Computation of Loss of Profit Claim | Steps, Formula & Average Clause Explained

Insurance

Insurance is a contract of indemnity in which one party, known as the insurer, agrees to compensate the other party, known as the insured, for any loss covered under the terms of the contract. This protection is provided in exchange for a fixed amount called the premium.

Insurance Claim

The insurer becomes liable to compensate the insured only when the specific event, against which the insurance policy was taken, actually occurs. The amount payable by the insurer on the occurrence of such an event is called the Insurance Claim or simply Claim.

Example: ABC Export has insured its inventory under an indemnity contract with United India Insurance Co. Ltd. After paying the required premium, ABC becomes eligible for compensation if the insured inventory suffers any loss.

Fire Insurance Claim

Fire insurance policies are generally issued for one year. The amount for which the policy is taken is known as the Policy Amount.

These policies typically cover the following risks:

1. Loss of stock
2. Loss of tangible fixed assets
3. Loss of profit

Claim for Loss of Stock (Stock Insurance)

Under stock insurance, the insurance company agrees upon payment of a fixed premium to indemnify the insured for any loss of stock caused by fire.

However, the insurer’s liability is restricted to the lower of:

1. The actual loss suffered by the insured, or
2. The policy amount.

The actual loss is calculated by deducting the value of stock saved or salvaged from the estimated value of stock on the date of fire. If the stock is under-insured, the insurer bears only a proportionate part of the loss.

1. Procedure for Determining the Amount of Claim

Step 1: Ascertain Stock on the Date of Fire To compute the stock on the date of fire, a Memorandum Trading Account is prepared up to the date of fire.

Memorandum Trading Account (for the period up to the date of fire)

Particulars	Amount (₹)	Particulars	Amount (₹)
To Opening Stock (at cost)		By Sales
To Purchases		By Stock on Date of Fire (balancing figure)
To Direct Expenses
To Gross Profit

The balancing figure on the credit side represents the value of stock on the date of fire.

2. Determine the Actual Loss by Fire

• Actual Loss = Value of Stock on Date of Fire – Salvage Value
• If the Average Clause does not apply, the actual loss becomes the amount of claim.

3. Apply the Average Clause (if applicable)

The Average Clause is used to discourage under-insurance, i.e., when the insured takes a policy for less than the actual value of stock.

This clause applies only when the amount of actual loss is less than the policy amount.

Formula:

Actual Insurable Value means the estimated value of stock on the date of fire.

Example:

• Estimated stock on date of fire = ₹80,000
• Policy taken = ₹50,000
• Actual loss = ₹20,000

By applying the average clause, the insured must bear the remaining portion of the loss himself. Hence, this clause is also known as the Coinsurance Clause.

Illustration 

Mr. Suresh prepares accounts to 30th June each year, but on 30th September 1993, a fire occurred in his premises which destroyed a considerable part of his stock. His books, which were saved, disclosed the following information:

Particulars	Rs.
Stock on 30th June, 1993	20,000
Purchases from 1st July to 30th September	40,000
Commission paid to purchase manager on purchases	2%
Carriage on purchases	200
Sales from 1st July to 30th September	60,000

Average percentage of gross profit to sales for the last three years was 25%.

The stock to the value of Rs. 5,000 was salvaged. Prepare an account to ascertain the amount to be recovered from the insurance company.

Solution:

Memorandum Trading Account for the three months ended 30th September, 1993

Particulars	Amount	Particulars	Amount
To Opening Stock	20,000	By Sales	60,000
To Purchases	40,000	By Estimated Stock (balancing figure)	16,000
Add: Carriage	200
Commission	800
	41,000
To Gross Profit (25% of 60,000)	15,000
Total	76,000	Total	76,000

Statement of Claim

Particulars	Amount
Estimated Stock at the date of fire	16,000
Less: Stock Salvaged	5,000
Amount of Claim	11,000

Claim for Loss of Tangible Fixed Assets

The procedure for determining the claim for loss of tangible fixed assets due to fire is similar to the method used for stock insurance. For the purpose of indemnification, the book value of the fixed asset is taken as its value on the date of fire.

To calculate the actual loss, the salvage value of the destroyed or damaged asset is deducted from its book value on the date of fire.

• Actual Loss = Book Value on Date of Fire - Salvage Value 

The resulting figure represents the amount claimable from the insurer, subject to the terms and limits of the policy.

Illustration 

Fairdeal Co. had a fire in the premises on 1st August, 1993 which destroyed most of the building. Fairdeal Co. has a fire insurance policy covering the building for Rs. 8,00,000. It was agreed that three-fourth of the building had been lost and that at the time of the fire, the book value of the building was Rs. 10,00,000. Find out the amount of claim.

Solution:

Actual Loss Suffered

= 10,00,000 × 3/4

= Rs. 7,50,000

Amount of Claim

= (8,00,000 / 10,00,000) × 7,50,000

= Rs. 6,00,000

Claim for Loss of Profits or Consequential Loss

When a severe fire occurs, it not only damages assets but also disrupts normal business operations. This disruption can lead to a significant decline in trading results due to the partial or complete suspension of business activities.

A standard fire insurance policy covers only the loss of property caused by fire. However, to cover the loss of profits arising from business interruption, a separate policy known as a Loss of Profit Policy or Consequential Loss Policy is taken.

This policy aims to indemnify the insured against losses resulting from the suspension or reduction of business operations following the destruction of property by fire.

Coverage of Loss of Profit Policy

A Loss of Profit (or Consequential Loss) Policy typically covers the following risks arising out of a fire:

1. Loss of Net Profit Loss of profit caused by the interruption of business operations after the fire.
2. Non-Recovery of Standing or Fixed Charges These are expenses that must be paid even when business activities are halted, such as:
• Rent
• Rates and taxes
• Salaries
• Maintenance expenses
• Other fixed overheads
3. Increased Cost of Working Additional expenses incurred to maintain business operations temporarily, such as:
• Renting temporary premises
• Temporary repairs to damaged assets
• Extra operational costs to reduce the loss of profit

Computation of Claim for Loss of Profit

To compute the claim under a Loss of Profit (Consequential Loss) Policy, the first step is to determine the period of claim.

Period of Claim

The period of claim will be the shorter of:

1. The Indemnity Period (as specified in the policy), or
2. The Actual Period of Dislocation, during which the business operations remain disrupted due to fire.

Six Steps to Compute the Claim

1. Ascertain the Reduction in Turnover (Short Sales)

The reduction in turnover during the claim period is called Short Sales.

• Short Sales = Standard Sales - Actual Sales during Claim Period

Example:

• Fire Date: 1st July 1993
• Claim Period: 1st July 1993 to 30th September 1993 (3 months)
• Standard Sales: Sales during the same period of the previous year (1st July 1992 to 30th September 1992)

2. Calculate the Gross Profit (G.P.) Ratio

This ratio represents the percentage of turnover that is expected to convert into gross profit during the current year.

It is based on the previous year's trading results:

3. Calculate the Loss of Gross Profit During the Claim Period

Once short sales and G.P. ratio are known: Loss of G.P. = Short Sales × G.P. Ratio 

4. Add Claim for Increase in Cost of Working

These are additional expenses incurred by the insured to reduce the fall in turnover, such as:

• Hiring temporary premises
• Temporary repairs
• Extra machinery hire

The Increase in Cost of Working (ICW) is added to the loss of gross profit.

5. Deduct Savings in Insured Standing Charges (if any)

If any of the insured standing charges are saved during the claim period (e.g., reduced rent or electricity), they must be deducted from the combined total of:

• Loss of Gross Profit
• Increase in Cost of Working

6. Apply the Average Clause and Compute Net Claim

The Average Clause applies only when there is under-insurance, i.e., the policy amount is less than the gross profit on annual (adjusted) turnover.

This clause ensures that the insurer pays only a proportionate amount if the business is under-insured.

Illustration 

From the following details, ascertain the value of a claim under a loss of profit policy:

• Indemnity Period: 6 Months
• Value of Policy: Rs. 50,000
• Date of Fire: 1-10-1993
• Dislocation up to: 28-2-1994

Particulars	Amount (Rs.)
Sales for 1992 accounting year	2,40,000
Net Profit for 1992	26,000
Standing Charges for 1992 (all covered)	34,000
Sales from 1-10-1992 to 30-9-1993	3,00,000
Sales from 1-10-1993 to 28-2-1994	9,000
Sales from 1-10-1992 to 28-2-1993	60,000

Solution:

• Indemnity Period: 6 months
• Dislocation Period: 5 months
• Hence, Claim Period = 5 months

Step 1: Calculation of Short Sales

Particulars	Amount
Standard Turnover (i.e., Sales from 1-1-1992 to 28-2-1993)	60,000
Less: Actual Turnover during claim period	9,000
Short Sales	51,000

Step 2: Calculation of G.P. Ratio

Step 3: Loss of Gross Profit during claim period

G.P. Lost = Short Sales × G.P. Ratio  =51,000×25%=Rs.12,750

Step 4 & 5:

No additional information regarding increased cost of working or savings in standing charges.

Therefore, Gross Claim = Rs. 12,750

Step 6: Ascertaining Net Claim

Calculation of Actual Insurable Value

Particulars	Amount
Annual Turnover = Rs. 3,00,000
Actual Insurable Value (i.e., G.P. on Annual Turnover) = 3,00,000 × 25%	Rs. 75,000

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