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Private Equity and Venture Capital: Insurance Expense – Risk Managers Bring Value to Portfolio


8/21/13

Key Takeaways

Richard Schurig, CPA, Partner and member of CohnReznick’s Private Equity and Venture Capital Industry Practice says:

  • Consult with independent risk managers during the normal course of business operations and during the due diligence process
  • Use the bid specification process to tailor your insurance coverage to your risk profile
  • Independent experts will understand and advise appropriately on the coverage provided by the company’s insurance policies
  • Insurance costs can dramatically affect the valuation of a company being bought or sold

 

Private equity firms and their portfolio companies value the benefits of managing risk – therefore, when possible, they often engage independent risk managers that assist them in navigating the complicated business of protecting them from risks and liabilities. For private equity firms, assessing risk is particularly critical, translating to a bottom-line benefit for the firm’s portfolio companies and consequently a direct value enhancement.

At most Fortune 500 companies, teams of internal risk managers carefully negotiate with insurance companies and insurance brokers. They craft bid specifications that tailor insurance coverage to the needs of the individual company. They are responsible to read through each line of each insurance policy, which often runs to hundreds of pages per policy, to ensure that they:

  • Have enough of the right type of coverage
  • Are getting competitive pricing
  • Are absorbing and transferring exposures to risk in financially and strategically responsible ways
     

However, many private equity firms and portfolio companies may be at an intellectual capital disadvantage and may not be in a position to hire a full-time risk manager and required ancillary support – yet, they can consult with independent risk management experts who can provide the highest level of risk management advice, and provide strategic plans to achieve the client’s risk management goals. 

Risk management consultants can act as if they are in the office down the hall and bring a broad spectrum of ideas and best practices, which can be a significant advantage in countering the silo effect. The silo effect occurs when the insurance industry (brokers/insurers) categorizes and underwrites within only industry-specific guidelines.  This oftentimes does not allow creative solutions and fosters repetitive transfer structures which yield the same results year after year.

The numbers tell the story. As a representative illustration, one of the CohnReznick’s national private equity firm clients engaged an independent consultant in each of their 18 portfolio companies and in due diligence on prospective acquisitions. The relationship delivered savings in excess of $40 million in insurance premiums, and created in excess of $100 million in increased portfolio company valuations.  

Tailor the coverage to the company

Companies that are able to hire independent risk management consulting firms often begin with a due diligence process consisting of a full audit of the company’s exposures to risk and its existing insurance contracts. Insurance companies sometimes offer relatively generic policies. Risk management consultants can recommend potential changes to the company’s coverage and tailor it to meet their unique needs.

Many portfolio companies that don’t consult with an independent risk manager are often over-exposed and/or under-covered. They may buy insurance for risks that they don’t realistically face, and components of their current insurance program may not align structurally with their particular risk profile. Such excess premiums could amount to millions, or even tens of millions of dollars, reducing portfolio company earnings and the fund’s total return. Moreover, gaps in coverage could be even more disastrous.

The process of defining the coverage that a company needs is called an “exposure analysis” which, once agreed, gets transferred to a “bid specification” which requests the proper coverage for the exposure. Fortune 500 companies are very familiar with the bid specification process and spend a significant amount of time formulating the specific coverage that they agree to purchase, in advance of actually purchasing their policies. Other companies leave the bid specification process to their insurance brokers or rely on applications or websites to convey their risk profile to the underwriting community.  This method does not often align with the best risk profile of the company.

Unbiased independent guidance

Independent risk management consulting firms bring a unique perspective to the analysis, negotiation, purchasing, and performance oversight of insurance products and services.  From a vantage point completely outside the insurance sales and distribution system, these consultants strengthen a financial officer’s ability to obtain optimal transfer-of-risk products and services at the most competitive terms. 

A pure risk management consultant is compensated solely and directly by the client and will have no contractual arrangements with brokers or insurers -- yielding a transparent and unique advisory arrangement that aligns the consultant’s interests with those solely of the client.  Furthermore, the risk management consultant is able to identify coverage gaps, recommend enhancements, negotiate rates, and most importantly, guide the client through how the insurance “system”’ works to the client’s advantage.

Read the policy

Risk management consultants carefully read through the insurance policies purchased by their clients – often starting with the exclusions and endorsements in the back.

At most middle-market private equity firms and their portfolio companies, executives often simply don’t have time to read the insurance policies, let alone carefully analyze the impact of every line. A typical insurance policy can run to 100 - 200 pages of technical contractual language. Some middle-market portfolio companies carry close to a dozen of these policies, not including health and pension insurance. Common insurance policies include Property, General Liability, Worker’s Compensation, Directors’ and Officers’, Employment Practices Liability, Fiduciary Liability, Employee Theft (Crime), and Auto Fleet. Each policy begins with a summary of the insurance coverage, followed by page after page of definitions, conditions, exclusions and endorsements that often substantially alter, reduce, or altogether eliminate coverage that the buyer thought he or she had purchased.

Accordingly, a portfolio company is at risk because these “exceptions” to coverage may go unnoticed until a subtle discrepancy is discovered at a time when coverage is most needed — such as after a natural disaster impacts a company’s ability to continue operations. Catastrophic occurrences can have a dramatic impact on a company’s bottom line if the risk is not identified and transferred properly. This is the case whether there is a direct loss to domestic operations or to suppliers located around the world, causing supply chain disruption and financial loss. Examples of these occurrences in more recent years include domestic storms like Super Storm Sandy and Katrina, as well as the Tsunami which hit Japan and caused pervasive flooding in Asia.
 
Most insurance policies arrive with a letter to the client requesting that they review their policy such that it meets their needs and advise if any changes are needed. However, does the client take the time to read the policy?  If they do, will the nuances in wording be apparent?

Risk management consultants guide their clients through the process of negotiating with their existing brokers and insurance providers, or soliciting and evaluating bids from alternate providers. When the written insurance policy finally arrives from the insurance company, risk management consultants carefully review and verify the policy, with all of its exclusions and endorsements for their clients. In the absence of strong technical advice and oversight, it’s not uncommon for the actual insurance policy to arrive with significant differences from the coverage a company agreed to purchase in its bid specifications.

Portfolio companies that use risk management consultants also examine the levels of exposure that they choose to retain through the purchase of high-deductible or high-retention insurance policies. Typically, the formal administration of these self-insured or retained claims is carried out by an insurance company or a Third Party Administrator (TPA) in exchange for a fee. Risk management consultants carefully track the cost of claims and also ensure that the claims administrator has the staff resources to handle these self-insurance claims, including both the staff’s experience levels and overall workload.

What Are the Benefits of an Independent Insurance Due Diligence Review?

The benefits of engaging an independent risk management consultant are especially significant in the due diligence process, when every dollar saved in operating cost can add multiple dollars to the valuation of the company

If private equity firms and their portfolio companies do not carefully understand their exposures, and how to request/negotiate for their insurance, they might miss out on discounts, credits, or coverage that insurance companies offer to other companies with a similar risk profile.

Some portfolio companies with more than $700,000 a year in insurance costs (other than health and pension insurance) have often achieved annual savings from 4 to upwards of 12 times the amount of the annual fee they pay for the service.

When evaluating a potential acquisition, a good independent risk management consultant conducts a comprehensive due diligence process that analyzes the risk management issues involved and recommends both insurance and non-insurance-related actions where necessary. In many cases, the consultants find significant potential insurance savings that can make a financial impact in getting a deal done.

Contact:  

For more information, please contact Richard Schurig, Partner, at 973-364-6670.

For information on CohnReznick’s Private Equity and Venture Capital Practice, visit our webpage.


Circular 230 Notice: In compliance with U.S. Treasury Regulations, the information included herein (or in any attachment) is not intended or written to be used, and it cannot be used, by any taxpayer for the purpose of i) avoiding penalties the IRS and others may impose on the taxpayer or ii) promoting, marketing, or recommending to another party any tax related matters.

This has been prepared for information purposes and general guidance only and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick LLP, its members, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.

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