Careful Review of Business Insurance During Diligence Can Reduce Operating Costs on Day One For M&A Buyers

Even sophisticated buyers normally perform only a rough-and-ready assessment of the target’s commercial insurance arrangements in the diligence process leading up to closing. Most of the time, they are missing a chance to reduce operating costs on day one of their new ownership. And the cost reductions could be material.

For most companies—even small and middle market ones—the business insurance portfolio represents a significant cost. Especially for companies with substantial manufacturing equipment, the “all in” cost of the enterprise’s commercial insurance will normally be five to ten times the cost of all outside accounting and finance services, and will often exceed all legal expenses.

But in the M&A deal process, the quality and cost of the acquired company’s business insurance rarely receives a disciplined and independent assessment. Dealmakers and their counsel would serve their clients well by making sure that such a studied analysis is conducted and discussed in detail before closing with capable brokers and product specialists, including the target’s incumbent broker and an independent advisor. By rightsizing the insurance in place to meet the risk appetite of the new owner, and by taking a fresh look at the appropriateness of data driving premiums, savings generally will be in six figures for smaller companies, and will often reach seven figures for larger targets. Here’s why and how:

• What usually happens in diligence
The usual approach to insurance diligence is the compilation of a list of the various policies in place, accompanied by a summary of the most essential information from the policy declarations. This is normally prepared by the seller’s broker or the buyer’s broker (who may be the same), and is then reviewed by buyer’s counsel. The going-in assumption is that “insurance pretty much takes care of itself”. Nothing approaching the buyer’s financial analysis to scrub the quality of revenues or earnings is conducted. Questions central to the appropriateness of the target’s insurance—and its cost—are usually not asked. And if they are, the answers are rarely independently tested.

• Two examples of frequently overlooked opportunities
What, specifically, will a fresh look at the target’s insurance purchases produce? The likely opportunities for cost reduction and coverage improvement are numerous, but here are two areas that in our work almost always result in revised approaches at materially less expense.

  • Estimates of business interruption loss by location are too high, resulting in higher property insurance premiums
    For most companies, the property insurance program will be the most costly, usually accounting for at least half of consolidated insurance premiums. The premium charged for this coverage is computed from a base comprised of two sets of estimated values submitted by the target company. One set is the estimated cost to replace buildings, plant, and equipment at each of the company’s sites. The second set, known as the “business interruption” or “time element loss”, is the estimate of lost gross profits for each site, assuming a hypothetical disablement of that site for a stipulated twelve-month period. The sum of these two sets of values constitutes the “total insured value” against which the premium is computed. (E.g., if the estimated cost of replacing all of the company’s property and equipment is $500 million, and the total of all estimated business interruption loss is $500 million, the total insured value is $1 billion. If the insurance company has quoted a rate of $.12 (twelve cents) per dollar of insured estimated values, the annual premium will be $1.2 million.

    We consistently find that companies—large and small—tend to overestimate the amount of business interruption loss that will occur at many of its sites. It is not uncommon to find an estimate for a small manufacturing location equal to many times the historical EBITDA for that site. Or for a sales office to be listed with significant estimated profit loss. When this happens, premium is being paid for loss that can never be payable under the policy. In the example above, if the combined business interruption loss has been overestimated by $200 million, the target is paying $240,000 more in premium than it should be, assuming the quoted rate is appropriate.

  • Liability insurance disconnects with target’s loss history and the nature of its business
    The selection of liability insurance is normally driven by: 1) the risk appetite of the company purchasing it; and 2) the broker’s success in recommending specialty policies. More attention should be paid to the actual paid loss history of the target under the coverage in place. Nothing else is as telling as to the appropriateness of the liability policies. One good example is coverage known as “employment practices liability” (EPL) insurance. Many companies, perhaps including your target, have purchased it, especially in recent years. This coverage can add value to companies with large employment forces but very small legal departments. The policy acts more like a claims handling mechanism, than as true risk transfer insurance. In our reviews for companies, we usually find that these policies rarely produce a paid claim, because the self-insured retention (including for legal fees) is normally much higher than any historical paid claim, and the claims that present high cost exposures (such as claims under the Fair Labor Standards Act) are expressly excluded altogether. If paid claims over the past five years reflect less than 75 percent of the aggregate premium over that period (and you will find they often reflect 0-10 percent), you are looking at the opportunity to send real money directly to the bottom line.

Rethinking Deductible Strategies: Are You Stuck In The “Same Old, Same Old”?

When asked to comment on liability insurance policies, we are often struck by the deductible or retention structure we find, and it’s close cousin, policy premium. We see many financially strong companies with modest deductibles or retentions and the high premiums commanded by them. And we are often surprised at the limit purchased—usually it is lower than we would expect in a risk-sensitive company carrying a low deductible or retention.

Many companies go year-in and year-out with the same deductible structure. For companies with revenues between $500 million and $2 billion, we often see a general liability (GL) deductible of $250,000, and sometimes even lower. At renewal, a routine conversation occurs with the broker. Benchmarking data is consulted. The outcome is almost reflexive. Usually, the deductible stays the same, even as limit is increased. (It is remarkable how as companies grow, the amount of insurance purchased tends to increase more significantly than the retention or deductible.) And keep in mind that benchmarking data is merely a way of seeing what others are doing. It does not mean others are doing it right!

Get the CFO’s Insights

In most companies the CFO receives an annual insurance renewal briefing. But how often is the following proposition put to the CFO: “Our current retention is $250,000. We’re a fairly large company. Would it really be a serious financial problem to us if we suffered a $2 million loss in a given year?” In our experience, many CFOs will answer: “No. But I wouldn’t want two or three of them in a year.”

In other words, most CFOs look at liability risk in periodic aggregate terms. Repeated big hits must be insured against because they aggregate to serious consequences. But the rare, single big hit can be tolerated, as can routine lower value losses. Conventional thinking about retentions and deductibles, on the other hand, almost always looks at the risk in terms of per occurrence or per claim, with the same retained exposure for each and every one of them, whether it’s the first claim or the fiftieth in the policy period.

Where is it written that all SIRs and deductibles must attach or apply at the same level for all occurrences or claims? It isn’t written anywhere. It’s just the way it has nearly always been done, and, unfortunately, without enough linkage to the company’s true risk appetite or consideration of alternative structures.

We think “drop down” retentions (sometimes referred to as “corridor” retentions or deductibles) deserve much more attention than they receive, especially for companies without high frequency loss histories and good cash flow. A $1 billion revenue company with a good loss history and a per occurrence or per claim deductible of $250,000 or less, will significantly reduce premium cost by moving to a $2 million retention for the first (or first two) covered occurrence or claim in the policy period, with its original lower retention or deductible applying to additional occurrences or claims, should there be any to pierce it. For most good risks, there won’t be.

The Bottom Line:

There are ways to work from the CFOs appetite and look at deductible structure more creatively. And many CFOs will be pleased by the results. Why? Because by rethinking your deductible approach, the true concern of the enterprise—losses large enough to impair the balance sheet—can be protected, while the premium component, (the certainty component) of Cost of Risk (COR), can be reduced, or redeployed to increase limits, thereby meeting what should be the real objective: insurance against disaster. You may well find that by restructuring your deductibles, you can buy smart, and buy more, if you should be, for the same overall expenditure.