Business Income Claims in a Recessionary Environment

There's been no shortage of reporting on the "global economic crisis" in the media. What started as a Wall Street problem of bad (or "toxic") loans and related write-downs culminated into a freezing of the credit markets in September 2008. This, in turn, spelled severe problems for Main Street.

At that point, consumer spending slowed dramatically, as did corporate profits; as a result, companies cut jobs, which hampered consumer spending even more. Companies then cut more jobs. And this vicious cycle continues. While the economic storm may have been brewing for some time, all of this happened rather rapidly. To the right is a chart that measures the year-over-year change in retail sales (excluding automotive and parts dealers) for 2008 relative to 2007 (click the chart to enlarge it). The chart shows that 2008 started out positive due to the effects of inflation and an increase in consumer demand. But then in October, the bottom fell out, so to speak. This data suggests that the economy is every bit as bad as the media portrays it.

The current state of the economy is having implications on the claims process, namely business income loss claims. These implications are both procedural and technical. From a procedural standpoint, time is of the essence like never before. Typically, the business income aspect of a significant property loss claim took a backseat to property repair or replacement. Insureds were more concerned about repairing/rebuilding property and/or replenishing inventory. This well-reasoned priority stemmed from the fact that resolving property aspects of the claim would prevent continued income losses. But with the current state of the economy, many companies are so strapped for cash that the slightest interruption in sales can wreak havoc on the day-to-day financial affairs. Thus, business income loss claims are now a serious priority.

Those businesses affected by the economy may pressure the adjuster for a quick settlement or advance. While a quick resolution to the claim is in all parties' best interests, the heightened pressure could lead to errors. For instance, if an advance is made to an insured based on pre-recession financial statements, the adjuster runs the risk of advancing more than the actual loss sustained. Most policies generally define business income as the combination of net income (or loss) and continuing normal operating expenses. Documentation of continuing expenses often serves as a basis for advances. However, if the business is operating at a loss (as is possible during a recession), or if operations are only partially suspended, the business income loss is less than the company's continuing expenses. Again, adjusters run the risk of over-advancing. With time sensitivity inherent in today's business income loss claims, a forensic accountant is paramount. If engaged early, the forensic accountant can gather basic information to estimate the loss, and facilitate advances. Even if current financial records are unavailable, a forensic accountant will be able to estimate the economic impact for the subject company.

From a technical standpoint, the recessionary environment is causing a need for increased scrutiny. The simple "comparison to last year" method for establishing a loss is now fraught with problems. For instance, comparing a retailer's December 2008 sales to its December 2007 sales may reflect a deviation. But how much of the deviation is due to the economy versus the circumstances of the loss? The answer will be found in a pre-loss trend analysis. Thus, year-over-year comparisons should not be used in isolation; they must be preceded by a trend analysis.

As a case in point, I was recently engaged in a case where a travel company experienced intermittent computer failures over an approximate 2-week period in December. There was a large gap between sales for December 2008 and December 2007, which was the basis for the claim. A pre-loss trend analysis revealed that sales were down between 30% and 45% in October and November 2008, relative to those months in 2007. Thus, I determined that most of the difference in December 2008 was due to the economy, not computer problems.

Trend analysis is critical. However, the trend must be correctly interpreted. For instance, if a company's sales were up say, 10%, for January through September 2008, but down 10% the rest of the year, a full year trend analysis may show an increase (9 months of an uptrend and 3 months of a downtrend). Recall the chart above, which revealed a rapid deterioration in consumer spending. Due to this change, sales trends prior to September 2008 are meaningless, in a lot of cases. Thus, one must carefully consider the intra-year trend, the changes in the trend, and the most likely trend during the claim period.

Business income analysis consists of both sales and expenses. Just as the sales part of the equation presents challenges in a recession, expenses do as well. For instance, if a company lowers its selling price to attract more customers, the gross margin and cost of sales ratios are affected. Thus, pre-recession margins are not an accurate indicator. In times of recession, companies typically first respond by reducing payroll. As a result, if one uses a pre-recession income statement to determine projected payroll expense, the projection may be overstated. Also, companies may be behind on rent payments. If the company keeps cash basis financial statements, rent expense is thereby understated. Accordingly, one may understate projected rent expense. The list goes on and on. The point is that one must be aware of which expenses have the potential to be impacted.

At some point, the economy will turn around. Claims subsequent to that period will have the inverse of the issues discussed in this article. For example, sales may be increasing so the trends experienced in the recession are irrelevant. Margins may expand, thus rendering the recession based cost of sales ratio useless. Payrolls will increase. And the pressure for quick advances and/or settlements may subside, as companies build cash reserves and favor accuracy over speed. Let's hope this time is just around the corner.