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other underlying books maintained by the business.

      As with gross profit, the term ‘purchases’ is in everyday use, and is not necessarily restricted to raw materials. For example, the term ‘purchases’ appears as a box on a standard VAT return, and, in that context, includes all types of purchase and expense, including utilities and even replacement of capital plant.

      It is commonly the case that, when buying BI cover, the policyholder tends to envisage an incident of major proportions such that, say, their entire premises are destroyed. In such cases, many overheads may well cease, or abate, and thus there would have been no need for these to have been insured. This approach is flawed in that it fails to recognise those circumstances where partial damage can, for example, leave a production line operational but far less efficient. This is just one illustration of how costs that are apparently variable prove, under certain circumstances, to be fixed.

      1.1.3What are the consequences?

      Differences in terminology or lack of clarity between the policy and the business community cause confusion.

      Many businesses, particularly manufacturing businesses, also deduct items such as wages and power in defining gross profit in the statutory accounts, and there is frequently a failure to appreciate that the definition of the term gross profit used in either the annual statutory or the monthly management accounts is likely to differ from the more specific definition of Gross Profit in an insurance policy.

      Businesses purchasing insurance can fail to appreciate the significance of this point even after their insurer or broker brings it to their attention, such that any misunderstanding crystallises in a potential shortfall in coverage when an incident occurs.

      If items such as wages and power are deducted in addition to purchases (adjusted for stock), the resultant gross profit that is insured will be lower than that defined in the policy. In the event of a claim, the insured may receive less than the full loss due to the application of underinsurance, policy limits, or potential voiding of the policy where a significant under-declaration of Estimated Gross Profit has been made. While the policyholder may suffer a one-off and very unwelcome and untimely shortfall, insurers would have been receiving less premium income, over the lifetime of being on cover, than if the correct level of cover had been chosen. In other words, both parties potentially suffer.

      In the example above, the Estimated Gross Profit of £45 million would be 42% inadequate compared to the insurable amount of £78 million.

      The claims presentation community, in discussion with clients post-incident, frequently highlights for the first time that the policy defines Gross Profit in a manner other than that used within the accounts. This can give rise to a major expectation difficulty, frequently leading to significant shortfalls in indemnity.

      The difference in terminology was highlighted in the case of Arbory Group Ltd v West Craven Insurance Services.³ In that instance, a calculation of gross profit using an accountancy/business definition as opposed to that in the policy gave rise to a significant shortfall in the settlement and a subsequent claim for negligence against the broker.

      Where the definition is not sufficiently clear, the level of under-recovery can be significant. On one occasion, financial information supplied after a fire was fundamentally irreconcilable to the level of declarations made in recent years. The business interruption loss was in the region of £5 million. The declarations were completed annually, showing turnover, purchases and opening and closing stock. It transpired that the finance director regularly summarised, over three pages of A4 paper, a significant list of costs (that represented things the business purchased) but entered only the total of that list against the term ‘purchases’ to reduce the amount of paper involved in the process. The existence of the list was unknown to the broker or insurer. The fact that purchases might be construed as relating to raw materials only did not occur to the finance director. If the definition used by the insured for declaration purposes had been adopted, under-recovery of 25% of the actual loss would have been achieved.

      1.1.4Potential solutions

      Given that the core difficulty here is an (erroneous) assumption on the part of the policyholder that Gross Profit in an insurance policy is likely to mean the same thing as it does in their accounts (which in some cases it will), it may be advantageous to introduce a new term that will require the business person to explore the relevant definition and necessary calculation when selecting the level of cover required.

      The term ‘Gross Profit’ could be replaced with ‘Insurance Profit’, ‘Insurance Gross Profit’, ‘Insurable Profit’ or any similar term. By way of example, one leading insurer has already decided to adopt the term ‘Insured Profit’ in future policy wordings.

      It has been suggested that the term ‘Gross Margin’ might replace ‘Gross Profit’, but it is unlikely that this would help, because gross margin is another technical accounting term in common usage; and, therefore, it is thought that it could prove equally confusing.

      With regard to the specific use of the term ‘purchases’, this could be more specifically defined as ‘purchases of stock, raw materials and components (and/or consumables)’. Some policies already do this, and this brings clarity, albeit there is still the potential risk of the term ‘purchases’, including other things in the accounts. Subcontracted manufacturing processes are the most likely area of difficulty given that the owner of a business may view those costs as purchases in the same way as raw materials. The definition of ‘purchases’ could be extended to include subcontract manufacturing processes.

      Given the significant number of businesses that do not use the term ‘purchases’ in their accounts at all, there may be merit in having a slightly wider and more flexible wording to include ‘purchases of stock, raw materials and components (and/or consumables) and other third party subcontracting costs’.

1.2 Gross Profit – Uninsured Standing Charges Clause

      1.2.1Current position

      Many policies include an uninsured standing charges clause. This will state that if an insured business fails to insure fixed costs, and thereby takes on the risk of part of the gross profit of the business, the policy will only pay a proportion of increased costs incurred to mitigate loss.

      Some policies omit (deliberately or otherwise) the uninsured standing charges clause.

      1.2.2What is the problem?

      The term ‘standing charges’ is not one in everyday commercial use, and the application of the uninsured standing charges clause may not be clear at first reading. To make matters worse, there is seldom, if ever, a definition of the term ‘standing charges’. This also begs the question as to whether there is any relationship between ‘standing charges’ and ‘working expenses’ used in the definition of Gross Profit.

      1.2.3What are the consequences?

      Difficulties with the term ‘standing charges’ are likely to arise as a consequence of the difficulty in establishing what is variable and what is not. Over the course of a microsecond all costs are fixed (you couldn’t stop spending any money that quickly even if you wanted to); over the course of 100 years, all costs are variable.

      It seems almost inevitable that applying the uninsured standing charges clause will prove problematic. The process of debating which costs have been shown to be fixed (although these were assumed to be variable when the sum insured was declared) will inevitably take time. Any lack of clarity over the meaning of ‘standing charges’ will be seized upon when a policyholder, having incurred additional expenditure in good faith to mitigate a loss, finds it will only be partially covered.

      1.2.4Potential solutions

      The term ‘standing charges’ should be abandoned, because it is not a term in general use and thus has no generally accepted meaning. The issue that the current clause seeks to address is that of working expenses that have specifically been uninsured but which are not truly variable costs.

      A

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