From the information given below, calculate the sum insurable : Date of fire—01.03.2016 Turnover from 01.03.2015 to 29.02.2016—₹ 88,00,000 Agreed GP ratio—20% Special circumstances clause provided for the increase of turnover by 10%

Correct — A, (a) ₹ 19,36,000. Under a loss-of-profit policy — also called a consequential loss policy — the thing insured is not the stock or the building but the gross profit that the fire destroys by stopping the business. The sum for which such a policy ought to be taken, the sum insurable, is therefore the gross profit on the annual turnover: the turnover of the twelve months immediately preceding the date of the fire, adjusted by the special circumstances clause where the trend of the business justifies an adjustment, and then multiplied by the agreed gross profit ratio.

The paper hands you all three inputs and the arithmetic is one line. The fire is dated 01.03.2016, and the turnover given runs from 01.03.2015 to 29.02.2016 — exactly the twelve months immediately preceding, the February date carrying twenty-nine days because 2016 was a leap year. That annual turnover is ₹ 88,00,000. The special circumstances clause provides for an increase of turnover by 10 per cent, so the turnover to be worked on is ₹ 88,00,000 × 110% = ₹ 96,80,000. Applying the agreed gross profit ratio of 20 per cent gives ₹ 96,80,000 × 20% = ₹ 19,36,000.

The order of the two steps does not matter, which is a useful check in the exam hall: taking 20 per cent of the unadjusted ₹ 88,00,000 gives ₹ 17,60,000, and raising that by 10 per cent gives the same ₹ 19,36,000.

The reason the sum insurable is computed at all is the average clause. If the policy is taken for less than the sum insurable, the insurer treats the assured as his own insurer for the shortfall and scales the claim down in the ratio that the sum insured bears to the sum insurable. A firm that insures for ₹ 15,00,000 when the sum insurable is ₹ 19,36,000 recovers only about 77 per cent of its computed loss, however genuine the loss is. Getting this figure right at the time of taking the policy is what protects the claim later.

Why the others are wrong

• (b)₹ 48,40,000 — ₹ 48,40,000 is exactly half the adjusted annual turnover of ₹ 96,80,000, and no step in a consequential-loss computation produces a half. The check that disposes of it takes a second: when the agreed gross profit ratio is 20 per cent, the gross profit cannot possibly be 50 per cent of turnover. This figure is two and a half times the correct answer, which is the size of error that comes from applying a percentage to the wrong base or from slipping a place while working in lakhs.
• (c)₹ 10,32,000 — ₹ 10,32,000 is smaller than the gross profit on the turnover before any adjustment at all — 20 per cent of ₹ 88,00,000 is ₹ 17,60,000 — and the special circumstances clause here works upward, not downward. So a candidate who has completed even the first step of the computation can strike this option out without finishing the sum. It corresponds to no stage of the calculation the data support.
• (d)₹ 24,20,000 — ₹ 24,20,000 is 25 per cent of the adjusted turnover of ₹ 96,80,000, and it is the trap this item is built around. A gross profit of 20 per cent on sales is the same margin as 25 per cent on cost, and a candidate drilled on that conversion may perform it here out of habit. It is the wrong move: in a loss-of-profits policy the agreed gross profit ratio is by definition a ratio to turnover, so it is applied to turnover as it stands. Convert it to a cost-based rate and you inflate the sum insurable by a quarter, which would mean paying premium on profit the business never earns.

A loss-of-profit or consequential loss policy indemnifies a business for what a fire costs it after the flames are out — the profit it fails to earn while it cannot trade, and the standing charges it must keep paying anyway. The vocabulary is fixed and every one of the terms has a defined meaning. Gross profit for this purpose is net profit plus insured standing charges, expressed as a ratio to turnover from the last completed accounting year. Turnover is the money paid or payable for goods sold and services rendered. Standard turnover is the turnover of the period corresponding to the indemnity period in the twelve months immediately before the fire, and annual turnover is the turnover of the twelve months immediately before it; both may be adjusted under the special circumstances clause so that they represent as nearly as possible the results that would have been obtained but for the fire. The indemnity period is the period, beginning with the fire and not exceeding the maximum stated in the policy, during which the results of the business are affected. The claim itself has two limbs — the gross profit lost on the short sales, and the increased cost of working incurred to keep the business going — reduced by any savings in insured standing charges, and then scaled by the average clause if the policy was under-written.

Key facts

• Sum insurable under a loss-of-profit policy = gross profit ratio × annual turnover, adjusted under the special circumstances clause.
• Annual turnover is the turnover of the twelve months immediately preceding the date of the fire.
• Here: ₹ 88,00,000 × 110% = ₹ 96,80,000; ₹ 96,80,000 × 20% = ₹ 19,36,000.
• Gross profit for a consequential loss policy is net profit plus insured standing charges, not the trading-account gross profit.
• The special circumstances clause exists to adjust standard and annual turnover for trends and special circumstances so the figures reflect what the business would have done but for the fire.
• The average clause reduces a claim in the ratio of the sum insured to the sum insurable whenever the policy is taken for less than the sum insurable.
• The claim comprises gross profit on short sales plus increased cost of working, less savings in insured standing charges.
• The indemnity period runs from the date of the fire for the maximum period stated in the policy, during which the results of the business are affected.

Common traps

• Applying the gross profit ratio to the unadjusted turnover and ignoring the special circumstances clause, which here loses ₹ 1,76,000.
• Converting a gross profit ratio on sales into a mark-up on cost. The agreed ratio in this policy is already a ratio to turnover.
• Confusing the sum insurable with the sum insured or with the claim; the first is what the policy ought to be taken for, the second what it was taken for, the third what is finally paid.
• Reading the twelve-month window wrongly when the fire falls early in a month, or forgetting that February 2016 ran to twenty-nine days.
• Forgetting the average clause when the sum insured is smaller than the sum insurable, which is the whole reason the sum insurable matters.

• practice — not a real PYQ

  A fire occurred on 01.07.2016. The turnover for the twelve months to 30.06.2016 was ₹ 50,00,000, the agreed gross profit ratio 30%, and the special circumstances clause provided for an increase of turnover by 20%. The sum insurable is

  • (a)₹ 15,00,000
  • (b)₹ 18,00,000
  • (c)₹ 20,00,000
  • (d)₹ 12,00,000

  Answer(b) ₹ 18,00,000

• practice — not a real PYQ

  Under a loss-of-profit policy, gross profit means

  • (a)sales less the cost of goods sold
  • (b)net profit plus insured standing charges
  • (c)net profit less uninsured standing charges
  • (d)sales less all standing charges

  Answer(b) net profit plus insured standing charges