cmabdtheblogger: Financial Accounting - Insurance Claims

FINANCIAL ACCOUNTING

INSURANCE CLAIMS

LOSS OF PROFIT POLICY

Part A: Discussion of basic theories and Steps to determine the amount of insurance claims for loss of profit consequent to loss of stock by fire

Part B: Three Illustrations with Solutions

Part A

A loss of profit policy covers loss of gross profit sustained in consequence of a business interruption due to destruction of / damage to property by fire. The loss of gross profit may result from both the following two situations:

(a) The reduction in turnover during the period of business interruption, and

(b) The increase in cost of working incurred during the period of business interruption for the purpose of avoiding or reducing the reduction in turnover.

The loss of profit policy is also known as “Consequential loss policy”. The claim for loss of profit insurance is granted only when the insured has a valid claim in respect of the property, the loss of / damage to which results in business interruption, being admissible under a corresponding fire policy. Therefore, it is a basic condition that, a business unit cannot have a loss of profit insurance policy without the presence of a fire policy covering property damage giving rise to the loss of profit claim.

SOME IMPORTANT TERMS / EXPRESSIONS

1. Net Profit: Net Operating Profit before Tax

2. Net Loss: Net Operating Loss before Tax

3. Standing Charges:

Standing charges are the fixed expenses which have to be incurred irrespective of the reduction of turnover.

4. Insured Standing Charges:

Insured standing charges are those standing charges which are mentioned in the loss of profit insurance policy and which the insured desires to recover from the Insurance Company in the case of an accident. It may include the following:

i. Rent, rates and taxes,

ii. Interest on debentures and long term loans,

iii. Salaries of permanent staff,

iv. Wages of skilled workers,

v. Directors’ fees,

vi. Auditors’ fees,

vii. Advertising expenses,

viii. Travelling expenses, and

ix. Unspecified standing charges (not exceeding 5% of the amount of specified standing charges).

5. Indemnity Period:

Indemnity period is the period from the date of hazard up to the date on which the organisation begins normal functioning, subject to the number of days / months mentioned in the policy as the indemnity period. Indemnity period, however, cannot be more than 12 months.

6. Standard Turnover / Adjusted Standard Turnover:

The turnover during that period, in the 12 months immediately preceding the date of the hazard, which corresponds with the indemnity period is called standard turnover.

Adjusted Standard Turnover =

Standard Turnover x (1 + Upward Trend)

7. Annual Turnover / Adjusted Annual Turnover:

The turnover during the 12 months immediately preceding the date of the hazard is called annual turnover.

Adjusted Annual Turnover =

Annual Turnover x (1 + Upward Trend)

8. Short Sales:

Short Sales =

Adjusted Standard Turnover – Actual Turnover during Indemnity Period

9. Additional Turnover:

This is the value of sales which have arisen during the indemnity period as a result of additional cost of working incurred during the same period. Actual turnover during the indemnity period may be more than additional sales, because there may be some sales which have arisen during the indemnity period without the aid of any additional cost of working. But actual turnover during indemnity period will be equal to additional turnover, if no sales during indemnity period are possible without the aid of an additional cost.

10. Additional Expenses (also called Additional Cost of Working):

These are the expenses incurred during the indemnity period which are directly responsible for the additional sales arisen during the same period.

11. Claim for Additional Expenses:

The least of the following three:

i)	Additional Expenses x [G.P. on Adjusted Annual T.O. ÷ (G.P. on Adjusted Annual T.O. + Uninsured Standing Charges)]
ii)	Gross Profit on Additional T.O.
iii)	Actual Additional Expenses

12. Insured Gross Profit for the last A. Y.:

= N.P. for the last A.Y. + Insured Standing Charges

OR, AS THE CASE MAY BE,

= Insured Standing Charges – [Net Loss for the last A.Y. x (Insured Standing Charges ÷ All Standing Charges)]

13. Gross Profit Rate (G. P. Rate):

= (Insured G.P. for the last A.Y. ÷ T.O. for the last A.Y.) x 100 %

14. Upward Trend in Turnover:

= [(Annual T.O. – T.O. for the last A.Y.) ÷ T.O. for the Last A.Y.] x 100 %

Usually upward trend in turnover is given in the problem. But if it is not given, the above formula will be used to find out the upward trend in turnover. However, upward trend in turnover less than 5% may be ignored with an appropriate note appended to the solution in this regard.

15. Gross Claim:

= G.P. on Short Sales + Claim for Additional Expenses – Savings in Insured Standing Charges during the Period of Indemnity

INSURANCE CLAIM TO BE MADE

(i) If the Policy Value < the Gross Profit on Adjusted Annual Turnover –

Insurance Claim =

Gross Claim x (Policy Value ÷ G. P. on Adjusted Annual Turnover)

(ii) If the Policy Value ≥ the Gross Profit on Adjusted Annual Turnover –

Insurance Claim =

Gross Claim

SUM TO BE INSURED

Particulars	Rs
Net profit for the last accounting year	×××
ADD: All standing charges for the last accounting year	×××
ADD: Estimated increase in gross profit due to anticipated increase in turnover during the current accounting year	×××
SUM TO BE INSURED	×××