In the past, most readers were keen on sales-related topics, and tolerated the broader management and other topics but were decidedly cooler on this topic. Most know they (people and businesses) should set aside a portion of their income for a "rainy day", and despite that, too many fail to do even that, let alone prepare for a major business interruption. If you have gone through the process some time ago, how has it worked for you during the current pandemic? Before you leap into yet another year of uncertainty, this is a great opportunity to tackle this often-neglected area or to review your current preparedness.
We’re going to talk about business interruption and how to manage the risks that can cause it. It’s an important concept that every owner of a small business needs to understand. Most proprietors have thought about the possible effects on their business of a disaster like a fire or a flood. Some even have insurance against specific events like cyclones and earthquakes. But that’s not the same as planning for a business interruption. The difference between planning for a disaster and planning for a business interruption can be the difference between recovery and going out of business.
Business interruption is a general concept that relates to the disruption of normal business operations as the result of an identifiable event beyond the entity’s control. The term is often used in insurance or legal contracts concerning the financial impact on a business during a defined period. We're not talking specifically about pandemics but as a general guide (every policy can vary) many business interruption policies default to excluding pandemics.
There are three elements of a business interruption:
- Normal business operations are disrupted
- The disruption takes place during a defined period
- A financial impact or economic loss results from the disruption
Note that even a business that does not produce a profit still requires business interruption insurance. The insurance allows the business to recover its economic loss – usually based on a reduction or cessation of income, even if it is not trading profitably.
There are three broad categories of business interruption:
1. Operational problems - (These include hardware / software failure, power outages)
2. Natural events - (These include earthquakes, floods, oil spills)
3. Incited events - (These include arson, sabotage, terrorism, computer viruses - of which the latter has sadly become all too common)
All of these have the potential to put a business out of business. The U.S. Federal Emergency Management Agency studied the effects of these kinds of events from 1990-2000 and concluded that companies with a formal business interruption plan increased their chance of business survival by 70% over those companies that didn’t have a plan.
Power outages are the number one cause of business interruptions, reflecting our growing dependence on technology. Not so long ago a power outage was an inconvenience but businesses could still manage to keep on trading. In the 21st century, a power outage is enough to bring most businesses to a halt. The failure of the four power cables feeding the CBD of Auckland meant the business district was crippled for over four months and many firms went bankrupt.
With a standard Industrial Special Risk insurance policy, your business would not be covered for a business interruption resulting from most power outages.
Business interruptions are a fact of life. They vary in size and impact, from inconvenient to catastrophic. They happen all the time. Since the majority are inconveniences, likely, your business hasn’t suffered a major financial hardship as the result of a business interruption. That means two things – (a) you’ve been lucky, and (b) it’s time to start developing a plan to deal with business interruptions.
The two major avenues of preparing for a business interruption are through Insurance and through Business Interruption Planning – better known as Risk Management. We’ll go through each of these in some detail to give you an idea of how they work and how they each have a part to play in your business. First, we’ll look at insurance.
Cover yourself with insurance
Business Interruption or Loss of Income Coverage is a specialised type of insurance policy that covers the costs associated with the interruption to the business. Its purpose is to help your business get up and running again. This type of coverage compensates you for the money your business would have earned if a covered event forced it to close its doors or otherwise interrupted your business operations.
If an event that’s not covered causes the interruption, you get nothing. This highlights the need to be very specific when the policy is being prepared. Loss of Income coverage is also available to protect against income loss caused by events such as damage to specialised, hard-to-replace equipment or even the loss of key personnel in certain circumstances.
This is a highly complex area of insurance, but it can be a business lifesaver when times get tough. Here’s how it works.
The more familiar type of insurance covers property damage. If a restaurant has a fire this kind of insurance pays for the replacement of items like the carpet, tables and chairs, and kitchen equipment. But if the restaurant is closed for three or four months before it reopens most of the customers will have gone elsewhere. Even if all the damaged fixtures and fittings are replaced the business will have suffered a serious loss of profits and it could take a long time before trade returns to pre-fire levels. Business interruption insurance can cover the restaurant for these losses, compensating the owner until the business is once again running at pre-interruption levels.
Be very careful with the cover you get. The complex terminology and application of insurance policies can easily mean that businesses are not adequately covered or don’t maximise their recovery when claiming compensation.
An insurance company will appoint a qualified loss adjuster to act on their behalf and advise them on the amount payable. This person is often a qualified accountant, well-versed in the policy terms and conditions as well as an expert in reviewing claims. The insured needs to be from the outset similarly and expertly represented throughout the claim process.
When a key supplier is unable to sell you what you need it can cause your business to suffer. Even worse is that you have no control over getting the supplier back online. Unless you can source what you need elsewhere you’re out of business too, even if it’s only temporary.
It is possible to get business interruption insurance that covers you for this type of incident. This is usually done through extensions to the basic coverage. The main situations in which these extensions are used is when your business:
- •Has a sole supplier or depends on a few suppliers for material or merchandise,
- •Has a supply agreement with one or a few customers for the purchase of its product, or
- •Produces a unique product that cannot be readily sold elsewhere.
You can also obtain cover for your dependence on certain key customers in the event they are unable to continue purchasing from you.
Words have to be just right, It’s highly recommended that a business engages the services of an insurance broker who has the necessary expertise to develop a business interruption policy that meets its specific needs.
A resort on the outskirts of Sydney suffered serious losses one summer due to fires around Sydney that caused their guests to rethink their holiday plans and cancel their reservations. The resort’s business interruption policy protected them from the consequences of fires “in the vicinity”. If ‘vicinity’ had been defined in the usual way it would have meant a radius of from one to five kilometres and since the fires were further away they would have received no compensation for their losses. But because the wording of the policy defined ‘vicinity’ as a radius of 100 kilometres which included the city of Sydney the resort was compensated for its losses. The importance of getting the policy wording ‘just right’ can’t be overstated. It has to ensure the unique operating circumstances of the business are covered.
Risk Management
It’s simply not good enough to rely on insurance to get you through a business interruption incident. You need to do everything possible to reduce the risk of incidents occurring and to lessen the impact of any business interruption events that do take place.
Risk management consists of two main areas:
- Identifying and analysing the events that may cause loss through business interruption,
- Choosing the best way to deal with each of these potentials for loss.
Some (but not all) sources of risk for SMEs are:
- Commercial and legal relationships with third parties - this includes customers, suppliers, lessors, members of the public, lenders and insurers.
- Economic circumstances - the characteristics and conditions of the environment in which the business is conducted.
- Human error - most accidents are caused by people.
- Natural disasters - major events that cause significant damage, destruction, or human casualties.
- Government activities - issues of compliance with laws and regulations.
- Technology - the business’s reliance on computers, Internet, and telecommunications resources to conduct its operations.
- Management decisions - the need to accept risk to achieve business goals.
Identifying your loss exposure is the first step to risk management. Until you know the scope of all possible losses, you won't be able to develop a realistic, cost-effective strategy to deal with them.
Begin the process of identifying exposures by taking a close look at each of your business operations and asking what’s there that could cause a business interruption loss. Damaged equipment? Shortage of raw materials? A customer defaulting on a contract?
For each exposure you identify, ask yourself how serious that potential loss is. This includes the direct financial costs of things like repairs plus the effect on the profitability of the business if that loss occurs.
To set priorities for your business’s risk management, focus on its primary activities and determine how risk may affect them with questions like:
- Are the premises subject to flooding?
- Do customers regularly visit the premises, thereby exposing the business to personal injury claims?
- Does the business operate a fleet of vehicles that create an exposure to liability for motor vehicle accidents?
- Is the business highly dependent on a key employee or group of employees?
- Is the business highly dependent on key suppliers or customers?
Most of the exposures we think of first are external to the business - things like earthquakes or water damage. However, several exposures have to do with the people in the business. What would happen to your business if an accident or illness made it impossible for you to work?
Most of us would rather not think about that happening, but you need to prepare your business for survival long before a key person is disabled or dies, and that includes you. What would happen if you were to suddenly lose the services of a key person because of illness, disability or death? What impact will that person's absence have on sales volume? Costs? Productivity? Efficiency? The firm's credit rating?
And how much will it cost to replace them?
Manage your exposure to losses
Every business faces several types of risks and exposures. Small businesses are especially vulnerable because they usually have little or no backup for essential functions and people. Once your own business’s exposures have been identified and analysed you need to decide on the risk management measures that will protect your business. What can be done to prevent or limit exposure? There are several avenues to consider for managing each identified risk.
Small businesses are especially vulnerable because they usually have little or no backup for essential functions and people. Once your own business’s exposures have been identified and analysed you need to decide on the risk management measures that will protect your business. What can be done to prevent or limit exposure? There are several avenues to consider for managing each identified risk.
Most strategies for controlling risk fall into one of the following categories:
- Eliminate an activity that produces a negative risk - don't begin the risk-producing activity or stop it once it has begun.
- Modify an activity to reduce the likelihood of negative consequences.
- Restrict investment in a new opportunity.
- Create and implement contingency plans to respond to negative events.
- Manage events to minimise losses.
In all cases respond to events as soon as they occur to reduce the ultimate damages.
Risk avoidance
A basic principle of loss prevention and control is to avoid activities that are too hazardous. For example, a retailer may decide not to sell a particular product because it is likely to injure customers. By doing this the business avoids exposure to product liability claims.
Another principle is that if you can't avoid an exposure completely, at least minimise it. For example: The owner of a go-kart ride is concerned about public liability claims, so he insists all riders wear safety helmets and restricts the speed of his go-karts.
The risks aren’t eliminated completely but minimised to the greatest practical extent.
Risk-retention
An owner may decide that the firm can afford to absorb some losses, either because the frequency and probability of those losses are low or because the dollar value of the losses is manageable. For example: A manufacturing business with a fleet of older delivery vehicles decides to self-insure for collision damage because the book value of the fleet is low and there have been very few incidents over the past five years.
An alternative is that the manufacturer could decide to retain only part of the risk and insure the rest by agreeing with its insurer on a higher deductible figure applicable to every claim.
Risk transference
Another method of managing loss exposure is to transfer the risk. Insurance is the primary way to do this - the insurer carries the risk for a fee.
Another example of risk transference would be for the manufacturing business with its fleet of delivery vehicles to completely eliminate its exposure to collisions by subcontracting out its deliveries to another firm. This transfers the collision risk to the other firm as well as reduces the manufacturer’s exposure to all the other risks associated with owning and operating a fleet of vehicles.
Another example would be when a retailer cuts its own inventory by placing smaller more-frequent orders with its supplier. This reduces the retailer’s exposure to property losses – a smaller warehouse can be utilised, and also reduces the retailer’s exposure to losses from damage to stock in storage.
There’s money in risk management
There are many financial benefits of risk management:
- A strong quality-control programme can improve a business's goods or services, reducing the potential for lawsuits and improving the business's competitive position in the marketplace.
- An accident-prevention programme can help ensure that a business's resources are put to their best possible use, instead of being diverted to make up for accident-related costs.
- Advance agreements with lenders for access to financial resources can reduce the likelihood of a cash-flow crisis in case of business interruption.
- Acting on advice from professionals, such as accountants and lawyers, can improve a business's financial position and its compliance with legal and regulatory requirements.
Risk management should be a part of every business plan. These plans evolve with the organisation in response to changes in the business environment and risk is one of the issues to be considered in this process.
Risk management is a part of good management. A business manages its risks by including them as one factor in all management decision-making.
Risk management a not a short-term project with specific goals to achieve. More than anything else it’s a way of thinking that becomes a part of everything that you do as a business owner.
Four ways to succeed
A business that undertakes a risk-management programme is most likely to succeed if it has the following four characteristics:
- The owner is strongly committed to risk management and demonstrates this commitment to employees.
- All levels of the organisation are involved in risk management. Employees and their supervisors all have valuable perspectives on the business' sources of risk that should be taken into account.
- The owner actively monitors changes in the business environment - from the condition of adjacent buildings to health and safety regulations.
- The business model can respond quickly to change, whether it's the loss of a key supplier, the introduction of new technology, or a disaster that affects the whole community.
An ongoing process
Once you begin to implement risk management practices your business will change. It will be more aligned with changes in its environment and the world as a whole. SMEs today are at significant risk from dangers like computer viruses and terrorism that might have been left out of managerial considerations ten years ago. Now, any business that doesn’t take these risks into account when planning the future may not have a future!
For risk management to succeed it must become an ongoing process within your business. It should be incorporated into your management thinking, and be a part of every business decision you make.
Summary
A business interruption can put you out of business. It can be caused by factors within your business or be externally caused by suppliers, customers or other sources.
You can obtain insurance coverage against business interruption but you need to be very careful to be sure your businesses’ particular risks are covered.
To protect your business from the negative impacts of business interruption you should also incorporate risk management into your business thinking.
Risk management is an ongoing strategy that offers financial advantages as well as minimising your exposure to losses.
You need both the right business interruption insurance cover and effective risk management to be sure your business stays in business.