The insurance traps that FDs must avoid
08 Sep 2011, Financial Director
Roger Flaxman, Flaxman Partners
INSURANCE IS the bane of many an FD's life. 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. This
strategy can backfire, as a finance 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 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 was 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 this was what caused the fire.
The company was in breach of a "storage and packaging condition" in the policy that required all plastic
and other hazardous material to be stored away from any heat-generating equipment. 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 rise in premiums from the new insurer.
The sum insured on business interruption (BI) was also completely miscalculated and the BI cover period
– 18 months – turned out to be 15 months too short. Unexpectedly, it took 14 months to get planning
permission to rebuild and another 19 months to build and re-equip the factory with machinery and plant.
BI is notorious for often being under-assessed. The net cost to the company, uninsured, was £2.6m,
representing an overall under-insurance of 37% on a total loss of more £7m.
The FD had relied heavily upon the broker firm for support and guidance on sums insured and adequacy
of cover. The broker did its best but it did not know much about the finances of the company and its
ability to survive a serious event because it received little or no support from the FD or the firm's
Upon investigation of 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 and measuring
risk and the effects of a serious loss was wholly inadequate. Whose fault was it? That was the inevitable
question asked of the board and of the several directors whose business lives and reputations were
damaged by a protracted loss of business and custom.
This case sadly reflects some of my own experiences as an insurance claims advocate handling disputed
insurance claims for companies. It is reinforced by the recent findings of 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: what
are the implications for company directors and boards, and how the report's recommended protocols can
be implemented in practice.
The report's beneficial recommendations are predicated on the idea that the insurance industry becomes an
insurance profession which, in my opinion, will be a sea change of an unprecedented magnitude. But
there are still elephant traps of which finance directors should be aware.
Consider how insurance is typically bought
The 300-year-old UK market is fundamentally a transactional trading industry. Insurance is mainly
bought on price. According to Mactavish/PwC, brokers, the main distribution and sales channel for
commercial insurers, are paid between 0.1% and 0.2% of the contingent capital arranged, whereas banks
are paid between 10.0% and 20.0% 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 have a duty to take more care in buying the insurance
products and services is sound advice. There is an implied duty to the company to take care to transfer its
risks away from the balance sheet. The Mactavish/PwC report creates 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 they
know 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 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, could give rise to embarrassing questions for
the board from shareholders and stakeholders, should a loss or claim goes unpaid.
Roger Flaxman is managing director of Flaxman Partners