Is a director obliged to ensure that their company has in place adequate business interruption cover? asks Shane Gleghorn
Business interruption insurance covers the loss of profit and the continuing expenses incurred by an insured as a consequence of physical loss or damage to insured property by perils such as fire or flood. This type of insurance is designed to indemnify the insured against losses arising from its inability to continue normal trading, and adequate insurance cover may go so far as to stave off ruin. The cover is usually written in connection with a policy covering property damage to specified assets, although almost any business interruption risk can be insured. Business interruption insurance is, therefore, similar to income protection insurance for individuals, because it protects a corporate insured from cash flow difficulties when its business has been brought to a halt by an insured peril.
LIABILITY OF A DIRECTOR TO THE COMPANY
In order to estimate its exposure to business interruption risks, a prudent organisation will investigate, identify and evaluate the perils to which its business is exposed. Is a director, therefore, obliged to ensure that a company obtains business interruption insurance? If so, how comprehensive will it need to be for this duty to be satisfied? These questions underline the dilemma faced by directors. To insure against every conceivable risk would be a waste of company resources, but failing to insure against foreseeable risks may expose the company to ruinous losses and, perhaps, allegations of negligence by the company against the directors themselves.
THE COMMON LAW
Unless the articles of the company provide otherwise, directors must exercise skill and care in carrying out their managerial functions. Accordingly, directors owe a duty of skill and care to the company to consider whether it is necessary to obtain appropriate insurance cover in respect of such foreseeable risks, including (where relevant) business interruption risks.
However, a mere error of judgment will not amount to a breach of the duty of care which a director owes to a company. Conversely, a director runs the risk that a court will characterise his or her conduct as falling short of the appropriate degree of skill and care if there is no (or no adequate) risk analysis undertaken of the company's business.
Thus, although directors are not under any specific obligation to ensure that a company is insured, it seems likely that the common law will require a director to exercise an appropriate degree of skill and care (ie given his or her experience and skills) in considering whether it is appropriate for a company to obtain insurance. The importance of a board of directors formulating a coherent risk strategy is highlighted by the case of Re Simmon Box (Diamonds) Ltd  B C C 275. The facts of the case are unusual (involving the disappearance of valuable jewellery on a cross-channel ferry trip), but the decision indicates that it is possible for a director to be held liable for neglecting to arrange appropriate insurance in respect of foreseeable risks. In particular, the court noted that it was entirely foreseeable that jewellery being ferried by a director to an overseas customer would be exposed to risk on a cross-channel excursion and, accordingly, the director was held to have acted recklessly in relation to the company's assets by failing to arrange appropriate insurance cover.
Although the Re Simmon Box (Diamonds) Ltd case concerns the liability of a director for misfeasance under section 212 of the Insolvency Act 1986 (ie in circumstances where the company had gone into insolvency), the case has a wider application because section 212 codifies the common law duty of care owed by a director to a company. This was established by the case of Re D'Jan of London  B C C 646 where Hoffmann LJ held that a director who failed to read an insurance proposal before signing it was liable to the company in negligence (ie because a misrepresentation contained in the proposal form entitled the insurer to avoid the insurance policy obtained by the company). Consequently, it seems likely that the courts will find the reasoning in Re Simmon Box (Diamonds) Ltd to be persuasive when considering whether a director has breached his or her duty of skill and care by failing to arrange any (or any adequate) insurance for the company.
COMBINED CODE ON CORPORATE GOVERNANCE
A second source of guidance for directors is found in the UK "Combined Code on Corporate Governance". The Combined Code applies to directors of listed companies and serves as a guide to best practice for directors of unlisted companies. Accordingly, although each case will necessarily be fact-sensitive, the courts are likely to regard significant deviations from the Combined Code as indicative of a lapse of the skill and care that a director is obliged to exercise. Helpfully, the Combined Code incorporates a section on how to achieve a balance between the impossibility of insuring against every conceivable risk and the desirability of insuring against foreseeable risks. This is known as the Turnbull Guidance, and provides directors with a framework for the creation of a risk-management strategy.
A director is specifically advised to consider:
- The nature and extent of the risks facing the companies;
- The extent and category of risks which the board regard as acceptable for the company to bear;
- The likelihood of the risk materialising;
- The company's ability to reduce the incidence and impact on the business of risks that do not materialise;
- The costs of operating particular controls relative to the benefit thereby obtained in managing the related risks.
Although insurance by itself will not necessarily constitute an adequate risk-control strategy, it will generally form part of most risk-control strategies. Indeed, the guidance states that the risk management strategy adopted by the board should provide "reasonable, but not absolute, assurance that a company will not be hindered in achieving its business objectives, or in the orderly and legitimate conduct of its business, by circumstances which may reasonably be foreseen". Accordingly, the guidance assists the board of a company to formulate an overarching risk control strategy, which may or may not include the use of insurance. It seems clear, therefore, that directors are required to assess whether there is the need to insure against foreseeable risks. For instance, applying the Turnbull Guidance to the facts of Re Simmon Box, an effective risk-control strategy would have involved the jewellery being transported by a specialist security company in conjunction with an appropriate insurance policy.
RISK MANAGEMENT AND BUSINESS INTERRUPTION INSURANCE
There are a number of factors which a board of directors will have to consider when determining whether it is appropriate to obtain business interruption insurance. The board will, for example, have to determine whether the premium charged by the insurer is prohibitively expensive relative to the risk of the peril taking place. To reach such a conclusion, a prudent board should conduct and document a risk-review process, covering factors such as the cost and required length of the coverage. Ordinarily, this process will result in the preparation of a business continuity plan which is intended to enable the company to respond to any foreseeable peril and provide the company with a means to continue trading in the event of business interruption.
Although premiums for business interruption cover usually use the same basis rate as the connected property insurance, there are important differences in the way the claims payouts and, therefore, premiums, are calculated for the two types of cover. Generally speaking, the basis rates are the same because the probability of the peril (eg fire or flood) occurring and damaging property is roughly the same as the probability of the same peril occurring and causing an interruption to the insured's business.
Premiums are a function of the basis rate and the expected payment if a covered event occurs. While a property damage policy will generally deal with the calculation of the loss of identifiable assets at a particular point in time, a business interruption policy involves the estimation of the impact of the property damage on the trading results of the insured's business. Consequently, business interruption policies usually contain a formula for calculating the reduction in estimated turnover of the insured's business. The key elements of such a formula will be the indemnity period, the revenue which the insured would have expected to achieve during the indemnity period, the revenue that the insured's business does in fact achieve during the period of interruption, and any extraordinary costs incurred by the insured's business as it attempts to recover. In practical terms, this will usually require the board of directors (or those who have been delegated the task) to closely scrutinise the insurance arrangements to ensure that this formula will provide the company with adequate coverage.
The length of the period during which the business interruption insurance will pay for an interruption depends on the terms of the policy. A business interruption endorsement will usually provide insurance coverage for the period it takes to restore the insured's business to normal trading. The period of business interruption begins with the physical damage to property and concludes when that property is repaired or replaced and normal trading resumes. This may, however, be subject to a maximum indemnity period, which can range from several months for a small business, to several years for a large one. Accordingly, it will be prudent for the board to take into account the possibility that it may take a significant period of time to restore the company's turnover to its original levels. As the insurer's exposure tends to become smaller over time (because the disruption to the insured's business is likely to be greater immediately after the event than a year after it), the monthly premium charged by the insurer will tend to decrease as the maximum length of the indemnity period is increased.
CONTINGENT BUSINESS INTERRUPTION
Most companies are aware that there are business interruption risks associated with damage to buildings or plant. The board will also, however, have to consider whether less obvious types of interruption risk are relevant to its business. The board must be conscious of the need to protect the company's balance sheet, and one of the priorities should be to preserve the sources of income flow. For example, a common type of interruption insurance not necessarily related to direct physical damage, is the failure of a key customer or supplier. This is sometimes called contingent business interruption insurance. The board would be well advised to consider the impact of a major supplier, sub-contractor or customer suffering a business interruption and, in particular, whether it is appropriate to ensure coverage for such an event. Although it may be possible to locate alternative suppliers or customers, a material difference in trading terms could have a significant impact on the company's net profits unless appropriate insurance coverage is in place.
The investigation, identification and evaluation of possible business interruption risks are critical to a company's risk management strategy.
Having identified the risks, the board should take action to reduce or eliminate interruption risks by practical measures (eg taking measures to protect certain buildings and plant) and develop a contingency plan for operating during different types of business interruption scenarios.
Even if it is impossible to eliminate the necessity of business interruption insurance, such steps as are likely to assist the insured when negotiating a suitable premium should be taken. Insurers expect corporate insureds to manage their risks, and risk management programs are frequently accepted by insurers for the purpose of lowering premiums.
The documentation generated by a company's risk analysis should record the thoroughness with which the exercise was undertaken, including the consideration given to any expert advice that informed the decision-making process (eg advice given by an insurance broker). Although each case will turn on its facts, it will usually be helpful for the paper trail to record the consideration given to the following factors:
- the advantages of insurance protection relative to the cost of obtaining coverage;
- the losses which would be suffered by the company if key assets became unavailable;
- the anticipated losses associated with a major supplier or customer suffering a business interruption; and
- the availability of alternative suppliers or customers and the period required to put in place such alternatives.
In addition to being of central importance to the protection of a company's balance sheet, a well documented risk assessment process is likely to help the directors to show that they acted prudently even where they had decided not to purchase business interruption insurance. Indeed, where a decision not to obtain insurance turns out to be an unfortunate one, it is likely that the directors will wish to rely on the paper trail to show that this decision was made in accordance with the company's risk management strategy.
- Shane Gleghorn is a member of Baker & McKenzie's Global Insurance Practice.