LITMIR.BIZ

      Reference is made to the following illustrative profit and loss account in some of the sections.

      XYZ Ltd, accounts for the year ended 31 December 2010

1.1 Gross Profit – Definition

      1.1.1Current position

      Many business interruption (BI) policies are written on a Gross Profit basis, whether these are declaration-linked or not. The policy usually allows the insured to select the costs (variously described as Specified Working Expenses, Variable Costs, or Uninsured Working Expenses) to be deducted from turnover (or Revenue, Takings, or Sales) in defining Gross Profit. This is intended as a benefit rather than a complication, because it means that the purchaser of the insurance (who has the best understanding of their own business) can decide on what will make the cover most meaningful to them.

      The majority of general combined commercial policies define Gross Profit as the difference between the sum of turnover plus closing stock and work in progress, and the sum of opening stock/work in progress plus Specified Working Expenses, Uninsured Working Expenses, Uninsured Variable Charges, or some similar term. Some explicitly use the word ‘Purchases’, which may or may not be denoted with a capital ‘P’, and similarly may or may not be defined. In many wordings the costs to be uninsured are not listed within the policy wording itself, but reference is made to the Schedule in which they should be set out.

      Package policies often offer a definition rather than referring to a specific list of Uninsured or Specified Working Expenses. In some cases, definitions of Gross Profit refer to lists of costs set out in the Schedule, but the Schedule does not always include such a list.

      1.1.2What is the problem?

      Gross profit is a term in everyday use in the business community, and is one that has no particular definition. It is not defined in statute. It is not defined in any accounting standard. In stark contrast, insurance policies explicitly include a definition, which typically may be stated as turnover less purchases (adjusted for stock) less bad debts and carriage out.

      Confusion over an everyday commercial term arises.

      With reference to the example profit and loss account above, the gross profit for accountancy purposes amounts to £45 million. However, based on an insurance definition only deducting purchases of raw materials, and allowing for the movement between opening and closing stock, the insurance gross profit would be £78 million:

      In some cases, the policy refers to the Schedule to ascertain the list of uninsured costs. However, some Schedules do not contain any list, which effectively means that Gross Profit, for policy purposes, is not accurately defined pre-incident.

      In other cases, insurers pre define Gross Profit, resulting in the policies not being tailored to the needs of policyholders, and lacking the flexibility otherwise available (albeit this may be an unavoidable necessity for an small and medium enterprises (SME) ‘package’ product).

      Where the term ‘purchases’ is used, the BI texts, including Riley on Business Interruption Insurance¹ and Honour and Hickmott’s Principles and Practice of Interruption Insurance,² both take the view that ‘Purchases’ represent physical raw material purchases. Costs closely associated with Purchases, such as subcontracting expenses, are not always explicitly dealt with. Even where policies do contain a tight definition of purchases, it may be that that term does not appear in the books of account of the insuring business. There can therefore be a disjoint between terminology used in the policy and terminology used in the books of account. Even where the policy acquiesces to use terms in the books of account (accounts designation clause), it is not

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