What it means
The term does two jobs, one in insurance and one in contract law. In insurance it names the cover that pays for lost profit and extra working costs after an insured event, usually sold as business interruption cover.
In contracts it turns up in exclusion clauses, where one side refuses to be liable for the other's lost profits, lost contracts or damaged reputation. A supplier selling a $4,000 valve does not want to be on the hook for the $2,000,000 of production a customer lost when that valve failed.
Courts read those clauses narrowly, and what counts as consequential is less obvious than it sounds. Losses that flow naturally from a breach are often treated as direct, while losses arising from special circumstances the supplier was told about are the ones normally labelled consequential.
On the insurance side the calculation rests on gross profit, defined as turnover less the costs that disappear when trading stops. That definition is narrower than the accounting one, so a business that insures the wrong figure discovers it is underinsured at the worst possible moment.
The other moving part is the indemnity period, the maximum length of time the policy will keep paying. Firms pick twelve months out of habit, when a specialist plant may need two or three years to rebuild, re-equip and win its customers back.
In practice
Real-world examples.
Example
A bakery loses its main oven to an electrical fault. The oven costs $40,000 to replace, but the six weeks of missed supermarket orders wipe out $180,000 of gross profit, and the supermarket hands half the shelf space to a rival while the bakery is out of action.
Example
A cloud software provider caps its liability in every contract at twelve months of fees and excludes consequential loss outright. When an outage costs a retail client an estimated $900,000 in abandoned baskets, the client recovers only the $75,000 of annual subscription fees.
Example
A shipping delay leaves a furniture importer without stock for the whole of its peak trading quarter. The freight forwarder refunds the $18,000 shipping charge but refuses the $260,000 of lost margin, pointing to the consequential loss exclusion in its standard trading terms.
Formula
Calculation
Insured consequential loss = (lost turnover x gross profit rate) + increased cost of working - savings in insured standing charges
Gross profit rate = insured gross profit / turnover
A components manufacturer turns over $3,000,000 a year with variable costs of $1,800,000, so its insured gross profit is $1,200,000 and its gross profit rate is $1,200,000 / $3,000,000 = 40%. A fire closes the plant for four months, a period in which normal turnover would have been $250,000 a month, so lost turnover is 4 x $250,000 = $1,000,000.
Lost gross profit is therefore $1,000,000 x 40% = $400,000. The company also spends $60,000 renting temporary premises to keep its largest customer supplied, and saves $25,000 of insured standing charges such as power and haulage that it never incurred while shut. The consequential loss claim is $400,000 + $60,000 - $25,000 = $435,000, entirely separate from the material damage claim for the building and the machinery.Case study
Seen in the real world.
The following is an illustrative and entirely fictional example. Halberd Extrusions, an invented aluminium fabricator, insured its factory for $6,000,000 of material damage and bought business interruption cover with a twelve month indemnity period based on $1,200,000 of annual gross profit.
A fire in the paint line destroyed the presses. Rebuilding the shell took nine months, but the specialist presses carried an eighteen month lead time, so the plant did not return to normal output until month twenty two. The policy stopped paying at month twelve, leaving about ten months of lost profit, roughly $1,200,000 x 10 / 12 = $1,000,000, entirely uninsured.
The lesson the finance director drew afterwards was that the indemnity period, not the sum insured, had been the binding constraint. At renewal the fictional company moved to a thirty six month period, which raised the premium by about 40% and removed the exposure that had nearly ended the business.
Watch out
Common mistakes.
- Insuring the accounting definition of gross profit rather than the insurance definition, which adds back fixed costs and usually produces a much larger figure to insure.
- Assuming that an exclusion of consequential loss removes all liability for lost profit, when courts frequently classify ordinary lost profits as direct damage.
- Choosing a twelve month indemnity period by default without asking how long replacement plant, planning consent and customer recovery would genuinely take.
Questions
People also ask.
Does business interruption cover start paying immediately?
Most policies apply a short waiting period, often 24 to 72 hours, and only respond to losses caused by an event the material damage section of the same policy also covers.
What is increased cost of working?
It is extra spending incurred purely to reduce the loss of profit, such as renting temporary premises or paying for express freight, and it is claimable up to the amount of profit it saves.
Can a contract exclude consequential loss in both directions?
Yes, and mutual exclusions are common, though a buyer with real bargaining power will usually carve out data breaches, intellectual property claims and death or personal injury.
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