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Reducing Default Rates and Costs through Assurance of Adequate Borrower P & C Insurance Programs
by Joseph M. Inwald, J.D., CPCU
Joseph M. Inwald, J.D., CPCU provides Expert Services related to P & C Insurance Program adequacy and Broker conduct. He worked in Hospital Administration and as an associate at a mid-sized Law Firm representing various Health Care Providers and Insurers prior to service as an Officer at an International Insurance Broker and at a leading Insurer of Hospitals and Physicians prior to the establishment of ICS, Inc. in 1992. ICS also provides product development and management consulting services to Insurers and Alternative Risk Vehicles. He is a graduate of the Wharton School and the U. of Michigan Law School. He can be reached at (248) 406 5038 or at JInwald@comcast.net.
How an Appropriately Experienced Insurance Expert May be a cost Effective Solution
How to properly incent staff and Experts in this context
Banks and other lending institutions serve a vital role in providing capital to productive business enterprises. Their core competence is to identify organizations that can make good use of capital, to identify those that are good business risks, and to properly document resulting loans. While most loans are asset based in some sense, those loans where the primary security consists of Accounts Receivable and Inventory are particularly susceptible to non-business risk associated with inadequate insurance. The focus of this article to identify some significant exposures that, through no fault of ongoing borrower management or the loan approval process, could impair the expected value of the business collateral and, in the absence of Property & Casualty Insurance claim payments, prevent expected and achievable loan repayment.
We will discuss the necessary elements of an effective loan officer protocol in this context and also suggest the type of external service offerings that can support or, in certain contexts, provide a cost-effective substitute for inherent internal limitations.
Scope of the Problem
Every day thousands of loans are written off or written down. Of those, hundreds are caused by losses to business assets, third party claims, or customer claims that a well-structured Property & Casualty (P & C) insurance program would have responded to. For instance, using the Katrina experience as a good model, many businesses and their bankers learned expensive lessons regarding the various ways that inadequate limits, unexpected exclusions, and uncovered assets created significant uninsured losses. Otherwise successful businesses and their lenders suffer unnecessary loss. This is, from our perspective, an area where an ounce of prevention is worth many pounds of cure.
The term P & C Insurance is intended to encompass both common policy types and others that many bankers and other business people are not always familiar with. Most of us have some sense of the need for coverage typically provided by a Property, Commercial General Liability (CGL), Commercial Automobile (Auto), and Umbrella or Excess Liability Policies. Fewer understand that when there is a products liability or a products recall, an Employment Practices Liability Insurance (EPLI), an Inland or Ocean Marine, a Directors & Officers (D & O), a Pollution, or a Professional Liability Insurance Policy can enable a borrower to continue its business success in the face of a large loss caused by an unexpected accident, disaster, or law suit. Fewer still have the time and expertise to evaluate whether the insurers have reasonable financial strength and have supplied insurance policies without exclusions that would preclude coverage for such loss events. It is also difficult, even with access to benchmark data, to assess whether limits of coverage are sufficient in the circumstances.
Steps to Assure Proper Coverage at Loan Inception
Buildings, vehicles, and business equipment need to be properly listed, or referenced, on insurance documentation in order to be covered by most standard commercial insurance policies. Any discrepancies between (1) asset listings supplied by the borrower, OR (2) aggregate values contained in financial statements, AND (3) the values or items listed in the policies and the attached schedules of insured items, need to be reconciled. For instance, one recent borrower had inadvertently reported 44 vehicles to its insurer and more than 200 as a part of the loan application. This oversight was corrected prior to loan closing. In this case, the lack of liability coverage was more significant than the impairment of physical capital exposure. With regard to the latter, it is easy to envision a fire or flood in the yard impairing a large percentage of the borrowers collateral. Items not insured need special attention with regard to protection or risk management. If, for instance, there is no earthquake coverage, then some investigation of how inventory is stored or how buildings have been secured would seem to be in order. Some exclusions which are hard to avoid can be managed and might be the subject of loan covenants or certifications. In the context of uninsured earthquake coverage, it might make sense to limit the percentage of inventory kept in a certain county or location. Ocean or Inland Marine Policies, which cover items being shipped, frequently have a sublimit applicable to single shipments, e.g., $100,000 per truck load or $250,000 per ocean going ship or barge. If these insurance limits can not be properly adjusted, then it is often prudent to have loan covenants/restrictions conformed to the Policies limitations. Limits in Property insurance are relatively more straightforward to evaluate than for liability policies. Verifying that building and equipment values reported are, in fact, insured based on current values, is typically a ministerial task. Assessing the adequacy of business interruption limits and coverage triggers requires familiarity with both the business operations and the fine print contained in often lengthy policy documents. Addressing the adequacy of liability limits requires both a more nuanced understanding of the business process and a sense of the range of expenses associated with major law suits. Various services report jury verdicts for various types of claims. There are also databases which can be accessed that contain survey data on insurance limits and deductibles purchased by business based on the type of coverage, SIC code, revenue, employee count, and geography.
For many borrowers specialized insurance policies are necessary to place foreseeable risk with insurers that can assess and help to manage these exposures. If no insurance is purchased, the lender, by default, may become the party that ends up paying for these claims when they arise. Most Property, CGL Policies, and Excess or Umbrella Policies, for instance, exclude Pollution and Product Recall costs. While these can be expensive, there is typically both risk transfer and specialized risk mitigation services bundled in these products. To the extent that the potential borrowers sole reason for not buying them is the cost, rather than a reasonable argument that they do not provide good value, we would suggest that a large red flag has just been raised. The underwriting process used often times prompts or requires business practices that are designed to reduce the frequency and cost of applicable claims. In the context of Pollution Policies, some exclude the use of particularly hazardous materials. Both Pollution and Product Recall Policies require formal contingency plans to address proper ways to deal with situations that could result in claims. They commonly include immediate access to experts that can play a meaningful role in both pre- and post-accident risk mitigation.
All insurance policies have exclusions. While there is almost always a section so labeled, they can also be found in the Insuring Agreements, in definitions, and in various Endorsements. In one recent Product Recall Policy secured by a commercial baker that was seeking a substantial loan, much of the expected value was obviated by an Endorsement which excluded claims where there were any genetically modified components (GMOs) in the product. It is not possible with any degree of certainty to ascertain whether or not trace GMOs could enter into the borrowers complex supply chain. In this instance, other financially strong insurers provided similar coverage without this endorsement.
Role of the Insurance Broker
Initially, it should be noted that the borrower is the brokers client. Captive agents, less prevalent for commercial as opposed to personal lines, owe their loyalty to their Insurance Company principal rather than to the customer. There is no countervailing duty to the public of the sort placed on CPAs or Attorneys. Second, there is a wide range of levels of expertise presented by insurance brokers (aka agents or producers). The license to sell commercial P & C Insurance can generally be secured by a high school graduate after completion of a 40-hour training course and a 2-3 hour multiple choice exam. While larger agencies employ personnel with significant and sufficient training, e.g. CPCU, RPLU, MBAs, & JDs, and experience, e.g., former insurance company underwriters, technical experts, the percentage of their staffs with appropriate skills and time to devote to their assigned clients varies. Larger agencies use smaller accounts as teaching material for new hires. The best and brightest at many agencies are slotted to sales or high level account management rather than to securing the optimal, or even good, policies for each customer. Sometimes there is a disconnect between the sales person or account manager that knows the most about the borrowers business and the person back in the office who negotiates with the insurer or reviews the policies assembled. It is the rare business that has a Risk Manager, or other knowledgeable employee or consultant, who reviews the policy set delivered by the broker.
Potential Solutions for Lending Institutions
As a starting point, lending officers should be asked to secure full copies of existing insurance policies rather than just certificates of insurance. Most officers can check whether assets such as vehicles or inventory are included on schedules of insured assets. Lending officers can verify that the declarations pages, aka Coverage Summaries, properly list the legal name and have current addresses for assets that might be encumbered as a part of the loan.
Reviewing the financial strength of Insurers can often be done internally. While many rely on a minimum A.M. Bests rating, wed suggest a more nuanced approach that also considers the amount of applicable business conducted by the nsurer, surplus, and reputation for prompt claim payments. Consideration of sufficient limits can also be done internally by many organizations, particularly in the context of property coverages.
In-house, or retained, counsel can provide valuable guidance on the interpretation of specific language in insurance policies and indemnity provisions. They are clearly critical in crafting insurance-related loan covenants.
Some larger institutions rely on their internal Insurance Risk Management personnel. With the appropriate staffing and prioritization, these individuals can provide great value and prevent their organization from becoming a de-facto insurer as well as the banker. Others ask their own insurance broker to serve in this role. Sometimes the broker can devote sufficient personnel to provide needed service, particularly when they see an opportunity to sell their services to your borrowers.