We have been receiving a lot of queries recently about how inventory is valued by an insurer in the event of a loss. One common question is, “Why do I get what I paid to buy the inventory rather than the retail price I charge for the inventory?” This post aims to clarify how inventory is typically valued for insurance purposes.
Claims settlement is based on the principle of indemnification. That is, you will be put back in the position you were in before the loss occurred. What this means in the case of a merchant’s inventory of goods for sale is that it is valued at what the merchant paid for the goods purchased for resale rather than what the retail price of the item is. In addition, a retailer can charge less than the manufacturer’s suggested retail price or even give the product away as a part of a promotion.
Entities value their inventory in one of four ways. They are Specific Unit, Weighted Average, First In First Out (FIFO) and Last In First Out (LIFO.) Using the Specific Unit method, the cost of the specific item in the inventory is used in the calculation of its value. The Weighted Average method bases an inventory’s value on the average cost of the items in the inventory. FIFO bases the value on the principle that the first item purchased in the inventory is the first item sold. LIFO makes this basis on the principle that the last item purchased is the first item sold. Not only does how inventory is valued affect the entity’s Income Statement, it also affects the amount of insurance coverage needed for the inventory and how any inventory loss is settled.
Another factor in determining how much coverage is needed is how the inventory fluctuates over time. Entities whose operations are affected by seasonality will see the amount of their inventory increase during their peak season compared to their off season. Entities who wish to have their business inventory valued at the appropriate level for the season can have their inventory valuation increased for the peak season to cover the time they have an increased amount of inventory.
Finally, in order to make sure the inventory valuation is correct, it is a best practice to conduct a physical inventory of stock annually to make sure that the valuation in the insured’s books and records reflects the actual inventory.
Now that we have discussed inventory, let’s get back to the initial question and what the merchant is really asking. The merchant may really want to know how his income from the business can be protected should a loss occur. Business Income coverage is designed to indemnify the entity for income lost during the period the entity is shut down for restoration.
Business income insurance also provides for reimbursement of certain continuing expenses that an entity incurs during the period of restoration. Examples of continuing expenses include salaries and employer mandated contributions of key employees, lease obligations of the insured that are continuing during the period of loss and (of course) premiums for insurance coverage.
Business income coverage can also include coverage for extra expenses incurred in order to shorten the period of restoration in the event of a loss. For example, the building a merchant’s store is in has been damaged to the point where the building is declared uninhabitable. The merchant would be indemnified for expenses associated with procuring space to conduct operations as well as having new inventory shipped to him overnight so that he or she can reopen sooner. The merchant benefits by being able to resume operations sooner and the insurer derives a benefit from this coverage in that it reduces the period of restoration for which an insurer is obligated to cover business income.
If you would like to learn more about how we can help you with your inventory, business interruption or other business insurance please contact us at 1-877-900-9998 or go to https://bizinsure.com