Machinery Loss of ProfitsInsurance

Münchener RückMunich Re

This publication was conceived, written and realized in terms of both graphic design and typography exclusively by Munich Re staff.

© 1997Münchener Rückversicherungs-GesellschaftAddress for letters: D-80791 MünchenGermany

http://www.munichre.com

Order number 0224-E-e/175.1

The paper used for this brochure was produced without chlorine bleaching.

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Machinery Loss of ProfitsInsurance

A publication of the Munich Reinsurance Company

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Increasing complexity and automation of industrialplants, e.g. in petrochemistry, have led to a higherclaims potential in the event of business interrup-tions.

Introduction

Under both machinery and fire insur-ance, indemnity is provided, in respect of damaged or destroyed machinery, solely for the material loss sustained bythe insured. These types of insurance dothus not protect the insured against allthe losses which arise in connection witha fire or the breakdown of machinery,since in most cases a material loss alsocauses an interruption or interference ofthe insured’s business operations. Theresult is a financial loss in the form of lostprofit and unearned standing charges. Inmany cases the loss sustained as a re-sult of an interruption or interference ofbusiness operations by far exceeds themere material loss.

An awareness of the need for insuranceprotection against the financial conse-quences of material damage arose at thebeginning of this century, and the resultwas the introduction of the two variants,loss of profits following fire insurance andloss of profits following machinery break-down insurance – also called machineryloss of profits (MLOP) insurance. As thesize of modern production facilities in-creases, MLOP insurance is becoming more and more important. Theindividual production stages in modernprocesses are often accomplished byjust one machine, the failure of whichleads to substantial interruption losses.

Moreover, the new electronics LOP hasbeen introduced. In principle, electronicsLOP is the same as MLOP; but it offersthe extended scope of cover of an elec-tronic equipment policy.

Munich Re will be glad to support clientsin this difficult class of insurance by as-sisting in inspections, preparing quota-tions, settling claims and providing training courses.

In the following, the basic features ofMLOP insurance will be dealt with.

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1 Subject matter insured

MLOP insurance provides cover for theactual loss of profits sustained as a re-sult of a business interruption caused bymaterial damage indemnifiable undermachinery insurance. MLOP insuranceprovides indemnity also in cases wherethe material loss amount falls below thedeductible to be borne by the insured under the machinery cover. Basicallyspeaking, a loss due to an interruption or interference of business operations is made up of the following factors:

a The reduction in operating profit, i.e.the profit from selling the goods pro-duced and traded by the insured andfrom rendering services.

b The standing charges, i.e. the costsincurred entirely or in part if operationsare interrupted or impaired. These com-prise wages and salaries, including so-cial security contributions if they continueto become due during the interruption;interest, economic depreciations, basicrates for third-party energy, expenses forthe current upkeep of buildings and ma-chines, rent, taxes and other non-speci-fied working expenses, expenses for thepreservation of vested rights, insurancepremiums and other business expenses,e.g. guaranteed commissions.

Not included in standing charges, how-ever, are turnover taxes and expensesfor raw or auxiliary materials, fuels andgoods purchased unless they serve tocontinue operations; excise taxes, freightcharges, specified licence and inventor’sfees and similar expenses.

Loss minimization costs are also coveredif they lower the insurer’s obligation to in-demnify. These include expenses thatavoid, minimize or terminate an interrup-tion loss soon after the occurrence ofmaterial damage.

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In the event of damage to the company power plant,business interruption can often be avoided by buyingthird-party energy. Increased cost of working insur-ance covers such cases.

60 MW diesel aggregates in a diesel power station.

Loss minimization is of great importancein MLOP insurance. The following are ex-amples.

– Purchase/sale of semi-finished goods

– Provisional repairs

– Early overhauls

– Purchase of non-identical (but com-patible) machinery

– Express, airfreight

– Overtime work, additional shifts, workon Sundays� to accelerate repairs� on undamaged machines to reducethe interruption loss

– Rent of machinery (e.g. transformers,boilers, compressors)

– Recommissioning of old machinery

– Shifting of operations to alternativeplants

– Making up for the production loss afterreopening

If, in the course of arranging the in-surance, it becomes evident that enter-prises can continue to work after material damage, e.g. by

– acquiring third-party electricity if thecompany power plant fails,

– renting machinery,

– applying alternative methods,

– purchasing semi-finished or finishedgoods,

then increased cost of working insur-ance is recommended for the plants inquestion as an alternative to full MLOPcover.

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2.2 MW back-pressure steam turbo-generator in asugar factory.

Damage to a steam turbine generator in a papermill.

2 Indemnity period limit and time excess

To make a risk assessable for the insur-er, it is necessary to apply certain limitsto the period for which indemnity is pro-vided. This is done by specifying a pe-riod of indemnity.

2.1 Indemnity period limit

In contrast to a material loss, the loss ofprofits following a business interruptiondepends on the time factor involved. Inother words, the longer the period forwhich operation is interrupted or im-paired, the greater the loss of profits. For this reason it is essential to set a cer-tain limit for the period during which theinsurer is obliged to provide indemnity foran interruption loss. This is done by theinsured specifying an indemnity period limit which represents the maximum timefor which an insurer is liable for loss ofprofits. The period of indemnity beginson the date on which material damagecould first be said to have occurred, as

judged according to the recognized principles of engineering, at the latest,however, on the date when the loss ofprofits commenced. Generally the in-demnity period limit is three, six, nine ortwelve months; a period of more thantwelve months can be agreed on re-quest. The basic rule is that the indem-nity period limit should relate to the amount of time required for removing theinterruption loss, i.e. for repairing the machinery damaged or for the delivery of new machinery in cases of a total loss,assembly and trial run. Higher premiumsare, of course, charged for long indem-nity period limits.

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Damage to a piston compressor.

Destruction of the gearing of an offset printing pressdue to the failure of control systems.

Even a short circuit in coils of a large electric motordriving an important machine may lead to major LOPdamage.

Broken calender of the coating unit in a paper mill.

2.2 Time excess

Under normal circumstances, losses dueto interruption lasting for a short periodof, say, up to seven days can be borneby the insured company itself. It is, there-fore, advisable to exclude such minorlosses from the cover provided. This isdone by specifying a time excess of anumber of days during which any loss ofprofits arising is borne by the insured.This is arrived at by multiplying the aver-age indemnifiable daily loss by the num-ber of days of the time excess agreed(proportional time excess).

The minimum time excess is two days,but normally it should not be less thanseven days. The time excess to be ap-plied depends on the quantity of finishedproducts stored, the possibilities of catching up with lost output, and the fi-nancial burden which can be acceptedby the insured company itself. If a longtime excess is agreed, the premium may be reduced considerably.

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Failure of the public power supply and deteriorationof the material processed can be covered under anMLOP policy. This feature is of importance for an aluminium smeltery, for example.

3 Sum insured, value insured, valua-tion period

The following terms are also of great im-portance in MLOP insurance:

3.1 Sum insured

The sum insured is made up of the oper-ating profit and the standing charges inthe course of twelve successive calendarmonths (i.e. normally the business year).

3.2 Value insured

The value insured is made up of the operating profit and the standing chargeswhich the insured would have earnedwithout taking any indemnifiable interrup-tions in the valuation period into consid-eration.

3.3 Valuation period

The valuation period comprises twelvemonths and ends at the point in time atwhich interruption lossses no longer oc-cur (lost operating profit and standingcharges), at the latest, however, at theend of the indemnity period limit.

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Operating profit

Wages, salaries, pensionsInterest, depreciationsNon-specified taxesFixed costs (e.g. licence fees)Basic power ratesInsurance premiums

Raw, auxiliary materials; fuelsVAT, turnover taxEnergy consumptionPostage and freight chargesLicence fees (non-specified)Contract penalties

Operating profit

Fixedcosts

Variable costs

Suminsured

Turnover

The indemnity period ends at the point in time atwhich interruption losses no longer occur.

Determination of the sum insured.

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Indemnity period limit

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Materialdamage

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4 Underinsurance

On the basis of the sum insured and thevalue insured, it is possible to checkwhether underinsurance is involvedwhen a loss of profits claim arises: Thisis the case whenever the sum insured islower than the value insured. Under-insurance can be avoided by makingallowance, when calculating the sum insured, for the probable trend of theinsured’s business in the financial yearfollowing the current period of insurance.

If the trend of the current period of insur-ance alone were considered, losses oc-curring towards the end of the year mightcause substantial underinsurance.

On the other hand, a special premium re-fund system is provided by MLOP insur-ance in the form of a premium adjust-ment clause to avoid the insured havingto pay an excessive premium due to avery conservative fixing of the sum insur-ed. According to this clause, a pro ratareturn of premium is made in respect ofthat share of the sum insured which ex-ceeds the actual value insured for thatperiod of insurance.

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Electronics LOP insurance covers electronic medical equipment for which no alternative exists.

5 Determination of premiums

To make MLOP insurance successful, itmust not only cater for the specific needsof the market but also charge premiumrates which are commensurate with therisks involved. Due allowance must therefore be made for the following factors when determining premiums:

– The general and the specific technicalrisk of the machinery to be insured

– The “moral” and technical hazard re-lating to the user

– The effect of machinery breakdownson the operating profit and standingcharges (factor of relative importance)

– The reserve facilities and spare partsavailable

– The possibilities of loss minimization

– The general economic and politicalconditions

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Wood pulp and paper industry plants are very exposed and therefore often protected by MLOP insurance, such as this paper machine for newspaper.

Red-hot shell of the rotary kiln of a wood pulp worksafter destruction of the lining.

5.1 The general and the specific tech-nical risk of the machinery to be in-sured

The general technical risk of a machineis dependent on its average claims fre-quency and the average interruption pe-riod. These two fundamental values mustbe calculated on the basis of statistics.Provided that maintenance of the machi-nery is first class, these values dependprimarily on the type of machine involvedand its capacity.

This basic premium rate resulting fromthese criteria applies to machinery ofproven design which is in good condition.However, it must be noted that these pre-conditions are often not met. Then thespecific technical risk must be conside-red in the basic premium rate by apply-ing a loading.

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Company “infrastructure” is an object for MLOP insu-rance, e.g. boilers for the generation of processsteam.

The protection of MLOP insurance also applies tosmall machines, e.g. rotary offset printing presses.

5.2 The “moral” and technical hazardrelating to the user

The moral hazard depends on how quali-fied the management and the staff of aplant are, and is also influenced by thestanding of the firm in the view of manu-facturers and service organizations. Thefollowing figures show to what extent themoral hazard is influenced by the qualityof staff.

Of 1,740 claims involving the most variedtypes of machinery, it was found in astudy that 62% were caused by faultyoperation. Statistics compiled in the Unit-ed Kingdom show that of 500 losses in-volving ammonia compressors, approxi-mately 53% were due to human error.

It is therefore quite obvious that when arisk is assessed, considerable impor-tance must be attached to the training ofthe operating personnel by the insured.

The technical hazard of the risk dependson the plant organization, the loss pre-vention measures taken (regular mainte-nance, systematic supervision by meansof indicating and measuring instruments,provision of safety devices and carryingout of non-destructive tests), and thepossibility of repairing damage either atthe plant itself or at least in the samecountry. Should the inspection of a plantto be insured reveal that standard lossprevention measures have not been taken or that repair work must nearly always be done abroad, insurance cov-erage can only be provided if a corre-sponding loading is charged on the premium.

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Compressors are often the reason for bottlenecks;their failure may lead to the standstill of the entireenterprise.

5.3 The effect of machinery break-downs on the gross profit (factor ofrelative importance)

Allowance is made for the effect of thebreakdown of machinery by means ofthe so-called factor of relative impor-tance. This factor corresponds to the per-centage effect which a complete stand-still of a machine during the entire periodof insurance would have on the operatingprofit and the standing charges. Whendetermining the factor of relative impor-tance, allowance should not be made forthe production. It should not be fixed ac-cording to possibilities of loss minimization. Ideally, factors of relativeimportance should be fixed on the basisof a flow chart which shows, in additionto these factors, the capacities of the ma-chines and any reserve machinery.

It is very important for the insured to de-termine and indicate the factor of relativeimportance himself, as he is the only onewho has the necessary detailed knowl-edge. If the factor indicated is too low,underinsurance will be claimed.

5.4 The reserve facilities and spareparts available

The reserve factor is determined on thebasis of the information provided regard-ing the reserve facilities available, and di-rectly influences the premium calcula-tion. The reserve factor is always lessthan 1, as any reserve facilities availablewill reduce the risk borne by the insurer.It is mainly dependent on the type andnumber of machines available, the num-ber of failures if one machine stands still,and the ratio between the total capacityavailable and the load requirement. Theavailability of spare parts is taken into ac-count when calculating the premium by acorresponding spare parts factor, alsoless than 1.

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Factors of relative importance depend on the operat-ing configuration.

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in parallel:

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5.5 The possibilities of loss minimiza-tion

The results of MLOP insurance dependto a great extent on the loss minimizationmeasures taken. It is therefore quite ob-vious that this topic deserves special at-tention. Such measures for loss mini-mization are, for example, the hiring ofsubstitute motors, generators, transform-ers, boilers, small turbines, etc. or thespeeding up of repair work by carryingout complex welding operations even onhigh-alloy materials or using metalockand other special repair methods on thedamaged components.

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Tube mill of a cement factory.

Discussion of loss minimization possibilities at thedamaged front wall of a cement tube mill ...

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Airfreight, if necessary with chartered wide-bodiedaircraft, shortens interruption periods considerably.

... and the front wall after provisional repair using theso-called metalock method.

5.6 The general economic and politi-cal conditions

Apart from delays in the repair of dam-aged machinery due to the location of aninsured plant, it is also quite possible thatthe general economic and political condi-tions prevailing in a country will result inan extension of the normal repair period.Such extensions may, for example, becaused by the time required for procure-ment of import and export licences, by ashortage of foreign exchange, or by pro-visions or restrictions imposed by gov-ernmental authorities or other public institutions.

In many countries it is often not possible,when concluding a policy, to anticipate allof these possibilities, so the risk involvedfor the insurer must be limited by apply-ing a so-called “delay in repairs clause”.

Conclusion

Modern machinery loss of profits insur-ance is a suitable means of meeting theincreasing need on the part of industryfor comprehensive tailor-made insuranceprotection from the consequences of business interruptions. Experienced en-gineers must carefully assess the plantsto be insured and calculate the premi-ums, duly taking into account all the fac-tors influencing the risk conditions in themost various countries. In this way it ispossible for insurers to obtain satisfac-tory results and further expansion in thisparticularly hazardous class of business.

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Modern slab line controlled by a process computer.Even small damage may lead to complete standstill.

Sources of illustrations:

Allianz (6); Aluminium-Zentrale (7); Archives (6); Bird & Ass. (14, 15); KWU(15); Kymmene Oy (10); Loos (11); Lurgi(2); MAN (4, 11); Mannesmann (12); Munich Re (5, 8, 13); Philips (9); Polysius (14); Siemens (4); Verein deut-scher Eisenhüttenleute (16); Voith (10).