Get a handle on company risk and insurance

Insurance is the bane of many an FD's life and only too often it fails to attract the time and energy that it really requires as part of the economic balancing of the company's risk profile.

This is not surprising. Insurance is costly, complex, understood by few, appreciated by even fewer and often fails to deliver when most needed. What is the incentive to spend time and effort as well as money on it? Brokers are relied upon heavily, possibly too heavily, to advise on cover and sums insured and this can backfire as a financial director of a company in the Midlands recently found out.

The company lost its entire factory in a serious fire caused by an electrical failure which ignited plastic wrapping on recently delivered stocks of materials. The insurers sent loss adjusters to calculate the damage and to report on the company's compliance with the policy terms and conditions. All was not well.
 
The sum insured on buildings was inadequate by more than 25%.

Stock was underinsured by nearly 300%; the reason given being that the company had taken advantage of a special price on stock, which was delivered to the factory with the intention of transferring it to another warehouse. Meanwhile, the stock was piled around machinery and equipment and it was this that caused the fire.
The company was in breach of a "storage and packaging condition" in the policy that, in essence, required all plastic and other hazardous material to be stored away from any heat-generating equipment (of which there was a lot ). This gave the insurers the right to refuse all coverage. They were persuaded not to do so in this case but the company was refused insurance at the next renewal, causing a severe uplift in premiums from the new insurer.
The sum insured on business interruption (BI) was completely miscalculated and the BI cover period, 18 months, turned out to be 15 months too short, it taking an unexpected 14 months to get planning permission to rebuild and a further 19 months to build and re-equip the factory with machinery and plant. BI is notorious for being under-assessed.

The net cost to the company, uninsured, was £2.6m, representing overall under insurance of 37% on a total loss of more £7m.

The FD relied heavily upon the broker firm for support and guidance on sums insured and "adequacy" of cover. The broker did its best but, because it received little or no support or meaningful information from the FD or the firm's accountants, the broker was not in a position to know much about the real financial economics of the company and its ability to survive a serious event.

Upon investigation of the facts behind the calculations given by the company to insurers, and relied upon by them for the placement of the insurance, it became clear that the entire process of assessing information, calculating and measuring potential risk and the effects of a serious loss was wholly inadequate. Whose fault was it? This was an inevitable question asked of the board and of the several directors whose business lives and reputations were severely damaged by a protracted loss of business and custom.

This case sadly reflects some of my own experiences as an insurance claims advocate of handling disputed insurance claims for companies. It is reinforced by the recent findings expressed in a study by Mactavish/PWC Corporate Risk & Insurance:  The case for placement reform”. Published in March and focusing on the inherent failings of commercial insurance law and practice, the study poses two essential questions; its implications for company directors and boards and how the report's recommended protocols can be implemented in practice.

While the report's wise and beneficial recommendations are predicated on the insurance industry becoming an insurance profession which, in my opinion, will be a sea change of an unprecedented magnitude, there are still elephant traps for financial directors to be aware of.

Consider how insurance is typically bought
The 300-year-old UK market is fundamentally a transactional trading industry. Insurance is mainly bought on price and brokers, the main distribution and sales channel for commercial insurers, are paid, according to Mactavish/PwC, typically between 0.1% and 0.2% of the contingent capital arranged whereas banks are typically paid between 10.% and 20% of the contingent capital they arrange. That says something about how little insurance is valued.

Understand the extent of your company’s duty of care with regard to risk
Mactavish/PwC's balanced assertion that buyers too have a duty to take more care in buying the insurance products and services is sound advice.  There is at least an implied duty to the company to take care to transfer its risks away from the balance sheet. The Mactavish/PwC report creates, by its publication alone, a useful benchmark for the duty and obligations of executive directors and their implied duty of care to the company on matters of avoiding risk and preparing for loss or damage by insurance or other suitable means.

Seek a balance in the contractual relationship
Insurers know everything about the words and phrases used in their proposal form and policy and how they will interpret them in the event of a claim. By comparison, the insured knows almost nothing and so is exposed to a wholly disproportionate and unreasonable imbalance of contractual risk despite the underlying two-way doctrine of utmost good faith upon which contracts of insurance are founded.

The Case for Placement Reform sets out some useful, correctly identified and undeniably prudent standards for insurance selection and buying that, if ignored, now that they are in the public domain could cause the board embarrassing questions by shareholders and stakeholders if their loss or claim goes unpaid.

Roger Flaxman ACII, MAE, CEDR Accr. Mediator.
Managing Director
Flaxman Partners