Machinery Loss of Profits

Insurance

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

© 1997
Münchener Rückversicherungs-Gesellschaft
Address for letters:
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Germany

http://www.munichre.com

Order number 0224-E-e/175.1

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produced without chlorine bleaching.
Machinery Loss of Profits
Insurance

A publication
of the Munich Reinsurance Company

1
 Increasing complexity and automation of industrial
plants, e.g. in petrochemistry, have led to a higher
claims potential in the event of business interrup-
tions.

2
Introduction

Under both machinery and fire insur-

ance, indemnity is provided, in respect
of damaged or destroyed machinery,
solely for the material loss sustained by
the insured. These types of insurance do
thus not protect the insured against all
the losses which arise in connection with
a fire or the breakdown of machinery,
since in most cases a material loss also
causes an interruption or interference of
the insured’s business operations. The
result is a financial loss in the form of lost
profit and unearned standing charges. In
many cases the loss sustained as a re-
sult of an interruption or interference of
business operations by far exceeds the
mere material loss.

An awareness of the need for insurance

protection against the financial conse-
quences of material damage arose at the
beginning of this century, and the result
was the introduction of the two variants,
loss of profits following fire insurance and
loss of profits following machinery break-
down insurance – also called machinery
loss of profits (MLOP) insurance. As the
size of modern production facilities in-
creases, MLOP insurance is
becoming more and more important. The
individual production stages in modern
processes are often accomplished by
just one machine, the failure of which
leads to substantial interruption losses.

Moreover, the new electronics LOP has

been introduced. In principle, electronics
LOP is the same as MLOP; but it offers
the extended scope of cover of an elec-
tronic equipment policy.

Munich Re will be glad to support clients

in 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 of

MLOP insurance will be dealt with.

3
1 Subject matter insured
MLOP insurance provides cover for the
actual loss of profits sustained as a re-
sult of a business interruption caused by
material damage indemnifiable under
machinery insurance. MLOP insurance
provides indemnity also in cases where
the material loss amount falls below the
deductible to be borne by the insured
under the machinery cover. Basically
speaking, 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 and
from rendering services.
In the event of damage to the company power plant,
business interruption can often be avoided by buying
third-party energy. Increased cost of working insur-
ance covers such cases.
4
b The standing charges, i.e. the costs
incurred entirely or in part if operations
are interrupted or impaired. These com-
prise wages and salaries, including so-
cial security contributions if they continue
to become due during the interruption;
interest, economic depreciations, basic
rates for third-party energy, expenses for
the current upkeep of buildings and ma-
chines, rent, taxes and other non-speci-
fied working expenses, expenses for the
preservation of vested rights, insurance
premiums and other business expenses,
e.g. guaranteed commissions.
60 MW diesel aggregates in a diesel power station.
Not included in standing charges, how-
ever, are turnover taxes and expenses
for raw or auxiliary materials, fuels and
goods purchased unless they serve to
continue operations; excise taxes, freight
charges, specified licence and inventor’s
fees and similar expenses.
Loss minimization costs are also covered
if they lower the insurer’s obligation to in-
demnify. These include expenses that
avoid, minimize or terminate an interrup-
tion loss soon after the occurrence of
material damage.
Loss minimization is of great importance – Overtime work, additional shifts, work
in MLOP insurance. The following are ex- on Sundays
amples.
to accelerate repairs

on undamaged machines to reduce
– Purchase/sale of semi-finished goods the interruption loss
– Provisional repairs – Rent of machinery (e.g. transformers,
boilers, compressors)
– Early overhauls
– Recommissioning of old machinery
– Purchase of non-identical (but com-
patible) machinery – Shifting of operations to alternative
plants
– Express, airfreight
– Making up for the production loss after
reopening
2.2 MW back-pressure steam turbo-generator in a
sugar factory.
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 the
company power plant fails,
– renting machinery,
– applying alternative methods,
– purchasing semi-finished or finished
goods,
then increased cost of working insur-
ance is recommended for the plants in
question as an alternative to full MLOP
cover.
Damage to a steam turbine generator in a paper
mill.
5
2 Indemnity period limit and time
excess
To make a risk assessable for the insur-
er, it is necessary to apply certain limits
to the period for which indemnity is pro-
vided. This is done by specifying a pe-
riod of indemnity.
Damage to a piston compressor.
Even a short circuit in coils of a large electric motor
driving an important machine may lead to major LOP
damage.
6
2.1 Indemnity period limit
In contrast to a material loss, the loss of
profits following a business interruption
depends on the time factor involved. In
other words, the longer the period for
which 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 the
insurer is obliged to provide indemnity for
an interruption loss. This is done by the
insured specifying an indemnity period
limit which represents the maximum time
for which an insurer is liable for loss of
profits. The period of indemnity begins
on the date on which material damage
could 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 of
profits commenced. Generally the in-
demnity period limit is three, six, nine or
twelve months; a period of more than
twelve 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 the
interruption 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 premiums
are, of course, charged for long indem-
nity period limits.
Broken calender of the coating unit in a paper mill.
Destruction of the gearing of an offset printing press
due to the failure of control systems.
2.2 Time excess
Under normal circumstances, losses due
to interruption lasting for a short period
of, say, up to seven days can be borne
by the insured company itself. It is, there-
fore, advisable to exclude such minor
losses from the cover provided. This is
done by specifying a time excess of a
number of days during which any loss of
profits 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 than
seven days. The time excess to be ap-
plied depends on the quantity of finished
products stored, the possibilities of
catching up with lost output, and the fi-
nancial burden which can be accepted
by the insured company itself. If a long
time excess is agreed, the premium
may be reduced considerably.
Failure of the public power supply and deterioration
of the material processed can be covered under an
MLOP policy. This feature is of importance for an
aluminium smeltery, for example.
7
3 Sum insured, value insured, valua- 3.3 Valuation period
tion period
The valuation period comprises twelve
The following terms are also of great im- months and ends at the point in time at
portance in MLOP insurance: which interruption lossses no longer oc-
cur (lost operating profit and standing
3.1 Sum insured charges), at the latest, however, at the
end of the indemnity period limit.
The sum insured is made up of the oper-
ating profit and the standing charges in
the course of twelve successive calendar
months (i.e. normally the business year).

3.2 Value insured

The value insured is made up of the

operating profit and the standing charges
which the insured would have earned DM/Time
without taking any indemnifiable interrup-
tions in the valuation period into consid-
eration.

Damage

Time

Interruption




Material Indemnity period




damage Indemnity period limit

The indemnity period ends at the point in time at

which interruption losses no longer occur.

Operating profit
 Operating
profit

Wages, salaries, pensions

Interest, depreciations Fixed Sum
Non-specified taxes costs insured
Fixed costs (e.g. licence fees)
Basic power rates

Insurance premiums
Turnover

Raw, auxiliary materials; fuels

VAT, turnover tax Variable
Energy consumption costs
Postage and freight charges
Licence fees (non-specified)

Contract penalties

Determination of the sum insured.

8
4 Underinsurance
On the basis of the sum insured and the
value insured, it is possible to check
whether underinsurance is involved
when a loss of profits claim arises: This
is the case whenever the sum insured is
lower than the value insured. Under-
insurance can be avoided by making
allowance, when calculating the sum
insured, for the probable trend of the
insured’s business in the financial year
following the current period of insurance.
Electronics LOP insurance covers electronic
medical equipment for which no alternative exists.
If the trend of the current period of insur-
ance alone were considered, losses oc-
curring towards the end of the year might
cause 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 having
to pay an excessive premium due to a
very conservative fixing of the sum insur-
ed. According to this clause, a pro rata
return of premium is made in respect of
that share of the sum insured which ex-
ceeds the actual value insured for that
period of insurance.
9
5 Determination of premiums
To make MLOP insurance successful, it
must not only cater for the specific needs
of the market but also charge premium
rates which are commensurate with the
risks involved. Due allowance must
therefore be made for the following
factors when determining premiums:
– The general and the specific technical
risk of the machinery to be insured
– The effect of machinery breakdowns
on the operating profit and standing
charges (factor of relative importance)
– The reserve facilities and spare parts
available
– The possibilities of loss minimization
– The general economic and political
conditions

– The “moral” and technical hazard re-

lating to the user

Red-hot shell of the rotary kiln of a wood pulp works

after destruction of the lining.

Wood pulp and paper industry plants are very

exposed and therefore often protected by MLOP
insurance, such as this paper machine for
newspaper.

10
5.1 The general and the specific tech-
nical risk of the machinery to be in-
sured

The general technical risk of a machine

is dependent on its average claims fre-
quency and the average interruption pe-
riod. These two fundamental values must
be calculated on the basis of statistics.
Provided that maintenance of the machi-
nery is first class, these values depend
primarily on the type of machine involved
and its capacity.

This basic premium rate resulting from

these criteria applies to machinery of
proven design which is in good condition.
However, it must be noted that these pre-
conditions are often not met. Then the
specific technical risk must be conside-
red in the basic premium rate by apply-
ing a loading.
Company “infrastructure” is an object for MLOP insu-
rance, e.g. boilers for the generation of process
steam.

The protection of MLOP insurance also applies to

small machines, e.g. rotary offset printing presses.

11
5.2 The “moral” and technical hazard
relating to the user
The moral hazard depends on how quali-
fied the management and the staff of a
plant are, and is also influenced by the
standing of the firm in the view of manu-
facturers and service organizations. The
following figures show to what extent the
moral hazard is influenced by the quality
of staff.
Of 1,740 claims involving the most varied
types of machinery, it was found in a
study that 62% were caused by faulty
operation. 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 a
risk is assessed, considerable impor-
tance must be attached to the training of
the operating personnel by the insured.
12
The technical hazard of the risk depends
on the plant organization, the loss pre-
vention measures taken (regular mainte-
nance, systematic supervision by means
of indicating and measuring instruments,
provision of safety devices and carrying
out of non-destructive tests), and the
possibility of repairing damage either at
the plant itself or at least in the same
country. Should the inspection of a plant
to be insured reveal that standard loss
prevention 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.
Compressors are often the reason for bottlenecks;
their failure may lead to the standstill of the entire
enterprise.
5.3 The effect of machinery break-
downs on the gross profit (factor of
relative importance)
Allowance is made for the effect of the
breakdown of machinery by means of
the 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 period
of insurance would have on the operating
profit and the standing charges. When
determining the factor of relative impor-
tance, allowance should not be made for
the production. It should not be fixed ac-
cording to possibilities of loss
minimization. Ideally, factors of relative
importance should be fixed on the basis
of a flow chart which shows, in addition
to 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 relative
importance himself, as he is the only one
who has the necessary detailed knowl-
edge. If the factor indicated is too low,
underinsurance will be claimed.
5.4 The reserve facilities and spare
parts available
The reserve factor is determined on the
basis of the information provided regard-
ing the reserve facilities available, and di-
rectly influences the premium calcula-
tion. The reserve factor is always less
than 1, as any reserve facilities available
will reduce the risk borne by the insurer.
It is mainly dependent on the type and
number of machines available, the num-
ber of failures if one machine stands still,
and the ratio between the total capacity
available and the load requirement. The
availability of spare parts is taken into ac-
count when calculating the premium by a
corresponding spare parts factor, also
less than 1.

Machine tools installed

in series:

100% 100% 100% 100%

1
2
3
4

in parallel:

60% 100%

100%

1
3 100%

2
4 100%
40% stand-by

Factors of relative importance depend on the operat-

ing configuration.

13
5.5 The possibilities of loss minimiza-
tion

The results of MLOP insurance depend

to a great extent on the loss minimization
measures 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 of
substitute motors, generators, transform-
ers, boilers, small turbines, etc. or the
speeding up of repair work by carrying
out complex welding operations even on
high-alloy materials or using metalock
and other special repair methods on the
damaged components.

Tube mill of a cement factory.

Discussion of loss minimization possibilities at the

damaged front wall of a cement tube mill ...

14
 Airfreight, if necessary with chartered wide-bodied
aircraft, shortens interruption periods considerably.

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

15
5.6 The general economic and politi- Conclusion
cal conditions
Modern machinery loss of profits insur-
Apart from delays in the repair of dam- ance is a suitable means of meeting the
aged machinery due to the location of an increasing need on the part of industry
insured plant, it is also quite possible that for comprehensive tailor-made insurance
the general economic and political condi- protection from the consequences of
tions prevailing in a country will result in business interruptions. Experienced en-
an extension of the normal repair period. gineers must carefully assess the plants
Such extensions may, for example, be to be insured and calculate the premi-
caused by the time required for procure- ums, duly taking into account all the fac-
ment of import and export licences, by a tors influencing the risk conditions in the
shortage of foreign exchange, or by pro- most various countries. In this way it is
visions or restrictions imposed by gov- possible for insurers to obtain satisfac-
ernmental authorities or other public tory results and further expansion in this
institutions. particularly hazardous class of business.

In many countries it is often not possible,

when concluding a policy, to anticipate all
of these possibilities, so the risk involved
for the insurer must be limited by apply-
ing a so-called “delay in repairs clause”.

Modern slab line controlled by a process computer.

Even small damage may lead to complete standstill.

16
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).