Insurance Claim for Loss of Stock and Loss of Profit

Recently updated on April 13th, 2023 at 06:23 pm

Though fire is common and is known to all, the legal meaning of fire is important. Fire means actual ignition and not chemical effects which may be similar to those which are produced by fire; for example, loss because of excessive heat will not be treated as loss by fire. Also, in case of fire giving rise to a claim, something which ought not to be on fire should be on fire.

Loss of Stock Policy

When a fire occurs, it destroys a number of assets such as building, machinery, furniture, stock, etc. The books of account maintain accounts of all the assets except (usually) stock-in-trade. The value of stock on hand on the date of fire, therefore, has to be estimated.

This is done by ascertaining the cost of goods sold (sales minus the gross profit at the usual rate) and then deducting it from the total of opening stock, purchases, wages and other manufacturing expenses. All figures except relating to gross profit will be available from the books of account; gross profit will be the average rate of gross profit earned in the previous

Average Clause:

In order to discourage under-insurance, fire insurance policies often include an average clause. The effect of this clause is that if the amount of the policy is less than the value of the subject-matter insured, the insurer will be liable only for that proportion of the loss which the amount of policy bears to the total value of the subject-matter. For example, if stock worth Rs 4 lakh is insured only for Rs 3 lakh and if the loss amounts to Rs 1,80,000, the claim admitted by the insurer will be Rs 1,80,000 x 3,00,000/4,00,000 = Rs 1,35,000.

Self-Insurance and Co-Insurance:

It is possible for a firm to build up its own fire insurance reserves—that will be by debiting the Profit and Loss Account every year and crediting a Fire Insurance Provision Account. Actual loss, if any, would then be debited to this Provision Account. Self-insurance can work only if properties are many and located at different geographical centres or if one has been lucky enough to build up a big provision before loss occurs. When a firm decides to assume the full risk, through a systematic creation of the fire insurance provision, it is a case of self-insurance.

Co-insurance means assumption of a part of the risk by the owner himself. Suppose, a policy has 75% co-insurance clause. It means that, subject to average clause, the insurer will pay the full amount of the loss up to 75% of the value of the subject-matter. For example, a property costing Rs 8 lakh is insured with a 75% co-insurance clause. The loss is Rs 6 lakh and the amount of the policy is Rs 6 lakh 50 thousand.

The insurer will pay Rs 6 lakh. If, however, the amount of the policy is Rs 5 lakh and there is a salvage of Rs 50 thousand so that the loss is Rs 4 lakh 50 thousand, the claim will be Rs 3,75,000, i.e., Rs 4,50,000 x 5,00,000/6,00,000. (Without the co-insurance clause, the claim would have been Rs 2, 81,250 i.e. 4, 50,000 x 5, 00,000/8, 00,000). It should be noted that in no case will the insurer be liable for more than the amount of the policy.

Accounting Entries

For purposes of insurance, fire means (unless otherwise agreed between the insurer and the insured):

  1. Fire (whether resulting from explosion or otherwise) not occasioned or happening through.

(a) Its own spontaneous fermentation or heating or its undergoing any process involving the application of heat;

(b) Earthquake, subterranean fire, riot, civil commotion, war, invasion, act of foreign enemy, hostilities (whether war be declared or not), civil war, rebellion, revolution, insurrection or military or usurped power,

  1. Lightning:
  2. Explosion, not occasioned or happening through any of the perils specified in 1 (a) above:

(i) Of boilers used for domestic purposes only;

(ii) Of any other boilers or economizers on the premises;

(iii) In a building not being any part of any gas works, of gas for domestic purposes or used for lighting or heating the building.

Loss of Stock:

When a fire occurs, it destroys a number of assets such as building, machinery, furniture, stock, etc. The books of account maintain accounts of all the assets except (usually) stock-in-trade. The value of stock on hand on the date of fire, therefore, has to be estimated.

This is done by ascertaining the cost of goods sold (sales minus the gross profit at the usual rate) and then deducting it from the total of opening stock, purchases, wages and other manufacturing expenses. All figures except relating to gross profit will be available from the books of account; gross profit will be the average rate of gross profit earned in the previous years adjusted for known changes.

Suppose:

(1) The stock on 1st April, 2012 was Rs 3, 10,600;

(2) Purchases up to 15th June, 2012, the date of fire were Rs 7, 64,800;

(3) Sales up to that date were Rs 10, 80,000; and

(4) The rate of gross profit on sales is 30%.

The value of stock held on the date of fire can be estimated as under:

The claim to be lodged with the insurer will be for Rs 3, 19,400 less value of the goods saved or salvaged. If salvage comes to Rs 1, 05,600, the claim will be Rs 2, 13,800. The student will see that the key to ascertaining the stock destroyed is the gross profit. Gross profit must always be calculated on the basis of sales. If the rate of gross profit is 40 per cent on cost, then the ratio of gross profit to sales is 40/140; thus

Cost 100
Profit 40
Sales 140

If sales amount to Rs 7, 98,000, the gross profit will be Rs 7, 98,000 x 40/140 or Rs 2, 28,000.

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