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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:
D-80791 München
Germany

http://www.munichre.com

Order number 0224-E-e/175.1

The paper used for this brochure was


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 b The standing charges, i.e. the costs Not included in standing charges, how-
incurred entirely or in part if operations ever, are turnover taxes and expenses
MLOP insurance provides cover for the are interrupted or impaired. These com- for raw or auxiliary materials, fuels and
actual loss of profits sustained as a re- prise wages and salaries, including so- goods purchased unless they serve to
sult of a business interruption caused by cial security contributions if they continue continue operations; excise taxes, freight
material damage indemnifiable under to become due during the interruption; charges, specified licence and inventor’s
machinery insurance. MLOP insurance interest, economic depreciations, basic fees and similar expenses.
provides indemnity also in cases where rates for third-party energy, expenses for
the material loss amount falls below the the current upkeep of buildings and ma- Loss minimization costs are also covered
deductible to be borne by the insured chines, rent, taxes and other non-speci- if they lower the insurer’s obligation to in-
under the machinery cover. Basically fied working expenses, expenses for the demnify. These include expenses that
speaking, a loss due to an interruption preservation of vested rights, insurance avoid, minimize or terminate an interrup-
or interference of business operations premiums and other business expenses, tion loss soon after the occurrence of
is made up of the following factors: e.g. guaranteed commissions. material damage.

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, 60 MW diesel aggregates in a diesel power station.
business interruption can often be avoided by buying
third-party energy. Increased cost of working insur-
ance covers such cases.

4
Loss minimization is of great importance – Overtime work, additional shifts, work If, in the course of arranging the in-
in MLOP insurance. The following are ex- on Sundays surance, it becomes evident that enter-
amples.  to accelerate repairs prises can continue to work after
 on undamaged machines to reduce material damage, e.g. by
– Purchase/sale of semi-finished goods the interruption loss
– acquiring third-party electricity if the
– Provisional repairs – Rent of machinery (e.g. transformers, company power plant fails,
boilers, compressors)
– Early overhauls – renting machinery,
– Recommissioning of old machinery
– Purchase of non-identical (but com- – applying alternative methods,
patible) machinery – Shifting of operations to alternative
plants – purchasing semi-finished or finished
– Express, airfreight goods,
– Making up for the production loss after
reopening 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.

2.2 MW back-pressure steam turbo-generator in a


sugar factory.

5
2 Indemnity period limit and time 2.1 Indemnity period limit judged according to the recognized
excess principles of engineering, at the latest,
In contrast to a material loss, the loss of however, on the date when the loss of
To make a risk assessable for the insur- profits following a business interruption profits commenced. Generally the in-
er, it is necessary to apply certain limits depends on the time factor involved. In demnity period limit is three, six, nine or
to the period for which indemnity is pro- other words, the longer the period for twelve months; a period of more than
vided. This is done by specifying a pe- which operation is interrupted or im- twelve months can be agreed on re-
riod of indemnity. paired, the greater the loss of profits. quest. The basic rule is that the indem-
For this reason it is essential to set a cer- nity period limit should relate to the
tain limit for the period during which the amount of time required for removing the
insurer is obliged to provide indemnity for interruption loss, i.e. for repairing the
an interruption loss. This is done by the machinery damaged or for the delivery
insured specifying an indemnity period of new machinery in cases of a total loss,
limit which represents the maximum time assembly and trial run. Higher premiums
for which an insurer is liable for loss of are, of course, charged for long indem-
profits. The period of indemnity begins nity period limits.
on the date on which material damage
could first be said to have occurred, as

Damage to a piston compressor. Broken calender of the coating unit in a paper mill.

Even a short circuit in coils of a large electric motor Destruction of the gearing of an offset printing press
driving an important machine may lead to major LOP due to the failure of control systems.
damage.

6
2.2 Time excess The minimum time excess is two days,
but normally it should not be less than
Under normal circumstances, losses due seven days. The time excess to be ap-
to interruption lasting for a short period plied depends on the quantity of finished
of, say, up to seven days can be borne products stored, the possibilities of
by the insured company itself. It is, there- catching up with lost output, and the fi-
fore, advisable to exclude such minor nancial burden which can be accepted
losses from the cover provided. This is by the insured company itself. If a long
done by specifying a time excess of a time excess is agreed, the premium
number of days during which any loss of may be reduced considerably.
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).

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 If the trend of the current period of insur-
ance alone were considered, losses oc-
On the basis of the sum insured and the curring towards the end of the year might
value insured, it is possible to check cause substantial underinsurance.
whether underinsurance is involved
when a loss of profits claim arises: This On the other hand, a special premium re-
is the case whenever the sum insured is fund system is provided by MLOP insur-
lower than the value insured. Under- ance in the form of a premium adjust-
insurance can be avoided by making ment clause to avoid the insured having
allowance, when calculating the sum to pay an excessive premium due to a
insured, for the probable trend of the very conservative fixing of the sum insur-
insured’s business in the financial year ed. According to this clause, a pro rata
following the current period of insurance. 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.

Electronics LOP insurance covers electronic


medical equipment for which no alternative exists.

9
5 Determination of premiums – The effect of machinery breakdowns
on the operating profit and standing
To make MLOP insurance successful, it charges (factor of relative importance)
must not only cater for the specific needs
of the market but also charge premium – The reserve facilities and spare parts
rates which are commensurate with the available
risks involved. Due allowance must
therefore be made for the following – The possibilities of loss minimization
factors when determining premiums:
– The general economic and political
– The general and the specific technical conditions
risk of the machinery to be insured

– 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 The technical hazard of the risk depends
relating to the user on the plant organization, the loss pre-
vention measures taken (regular mainte-
The moral hazard depends on how quali- nance, systematic supervision by means
fied the management and the staff of a of indicating and measuring instruments,
plant are, and is also influenced by the provision of safety devices and carrying
standing of the firm in the view of manu- out of non-destructive tests), and the
facturers and service organizations. The possibility of repairing damage either at
following figures show to what extent the the plant itself or at least in the same
moral hazard is influenced by the quality country. Should the inspection of a plant
of staff. to be insured reveal that standard loss
prevention measures have not been
Of 1,740 claims involving the most varied taken or that repair work must nearly
types of machinery, it was found in a always be done abroad, insurance cov-
study that 62% were caused by faulty erage can only be provided if a corre-
operation. Statistics compiled in the Unit- sponding loading is charged on the
ed Kingdom show that of 500 losses in- premium.
volving ammonia compressors, approxi-
mately 53% were due to human error.
Compressors are often the reason for bottlenecks;
their failure may lead to the standstill of the entire
It is therefore quite obvious that when a enterprise.
risk is assessed, considerable impor-
tance must be attached to the training of
the operating personnel by the insured.

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5.3 The effect of machinery break- It is very important for the insured to de- 5.4 The reserve facilities and spare
downs on the gross profit (factor of termine and indicate the factor of relative parts available
relative importance) importance himself, as he is the only one
who has the necessary detailed knowl- The reserve factor is determined on the
Allowance is made for the effect of the edge. If the factor indicated is too low, basis of the information provided regard-
breakdown of machinery by means of underinsurance will be claimed. ing the reserve facilities available, and di-
the so-called factor of relative impor- rectly influences the premium calcula-
tance. This factor corresponds to the per- tion. The reserve factor is always less
centage effect which a complete stand- than 1, as any reserve facilities available
still of a machine during the entire period will reduce the risk borne by the insurer.
of insurance would have on the operating It is mainly dependent on the type and
profit and the standing charges. When number of machines available, the num-
determining the factor of relative impor- ber of failures if one machine stands still,
tance, allowance should not be made for and the ratio between the total capacity
the production. It should not be fixed ac- available and the load requirement. The
cording to possibilities of loss availability of spare parts is taken into ac-
minimization. Ideally, factors of relative count when calculating the premium by a
importance should be fixed on the basis corresponding spare parts factor, also
of a flow chart which shows, in addition less than 1.
to these factors, the capacities of the ma-
chines and any reserve machinery.

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).