifying Business Interruption
The devastating effects of the disasters do not end with the mangling remains of the assets. They more than often have crippling effects on the finances of the organisation. The productions during the interruption period (white the restoration work is going on) come to a standstill, thereby resulting in financial losses to the organisation, till the factory is fit to commence operations. More than often, it has been seen that the business interruption losses are much higher than the material damage losses. We have discussed at length on how to get the sum insured of the assets right. But at the same time, it is much more critical to ensure that the customer has a Business interruption policy in place and the sum insured for the same is adequate.
A business interruption policy can come to the aid of an insured only if the following two areas have been taken care of:
— Get the gross profit right ….Gross profit is the sum insured under A BI policy!
— Arrive at the correct Indemnity period!
Indemnity period refers to the insured’s estimation of the maximum period of interruption which can happen following a loss
How to arrive at the correct gross profit?
The “Gross profit” which is the sum insured under a Business Interruption policy is distinct and different from the term which appears under the Trading account. In insurance parlance, gross profit refers to that part of Insured’s turnover which is affected following outbreak of a peril covered. This is the sum of “Net profit” and “Standing charges” OR Gross profit = Turnover less Variables.
Standing charges refer to those charges which an insured continue to incur even when the affected unit is closed following an accident ….fixed costs.
In order to arrive at the reasonably correct sum insured or gross profit, ideally the following steps should be followed:
— Using the latest available accounts, the basic gross profit is obtained (x) ….however it is critical to remember that it is possible that the latest accounts available could be of the previous financial year (the discussion on insurance will take time).
— Based on the trend of business for the last three years, this Gross profit needs to be extrapolated to account for the anticipated gross profit for the current year (y).
— Should the figure arrived at after Step-2 (x+y), be the sum insured? The loss can happen on the last day of the year and the interruption can continue deep into the next year. Thus a cushion needs to be maintained for the expected profits of succeeding year also (z).
— X+ y+ z will describe reasonably the gross profit to be insured … however, there is no harm in keeping a suitable further margin to take care of some unexpected trend. The Business interruption policy always carries “Return of premium clause” which means that it is always better to err on the higher side …since at the end of the year based on the actual gross profit earned, refund of premium up to 50% can be taken up. Thus, unlike material damage policy, there is not much danger of erring on higher side under a BI policy.
— In case the indemnity period chosen is more than 12 months, then the gross profit as arrived above needs to be further increased depending on the Indemnity period …e.g. if the Indemnity period is 18 months, then the gross profit arrived at should be multiplied 1.5 times.
Indemnity period …a crucial decision
Careful consideration is always required while arriving at the indemnity period. This represents the maximum interruption period which means that in the event of a loss, if the actual interruption period is more than the chosen Indemnity period, and then the insured would suffer, as the loss assessment would consider the Indemnity period as the maximum period for which reduction in turnover/ output would be computed. The factors which are required to be kept in mind while choosing the Indemnity period are as under:
— Maximum time which might be required to re-construct the damaged buildings … Time taken for dismantling the damaged building and removing the debris are often neglected, which can make a huge difference in case of major destruction (particularly when an earthquake strikes). The time which is expected to take clearance from authorities also needs to be factored in.
— Lead time for procurement of new machines / replacement of machines ….In case of imported machines the time required would be more. In case the insured is dependent on sole supplier, any problems at supplier’s premises can result in delay in supply of replacement machine.
— Time expected for repairs …any repair facility near to the site can hasten the restoration process. On the other hand, if the repair can only be carried out as overseas supplier’s premises, those additional days need to be factored.
— Availability of raw material …after the factory is restored back, unless there are raw materials, production would not start.
— Availability of labour …. Skilled labourers might be lost following an accident. The indemnity period should factor in how quickly the labour can be recalled.
— A very important factor could be the possibilities of maintaining production from alternate premises …while the increased cost of working will be considered during the assessment of loss, the choice of Indemnity period can also be influenced by this positive feature of the risk.
Conclusion:
An attempt has been made in the article to bring to table the essence of “getting the sum insured right” both under material damage as well as Business Interruption policies. Many organisations have suffered financially for not having adequate sum insured, even though the perils chosen were right. The methodology spelt out at various sections of the article are mere suggestions/ views of the author and not necessarily of any organisation with whom he may be associated and the readers are requested to weigh the suitability of these methods to those operations before implementing.