NSW Court of Appeal resolves a long-standing debate about the interpretation of a business interruption policy
Loss of Gross Profit
To those inexperienced in business interruption claims, the formulae stated in the policy to calculate the different types of financial losses insured under the policy may appear daunting. However, once explained, the principles behind the calculations are logical and mostly straightforward.
The most common claim is for loss of gross profit. If the turnover of my business reduces because my machinery is damaged, broadly three calculations determine how much gross profit I have lost:
- First, calculate how much my gross income has reduced compared to the previous year because of the damage, and then multiply that figure by the business’s current ratio of profit to gross income (e.g. my gross income reduced by $10,000; recently, for every $1,000 of gross income I have been earning $200 of gross profit (20%). Therefore, the gross profit I lost on $10,000 is 20% of that figure = $2,000).
- Second, add to that figure, any out of the ordinary expenses I incurred solely to achieve that gross income of $10,000 (e.g. extra advertising to attract more customers of $1,000). $2,000 + $1,000 = $3,000
- Third, deduct from that total any savings in my normal expenses that I would otherwise have had to pay out of my gross profit (e.g. my normal power charges reduced by $500 because only half my machines could operate). $3,000 – $500 = $2,500.
In this over-simplified example, the gross profit I lost was $2,500 and the policy indemnifies me for this. The NSW Court of Appeal considered a contentious issue in relation to the third calculation in Mobis Parts Australia Pty Ltd v XL Insurance Company SE.
The worth of a business’s machinery reduces over its working life through wear and tear and obsolescence. In order for the accounts of the business to reflect this reduction, a percentage of the cost of purchasing the plant is deducted from each year’s earnings at an appropriate rate. This reduction is called depreciation.
Although depreciation is an expense of the business, it is not a cash expense – no money changes hands. It reflects the declining worth of an asset of the business. That decline is not realised until the business sells or scraps the machinery and is faced with the cost of replacing it.
In the Mobis case, an insured event destroyed the insured’s machinery. During the indemnity period, the insured would normally have allowed an expense of $1.5M in its accounts for the machinery’s depreciation. However, because if its destruction the figure of $1.5M was not included as usual in the accounts. As I understand it, there was nothing contentious about this.
Calculation of savings
The issue that arose from this is whether that depreciation expense over the indemnity period that was not included in the accounts should be deducted from the gross profit calculation (3 above) as a ‘saving’.
As I understand it, there are competing accounting theories about this. Naturally, a depreciation figure as high as $1.5M is going to make quite a difference to the claim payment if it is to be deducted from the gross income figure.
How the Court of Appeal decided the issue
A court is a court of law, not accounting. It is not for the court to determine an accounting principle, but rather to determine the correct interpretation of a contract. Therefore, the court started by looking closely at the critical words used in the savings provision in the policy. They are:
… less any sum saved during the Indemnity Period in consequence of the Damage in respect of such of the charges and expenses of the Business payable out of Gross Profit.
The court noted that the words ‘saved’ and ‘payable’ tend to connote the transaction of cash. This is to be contrasted with a non-cash expense, such as depreciation.
The court noted one previous English High Court case, which had to consider the same issue. In that case, the court noted the same use of words also and it drew a similar inference from those words as the Australian Court. However, despite that, the English Court ruled the expense was deductible based on an argument around the indemnity principle.
The NSW Court of Appeal refused to follow that principle because it said the contract set out a specific formula to calculate the required indemnification and it must be followed. It found nothing in the context of the savings provision itself to justify any departure from the words actually used. Further, the court found that the very existence of the formula must have been intended to eliminate any argument about the principle of indemnity; in other words, ‘don’t worry about the indemnity principle, just apply the formula’.
In a win to the insured, the court held the elimination of the depreciation reduction during the indemnity period was not a saving to be deducted from the insured’s gross profit. It was not a saving in relation to an expense payable to someone else.
This case is an interesting example of just how important it is to draft the policy wording accurately, carefully choosing the right words to achieve the underwriting intention. A policy is a technical document.
For example, if the underwriting intention was to treat the removal of the depreciation expense from the accounts as a saving, this court case would never have happened if the savings provision have been drafted with the words underlined below added:
… less any sum saved during the Indemnity Period in consequence of the Damage in respect of such of the charges and expenses of the Business (including depreciation) payable out of Gross Profit.
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