Business Income Insurance Covers Continuing Expenses Without Reduction for Insured’s Operating Loss

It is typical for business income insurance, the modern version of business interruption coverage, to provide for two components of actual loss of business, namely (1) net profit or loss before income taxes that would have been earned or incurred during the period of restoration had there been no physical loss or damage to business facilities, and (2) continuing normal operating expenses incurred after the physical loss or damage, including payroll.

There is a difference of opinion in the cases, however, whether the amount of net loss must be subtracted from operating expenses in arriving at the amount of insurance proceeds payable by an insurer to its policyholder.

Representative of the affirmative answer to this question of policy interpretation are cases decided by Wisconsin Supreme Court in 1927 and the Supreme Court of Tennessee in 1992. These courts reasoned that any other policy interpretation would place the policyholder in a better position than it would have occupied had there been no business interruption, in any case where there is a net business loss, because the policyholder would still be paid its continuing operating expenses, without any consideration of the net profit or loss component of business income.

This result, the two courts concluded, would violate the purpose of business interruption insurance, which is to protect the insured against losses that occur when its operations are unexpectedly interrupted. Put another way, the function of business interruption insurance is to do for the insured business what it is disabled from doing for itself, paying indemnity no less but also no more than would have been earned without physical loss or damage.

A leading California insurance treatise has adopted the pro-insured posture:

“Where a policy provides coverage for both loss of net income (net profit or net loss that would have been earned/incurred absent the physical loss) and continuing operating expenses, these coverages apply separately. Thus, the insured is entitled to recover normal operating expenses even if the business had no net profits (i.e., it was operating at a net loss over operating costs at the time of the business interruption event).” (Rutter Group, California Practice Guide, Insurance Law, § 6:268. Emphasis in original.)

Contributing to the judicial debate most recently is Mullins v. N. Y. Marine & Gen. Ins. Co., decided December 21, 2017 by the United States District Court for the Northern District of California and reported at 2017 U.S. Dist. LEXIS 210481. The policy language in Mullins is typical:

We will pay for the actual loss of Business Income you sustain due to the necessary “suspension” of your “operations” during the “period of restoration.”

Business Income means the:

a. Net Income (Net Profit or Loss before income taxes) that would have been earned or incurred; and

b. Continuing normal operating expenses incurred, including payroll….

Amusingly, in light of the strenuous disagreements of the courts, the result seemed “obvious” to the Tennessee court from the wording of the policy. What was obvious was also convoluted: “[I]n any given case the amount of ‘business income’ will be a number that is the sum of a second number (‘net income,’ which may be either a net profit or a net loss) and a third number (continuing normal operating expenses incurred). The ‘business income’ provision of the policy clearly indicates that the amount of business income is to be determined by adding the second number and the third number together, and not, as contended by [the insured], by looking only to the third number and completely ignoring the second number.”

A 2010 California Court of Appeal decision followed in Mullins was not much clearer. It said that, contrary to the insurer’s argument in that case, construction in favor of the policyholder does not render the term “Net Loss” superfluous. “Rather, in the event that there is a net loss, the insured’s entitlement to benefits for loss of ‘net income’ is zero.” (Emphasis added.)

In fact, however, it is exactly the effect of Mullins and the cases it followed to ignore the amount of the net income component of business income loss. These cases overlook that business operating losses represent more or less negative amounts of business income. Losses can be large or small, and under the policy language an insured with a large loss should be compensated differently than one with a small loss. Zero won’t do. If the first component calculation prescribed by the policy defaults to that figure in case of a net loss, the result is a counterintuitive prescription for those with large and small operating losses to be “compensated” based exclusively on the amount of the second loss component, the continuing normal operating expenses, when both components should be measured and applied.