Why business interruption insurance is vital
The Asia-Pacific region is host to commercial, manufacturing, and logistics hubs dotted with small business enterprises. They are all highly exposed to disasters caused by natural hazards. Low investments in disaster resilience and business continuity management expose them to physical damage and economic losses to production facilities.
The financial consequences of natural hazards include the destruction of property and equipment, damage to stock, revenue loss, and rising operational costs. Loss of market share due to clients shifting to competitors, movement of skilled workers, and impaired relationships with suppliers and retailers also affects long-term economic sustainability, and sometimes even results in the closure of businesses. Often, the financial impact due to business interruption is much higher than the cost of physical damage.
In the US, more than 40% of businesses never reopen after a major disaster, and only 29% of those that open are still in business two years later. A critical risk that small enterprises connected to global production networks face is supply chain disruption.
Due to the butterfly effect, a loss in one region manifests in the form of knock-on effects on markets and enterprises in other parts of the world. The risks are not limited to single enterprises, sectors, or industries, and can severely affect entire economies. The 2011 floods not only disrupted Thailand’s exports in electronics and electrical appliances but also hurt Japan’s economy.
There was a 3.7% contraction in electrical component production. Small businesses need to manage their risks and internal processes very carefully by integrating disaster risk management into their business operations and decision-making processes.
The starting point is to carry out a risk assessment of the business unit’s threat landscape, the financial impact, and the recovery time. They should also reasonably quantify what an actual loss might entail, including the average cost of construction, and time to rebuild.
It’s also necessary to do an evaluation of the ongoing contractual arrangements or exposures to third parties that will continue regardless of whether the business is shut or open. A robust analysis of the costs and benefits of potential risk mitigation options is also required based on the frequency and severity of the impact of the disaster.
The risk reduction actions can range from structural measures to emergency management and risk financing, which help quantify the residual risk. Risk-sharing arrangements like guarantees and cost-sharing arrangements for liability exposures by entering into contracts with other parties should also be explored besides access to governmental emergency funds or other financing sources to cover for losses.
Purchasing insurance for business interruption should be the last step after an informed assessment to determine the amount of risk they can retain, the amount of premium they can afford to pay for risk transfer via insurance, and the amount of deductible.
There are significant gaps when it comes to protection from business interruption. Specialized coverage is typically needed, and business interruption insurance can cover losses of income and ongoing costs resulting from these three disruptions:
Property damage to an owned business facility
When a small restaurant owner has to shut down her business due to a typhoon, she will lose her income. Still, she will be obligated to incur additional expenses due to the disruption.
Standard business interruption insurance coverage will reimburse her for revenue lost due to the closure and payment of fixed expenses like wages to essential workers, rent, and utility bills. It will also cover additional operating expenses from a temporary location or advertising cost to announce the new address.
Disruption of business without physical damage to the insured, the supplier, or the customer
Exotic locations are often prone to natural catastrophes, like earthquakes and floods, and can cause extensive damage. The tourism industry can be especially affected by losses, potentially impacting the earnings of small businesses outside the area that was physically affected. Non-damage business interruption insurance will cover such microenterprises from income losses.
Interruption of business caused by property damage at the premises of a customer or supplier
It is common for small businesses to rely heavily on a single or small number of suppliers, manufacturers, or customers. A typhoon causes physical damage to a coconut oil processing unit. It destroys palm trees in the vicinity, and there is no raw material available to process post-repair.
A contingent business interruption insurance will compensate the insured enterprise for loss of income due to a halt in production and buy-in or importing raw material. Business interruption insurance coverage usually is not sold as a stand-alone policy. For reimbursement of an insurance claim, there must be direct physical damage to the property resulting from an insured event.
Determining a business interruption loss involves establishing what the small business owner would have earned had the disaster not occurred. Insurance companies examine account profit and loss statements, projected sales and non-continuing expenses, and past tax returns to verify the claim. Undocumented income is not covered.
In emerging Asia, 85% of small businesses do not fully comprehend the risk of natural catastrophes for managing business continuity. Less than 15% of those who have flood insurance have purchased business interruption cover.
Rising business costs increase domestic competition, and market turbulence poses challenges to their bottom line and makes insurance the lowest priority. By not prioritizing business interruption insurance and risk management, small businesses unduly expose their business to unforeseen financial losses arising from natural hazards. But how can business interruption coverage be made affordable and accessible?
There are three steps that can help: First, small business clusters can consider establishing cooperative arrangements akin to a risk pool where they can make contributions in proportion to the risk in their books. The pool can retain the more common and less severe risks and transfer the less frequent, but more severe risks to the insurance market. This arrangement will allow for better negotiation of insurance premiums.
Still, it will allow for paying small claims after a loss, which insurers usually do not pay. Insurers should consider deploying fintech solutions similar to those banks are now using to lend to small and medium-sized enterprises lacking financial reports.
These solutions use alternative risk scoring metrics based on the volume of their cash flows by using e-commerce payment platforms, digital wallets, and mobile financial services. Fintech will help insurers widen their reach besides assisting in underwriting, detecting underinsurance, and assessing business interruption claims.
Designing parametric insurance solutions. Traditional indemnity insurance products haven’t been practical for timely payment of business interruption claims. Parametric solutions using big data, artificial intelligence, and machine learning technology will be useful. With agreed parameters, verifiable indexes, and clearly described participants, it will enable immediate payment of claims once the trigger materializes.
It will also reduce administration costs, investigation, and reserving questions. Further, the use of payment platforms will close the loop from parameter to payment. Business interruption insurance is an essential tool in the business continuity toolkit and should be promoted through financial literacy programs. How small and medium-sized enterprises handle business interruption in the wake of a disaster could be the difference between reopening their doors or closing them for good.
Arup Kumar Chatterjee is Principal Financial Sector Specialist, Sustainable Development and Climate Change Department. This article was first published in the Asian Development Blog and has been reprinted under special permission.