Following an incident, an Insured party may be restricted by the conditions of the contract, which could significantly impact the business interruption loss, due to the effect on (i) the costs of raw material / feedstock or (ii) sales of final products to the business. However, the policy language does not always take into account the contractual commitments.
Feedstock / Raw Material Commitments
There are various contracts available on the “buy” side, however two common forms are:
If the minimum orders are not taken, it could result in additional costs to the buyer particularly if the clause restricts the buyer’s ability to consume the product at alternative locations or sell the product to a third party. The basis of the costs depends on the conditions of the contract and could be in the form of:
These costs may be avoided if there is a make-up clause allowing catch-up in later months, or if a Force Majeure Clause is triggered.
In the event of an insured incident which results in lower feedstock requirements, and if the contractual commitments cannot be avoided, it is not uncommon for the loss to form part of a Business Interruption claim, which can be substantial, as set out in the example below:
Raw materials / feedstock are usually uninsured costs, and as such, purchases are assumed to vary directly with sales and are therefore “saved” if sales reduce following an incident. However, if feedstock purchases are below the minimum offtake, then the cost will not vary with sales / production, resulting in part of the cost continuing. Although a financial loss has been sustained, this may not be indemnifiable as part of the loss of gross profit.
A feedstock loss is frequently claimed as an increased costs of working (ICWs), but this raises the question as to whether it would satisfy the policy definition of being
“necessarily and reasonably incurred for the sole purpose of avoiding or diminishing the reduction in turnover…but not exceeding the sum produced by applying the Rate of Gross Profit to the amount of the reduction thereby avoided.”
Ultimately, it is for Insurers to interpret the policy wording, however consideration would need to be given as to whether these costs “avoid or diminish the reduction in turnover”. Given the nature of the cost it may be difficult to link this to a mitigation of lost turnover.
Some policies may include Additional Increased Costs of Working (“AICW”) or Extra Expense (“EE”) extension. These extensions frequently require the costs to “protect turnover” or “resume or maintain normal business operations”, and are not subject to an economic limit, but are often sub limited. As such, it is necessary to consider whether the contractual cost is considered to be “protecting turnover” or “maintaining normal business operations”. However, these issues would need to be addressed on a case by case basis by Insurers / Adjusters after taking into account the circumstances and the wording of the policy.
A supply agreement to a customer may be for a specified volume each month / year or as stipulated by a forward sales commitment. Although in some regulated markets, the volume may simply state “market demand”.
If an insured incident occurs where such supply of final product cannot be satisfied, the options to the insured supplier would include:
Another option that may be open to the Insured is to declare Force Majeure.
This clause is frequently included in contracts and releases both the buyer and seller from the obligation to perform when an extraordinary circumstance beyond the control of the parties prevents either party from fulfilling its contractual commitment. The ability to declare Force Majeure can depend on many factors, including the wording of the clause and the nature of the event.
If the declaration is successful, this could avoid the obligation to incur the contractual penalties for feedstock / sales commitments, or to buy in final products.
The Insured’s response following an incident may not always be in its control, but driven by contractual commitments. Understanding the contractual commitments for both feedstock and product sales are key to ascertaining the potential impact to both the Insured and the Insurer, and whether suitable cover has been provided to indemnify the Insured for its losses to successfully transfer the risk.
The level of uneconomic costs being incurred could be significant, therefore consideration needs to be taken as to whether the AICW or EE cover would indemnify such costs, and if a sub limit is in place to provide the appropriate amount of cover.
Such losses may be diminished or avoided if the contract allows mitigation measures such as outsourcing, make-up clauses or through the declaration of Force Majeure. However, these deliberations would need to be carried out early in the claims review process to ensure the window for viable mitigation measures or Force Majeure declaration is not missed. Assuming at the underwriting stage that it would be possible to declare Force Majeure in the event of a loss is risky for both parties.
As appeared in Dubai - Onshore Energy Conference Magazine - 18 May 2016
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*Effective December 2018, RGL Forensics joined Baker Tilly US, LLP. This article was published while we were RGL Forensics. The author(s) or team member(s) quoted from RGL are now employees of Baker Tilly.