As forensic accountants, we frequently assist in quantifying business interruption losses and there is no doubt that, in the UK at least, gross profit policy wordings are the most commonly seen. Although these have been around a long time, confusion over just what has been insured under gross profit policies is still widespread. This was brought home to me by a recent case in which the definition of gross profit became a key issue worth several million pounds. Whilst a satisfactory conclusion was reached in this instance, the issue had the potential to derail the loss settlement process and it set me wondering, why is this such a perennial problem and is there a better solution?
An oft-cited answer to the first question is simply a misunderstanding of the term ‘gross profit’. Consider the duck-rabbit optical illusion. From a first glance at this image, I saw a duck and might assume you did too. However, you are equally likely to see a rabbit and unless we discuss our impressions of the image, we might never discover our differing views. Gross profit is similar in that what an insurer means by it and what a business understands by it, its ‘accounting definition’, may be quite different. It is often only when an incident occurs that the two parties find out there is a discrepancy in what they thought was insured and the potential for a major shortfall in coverage.
Confusion over the term gross profit is a common problem, but it is by no means the only complication we see. A key part of insuring gross profit involves making assumptions about which costs will stop or reduce following an incident. However, when a loss arises, particularly in the case of a partial loss, we often find costs are not saved as assumed per the policy. There can be many reasons for this: oversight and over-simplification may play a role, but the reality is, projecting costs is not straight-forward. Modern businesses and their bookkeeping practices can be so complex that even their owners struggle to interpret their results, experiencing what Warren East, CEO of Rolls Royce, has poetically described as an ‘accounting fog’. Compounding this inherent complexity is the unpredictability of what type of incident will occur and which mitigation strategies will be required; under these circumstances perhaps surprises are to be expected.
These problems are well-known to insurance industry professionals and some potential solutions were outlined in a 2012 CILA review of policy wordings. One popular idea discussed in this publication is to move away from gross profit policies, in favor of revenue-based wordings. The key advantage of a revenue policy is that the sum insured is based on turnover, a term whose meaning is less ambiguous and a figure which can normally be projected with more confidence. Misunderstandings over what is meant by gross profit are avoided, reducing the risk of uninsured losses and potentially streamlining the claims process.
