Bakery business interruption: rate of gross profit, average and the loss-avoided test
A bakery's single oven failed on 1 May and could not be replaced until 30 September, a five-month interruption. The policy insures gross profit over a 12-month indemnity period with a sum insured of CNY 2,700,000, an increased cost of working (ICW) limit of CNY 400,000, and a condition that ICW must not exceed the loss avoided. An average (coinsurance) condition applies to the gross profit item. Last financial year turnover was CNY 12,000,000, uninsured working expenses (purchases and variable costs) were CNY 8,400,000, and insured standing charges were CNY 900,000. Turnover in the corresponding five months of the previous year was CNY 3,000,000; during the interruption turnover fell to CNY 1,200,000 and saved standing charges were CNY 120,000. The insured hired a temporary oven for CNY 260,000, which preserved CNY 700,000 of turnover that would otherwise have been lost. The insured's accountant says the oven failure is "just bad luck" and that the sum insured was set three years ago by the broker.
1. Calculate the rate of gross profit, test the adequacy of the sum insured, and explain the consequence.
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Rate of gross profit. Using the policy definition - turnover less uninsured working expenses, divided by turnover:
- (12,000,000 − 8,400,000) ÷ 12,000,000 = 30%
The CNY 900,000 of insured standing charges is a component of that gross profit, not a deduction from it; check that the policy's definition matches the accountant's figures, because a mismatch here is the most common source of dispute.
Required sum insured. 30% × annual turnover of CNY 12,000,000 = CNY 3,600,000. The policy carries CNY 2,700,000, which is 75% of the requirement, so the average condition reduces every gross profit claim by 25%:
- 2,700,000 ÷ 3,600,000 = 0.75
Consequence. The insured is underinsured for business interruption by CNY 900,000 and will bear a quarter of any loss itself, on top of the uninsured working expenses. Note that this is a coinsurance issue, not a coverage issue: the claim is covered, just reduced.
Action before renewal. Recalculate the sum insured from audited figures, add a margin (typically 110%) for growth between renewal and loss, and review the 12-month indemnity period - a bespoke oven with a long lead time may justify 18 months. Consider an accountant's report or agreed-value endorsement for the first year to eliminate the average argument while the figures are rebuilt.
2. Assess the gross profit loss and the increased cost of working, and state the claim payable.
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Gross profit loss.
- Turnover shortfall: 3,000,000 − 1,200,000 = CNY 1,800,000
- Gross profit lost: 1,800,000 × 30% = CNY 540,000
- Less saved insured standing charges: CNY 120,000
- Net loss: CNY 420,000
- Apply average: 420,000 × 0.75 = CNY 315,000
Increased cost of working. The CNY 260,000 hire preserved CNY 700,000 of turnover, which at a 30% rate is CNY 210,000 of gross profit. The condition caps ICW at the loss avoided, and 260,000 exceeds 210,000, so the recoverable ICW is limited to CNY 210,000. The CNY 50,000 excess is the insured's own commercial decision - the hire cost more than the gross profit it saved, even though it may have protected customer relationships.
Total. Assuming ICW is a separately insured item not itself subject to average, and provided the policy is not worded otherwise:
- 315,000 + 210,000 = CNY 525,000
Both items sit within their limits (CNY 2,700,000 and CNY 400,000). If the wording applies average to ICW as well, the figure becomes 315,000 + 157,500 = CNY 472,500 - check the clause before issuing the settlement. Apply any policy deductible, and confirm whether the temporary oven hire period ran beyond 30 September.
3. The insured argues the broker is at fault and that the full ICW should be paid because the hire kept the business alive. Evaluate both arguments.
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The "bad luck" comment. It is irrelevant to the measure. The oven failure is a covered peril and the business interruption is consequential loss; the dispute is about quantum, not about whether the event is covered. Redirect the conversation to the figures.
The broker point. Whether there is a claim depends on what the broker undertook. If it agreed to review sums insured at renewal and did not, there is a potential professional indemnity exposure for the CNY 900,000 gap - which translates into the 25% reduction actually suffered, i.e. CNY 105,000 on this claim. If the insured simply never supplied updated figures, the broker has a much better defence. Tell the insured to preserve the point in writing, and notify the broker's professional indemnity insurer as a circumstance. The property insurer is not liable for the shortfall.
The ICW argument. Partly good. The full CNY 260,000 is not recoverable on these numbers, because the loss-avoided test is failed by CNY 50,000 over the five months. But two arguments are worth putting to the adjuster:
- The saved gross profit may not be limited to the interruption period. If the temporary oven preserved customers who would have gone elsewhere permanently, the loss avoided extends into the recovery period after 30 September, and the calculation should be run over the full indemnity period.
- Some wordings allow ICW that reduces - rather than fully avoids - the loss, and the test is applied to the loss that would otherwise have been incurred, including lost market share.
Check the indemnity period. If the five-month delay was extended by the insured's own failure to mitigate - for example by not ordering a replacement promptly - the extra period may not be recoverable.