July 16, 2020
Many businesses think of the “hard cost” side of builder’s risk or property insurance – the physical costs related to an insurable event, such as repairs or rebuild costs. However, the delay in startup can be an even larger portion of the total loss. Take the following example – an apartment complex is under construction when a major storm hits the area, causing significant flood damage to the complex and delaying the property opening by 60 days. While the hard costs to repair the damage are typically simple to support and values are relatively straightforward, the loss resulting from the delay in opening is much more complex to determine and may be even greater in value. In the above example, those 60 days could have a significant impact on the policyholder’s bottom line. Policyholders should understand the necessity for and potential challenges of quantifying and supporting delay claims to best prepare themselves in the event of an insurable loss.
Supporting the Period of Delay
It is important to document all of the facts and circumstances at the time of the delay. A serious problem a policyholder will encounter with a delay in startup claim is a lack of documentation available to prove that the delay is attributable to the covered event. Insurance companies typically hire construction consultants to evaluate the delay period, and in the case of complex delay analyses or disputes, policyholders may do the same. The construction consultants will request data and documentation to facilitate a delay analysis. Policyholders should anticipate these reasonable requests and should be prepared to answer fundamental questions about the impact of the insured event on the project. Further, policyholders should provide the documentation to support their responses and an analysis to support the delay portion of the claim. Consider the aforementioned example of an apartment complex under construction when a major storm hits the area. The policyholder in this example should be prepared to answer the following schedule and cost related questions using supporting contemporaneous documentation and an accurate analysis:
- What was the status of the construction project when the storm occurred?
- Potential supporting documentation includes but is not limited to the most recent construction schedule prior to the event; photographs; videos; and contemporaneous reports.
- What construction activities were directly impacted by the storm?
- Potential supporting documentation includes but is not limited to the schedule or fragnet highlighting the extension of time related to the incident; photographs; videos; and contemporaneous reports.
- What new construction activities were required as a result of the storm?
- Potential supporting documentation includes but is not limited to the schedule or fragnet identifying activities added to the post-loss schedule; photographs; videos; and contemporaneous reports.
- How was the project restart and completion date impacted by the storm?
- What efforts were undertaken by the policyholder to mitigate the impact of both the storm and the flooding on the construction project?
- What events and key decisions following the storm determined the duration of the impact to the construction schedule?
- Were there any delays to the completion of the project independent of the storm that preceded or occurred concurrent with the delays resulting from the storm?
Organizing and retaining documentation along with completing a sound analysis of schedule and cost impacts is essential following an insured event to ensure these questions can be answered. Information or assumptions that may seem obvious at the time of an insured event can quickly be lost as time passes. Further, anecdotal evidence will not carry nearly as much weight with an insurance company or adjuster as will an accurate schedule and cost analysis based on contemporaneous documentation. Therefore, maintaining orderly files of construction schedules, email correspondence, inspection records, purchase orders, daily construction reports, damage and progress photographs and videos, meeting minutes, telephone call memos, and other such records is of paramount importance. This is true not only for the period immediately following an insured event, but for the remainder of the project thereafter as well.
Quantifying Lost Income
When a company experiences a delay in start-up from an insured event resulting in an interruption to their business, they turn to their insurance policies to recover losses and return to the anticipated financial position had there been no loss. Delay in start-up or advanced loss of profits (ALOP) can be embedded within property insurance policies or stand alone in builder’s risk policies. These policies can cover losses resulting from incidents such as natural disasters, fires, machinery malfunctions or breakdowns, along with other significant events.
When measuring a typical business interruption claim for an existing or mature business, the first step is to examine the experience of the business before the date of loss. However, for a start-up business or operation, “experience before the date of loss” does not exist. Instead of using pre-loss experience, there are many other commonly utilized forecast methodologies. For instance, a multi-unit company can use other comparable non-impacted locations as a benchmark. If the loss occurs at a single-location business, or other locations don’t provide for a good benchmark, external sources such as market reports can be used. Further, many businesses prepare pre-opening forecasts, which can also be used in place of pre-loss experience. While forecasting can be relatively simple, challenges often arise with the determination of the loss period and measurement of losses.
Scenario #1: A Common Mistake in Measuring Lost Income for Start-Up Businesses and Delay Claims
The purpose of insurance is to put the policyholder back in the same position they would have been in absent the loss – no better, no worse. Some believe that losses should be measured from the date of the insured incident to the completion of repairs, taking into consideration the theoretical ramp up that would have occurred during the loss period – this is a common mistake. This scenario puts the policyholder in a position in which they are ramping up their operations twice – once during the forecasted theoretical ramp up and again during the actual post-loss ramp up, thereby placing the policyholder in a worse position absent the loss.
This common error is displayed in the following graph – the solid yellow area represents the incorrect calculation of loss. In this case, the loss period runs from the date of loss to completion of repairs, considering the theoretical ramp up and then fails to consider the actual ramp up that occurred after the completion of repairs. Based on the below example, Scenario #1 would incorrectly yield a loss of $140,000.
In this case, absent the loss, the policyholder would have been fully ramped up upon completion of the repairs. However, because the loss occurred, the policyholder now starts their actual ramp up after completion of repairs. If revenue is forecasted using this approach, ramp up is considered both in the forecast and actual cases, therefore putting the policyholder in a worse position.
Scenario #2: Measuring from the Date of Loss until Full Maturity
While repairs may have been completed, the loss period is not over. Losses are still incurred until the policyholder returns to the same position in which they would have otherwise been absent the loss. In the above example, had the loss not occurred the policyholder would have been fully ramped up at the time of repair completion. Therefore, the period of loss continues until revenue is fully ramped up. The following chart shows the corrected calculation of losses using the same example as above. In this quantification of the loss, the policyholder claims the loss during the time of repairs (the theoretical ramp up) and the loss during the actual ramp up period until they achieve the planned, fully ramped, revenue forecast. Based on the below example, Scenario #2 would yield a loss of $240,000.
Scenario #3: A Simpler Alternative
Instead of calculating losses using the above approach, accounting for both the theoretical and actual ramp up, there is a much simpler way for policyholders or their claims professionals to measure the actual loss sustained. This can be done by measuring losses based on full production or sales levels immediately following the loss during the period of restoration or delay period. Using this alternative approach, the theoretical ramp up is essentially being shifted to the place of the actual ramp-up after the loss, resulting in one ramp-up period. This alternative is represented in the graph below. Like Scenario #2, Scenario #3 would also yield a loss of $240,000, using the below example.
Using this approach, the loss measurement is the same as what is presented in Scenario #2. The insured will not incur both a theoretical and actual ramp-up. Rather, it captures the losses during the repair period and actual ramp-up after the repairs are complete. This approach still represents the actual loss sustained and returns the insured to the financial position in which they would have been absent the loss – no better, no worse. Further, it limits any complexity and potential dispute relating to determination of the ramp up period.
Loss of income claims are much more complex and time consuming for a start-up business or operation (e.g., new capital project). It is important for risk managers and accountants to understand the complexities and potential quantification issues which may arise in a delay in startup claim. Policyholders should ensure that they document and assemble the appropriate support and analysis to accurately quantify the period of delay resulting from the insured event. To properly quantify a claim, the losses should be measured based on the actual loss sustained, which includes the period starting on the date of loss and ending when the policyholder returns to the position it would have been absent the loss.
 It is important to note that if the insured can improve their ramp-up curve following the delay, Scenario #3 above would not be appropriate. For example, a business that can build up their sales pipeline during the delay period and does not have any ramp up constraints after opening may be able to improve their post-loss ramp up curve in comparison to the projected ramp up absent the loss. In a scenario like this, the measurement of loss needs to consider both the theoretical and actual ramp up curves (Scenario #2 above).