How to calculate a business income limit

A business income limit has two jobs, and they pull in different directions. It must be large enough to avoid a coinsurance penalty, which means at least the coinsurance percentage times your projected net income plus operating expenses for the next 12 months. And it must be large enough to pay what you would actually lose during the time it takes to rebuild and recover. Work out both numbers, then pick the policy structure that fits the gap between them.

What the standard form measures

In the ISO business income form (CP 00 30 10 12), Business Income is net income (net profit or loss before income taxes) plus continuing normal operating expenses, including payroll. The coinsurance test uses a slightly different yardstick: net income plus operating expenses, including payroll, that you would have earned or incurred at the described premises over the 12 months following the policy's inception or last anniversary. The form then lists expenses to deduct from operating expenses for the test. Among them: prepaid outgoing freight, returns and allowances, discounts, bad debts, collection expenses, cost of raw stock and factory supplies consumed, cost of merchandise sold, cost of other supplies consumed, services purchased from outsiders to resell that do not continue under contract, power, heat and refrigeration that do not continue under contract (if the related endorsement is attached), and payroll excluded by endorsement CP 15 10.

The form requires a Business Income Report/Work Sheet (ISO CP 15 15) when you elect Agreed Value. The same worksheet is a good way to do the arithmetic even when you are not electing it, and the steps below follow its logic.

Step by step

1. Project 12 months of revenue for each location, for the policy year ahead, not last year. Use the budget, adjusted for known changes: a new product line, a lease ending, a price increase.
2. Subtract the deducted costs. Take out cost of goods or merchandise sold, materials and supplies consumed, outgoing freight, discounts, returns, bad debts and any other cost on the form's deduction list. What is left is the coinsurance base: net income plus operating expenses.
3. Multiply by the coinsurance percentage (for example, 50%, 60%, 80% or 100%) to get the minimum limit that avoids a penalty.
4. Estimate your real exposure. Decide how long you would be down in a realistic bad case (rebuild time, permits, equipment lead times, and the ramp-up after reopening) and estimate how much of your base would be lost each month. Net income plus the expenses that would continue is what the policy pays, so identify what stops: hourly payroll you would lay off, and costs that vary with sales.
5. Add extra expense. Temporary space, rented equipment and expediting costs draw on the same limit, so include a sensible estimate. See extra expense coverage explained.
6. Compare the two figures and choose a structure: a limit that satisfies coinsurance, agreed value, a maximum period of indemnity or a monthly limit of indemnity.

The business income (interruption) limit calculator walks through these steps with your numbers.

A worked example (hypothetical)

Say a full-service restaurant projects $1,800,000 in sales for the policy year. Food and beverage cost is $540,000 and paper goods and other supplies consumed are $36,000. All figures are invented for illustration.

Now the real exposure. Hourly payroll of $380,000 a year would be laid off in a shutdown. That leaves $844,000 of income and continuing expenses at risk each year, or about $70,300 a month. The owner estimates six months to rebuild, then two months of reopening at half the normal rate, and $40,000 of extra expense for a temporary kitchen and advertising.

• Six months closed: about $422,000.
• Two months at a 50% shortfall: about $70,300.
• Extra expense: $40,000.
• Estimated exposure: about $532,000.

The coinsurance minimum ($979,200) is far above the realistic exposure ($532,000). If the owner simply buys a $532,000 limit on an 80% coinsurance form, a loss of $400,000 would be paid at roughly 54 cents on the dollar ($532,000 divided by $979,200 is 0.543), so the owner would receive about $217,000. A limit that exposes the owner to that is a poor fit for the exposure, even if it looks sensible. The owner's choices are the next section.

Matching the limit to downtime

In the restaurant example, a monthly limit of indemnity of 1/6 on a limit of about $430,000 pays up to roughly $71,700 per 30 days, matching the monthly loss of $70,300 and covering a six-month closure. The extra expense and ramp-up would sit on top of that, so the owner might round up to about $530,000. The fraction must be at least the share of the limit that you would lose in your worst month, or the cap bites before the limit is spent. Carriers set which fractions and options they will offer, so ask for quotes on more than one structure. The mechanics are covered in agreed value, blanket limits and margin clauses and business interruption insurance: how business income coverage works.

Variables people forget

• Seasonality. The form tests the coinsurance base across 12 months, but a fire in the peak season costs more than one in the slow season. If a single month produces a third of annual profit, a limit sized to an average month will fall short.
• Growth. A fast-growing business using last year's numbers is underinsured on day one. Use the forward projection.
• Payroll decisions. Payroll that continues is covered. If you would keep key employees on, include them; if you would lay off staff, the form pays nothing for payroll that stops. A payroll limitation endorsement changes this and also the coinsurance base.
• Multiple locations. The coinsurance test uses the limit for the described premises, so each location needs its own base and its own limit. A loss at one site can also interrupt others that depend on it; supplier and customer dependencies fall under contingent business interruption insurance and supply chain risk.
• Extended income and ramp-up. Extended Business Income pays for up to 60 consecutive days after reopening unless the declarations show a longer period.
• Rebuild time. The period of restoration is the time property should take to repair with reasonable speed. Code upgrades do not extend it; see ordinance or law coverage: paying for code upgrades after a loss.
• Annual refresh. Recalculate at every renewal, and after any change in the business.

Who should prepare the numbers

The owner or CFO supplies the financials, but a CPA or the broker's loss-control staff will keep the deductions straight. Insurers adjust claims from your accounting records, so a worksheet that matches the books helps a claim later. Keep the worksheet with the policy file. For how the numbers are used in a claim, see documenting a business interruption claim, from day one to final payment.

Key takeaways

• The coinsurance minimum is the percentage times projected net income plus operating expenses for the next 12 months, after the deductions the form lists.
• A limit that satisfies coinsurance may be larger than your real exposure; a limit sized to your real exposure may trigger a penalty. Resolve it by choosing the right structure, not by guessing.
• Maximum period of indemnity and monthly limit of indemnity avoid coinsurance and suit shorter or steadier exposures; agreed value suits owners who want a documented number.
• Extra expense, extended income and civil authority all come out of the same limit, so include them.
• Rebuild the calculation each year and whenever sales, payroll or locations change.