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Insurers develop a specialty that covers companies facing pending legal liabilities.
Russ Banham, CFO Magazine
November 1, 2000
Samsonite Corp. was struggling with some heavy baggage as it attempted to recapitalize a couple of years ago. The cause of the load: shareholder litigation, filed in the wake of the stock-price free fall from a failed attempt to sell the company. The suits hampered the Denver-based manufacturer's recapitalization efforts--and threatened consequences even more dire. "No one wants to put money in a company and have it paid out in litigation," explains Samsonite CFO Richard H. Wiley.
The company managed to remove its litigation burden, but not in any of the usual ways. "We insured it," says Wiley. By transferring the risk to an insurance company, in this case American International Group Inc. (AIG), Samsonite eased the worries of the investors it was courting. "The sword of Damocles that hung above us, in terms of how much these shareholder lawsuits would end up costing, disappeared like that," says Wiley, snapping his fingers. "We could focus on recapitalizing the company free from the time-consuming distraction of litigation." In October 1999, six months after buying the insurance, Samsonite got the shot in the arm it needed, raising $55 million.
Pending-litigation insurance, a line first cultivated by AIG, together with insurance broker Aon Corp., both based in New York, has expanded significantly in the past few years. Its recent growth is due in part to Axcelera Specialty Risk, a company started by two AIG executives credited with helping pioneer the strategy. The executives, Gregory Flood and Michael Mitrovic, got major financial backing for Axcelera from Zurich-based Swiss Reinsurance Corp., and they now focus their coverage on what they call "litigation loss mitigation." Other insurers now in the game include Liberty Mutual, the Gulf Insurance unit of Citigroup, and Bermuda-based XL Insurance Co. Companies evaluating the market include Chubb Corp., Kemper Insurance, and Hartford Insurance Group, says Michael Schoenbach, a managing director of loss mitigation at Aon.
While so far most of the pending-litigation deals involve securities lawsuits, insurance can also absorb existing or prospective claims stemming from product, professional, environmental, and employment-practices liabilities. "I've even put together a policy for personal-lines litigation," says Schoenbach. His client, a large corporation, was being sued by an injured employee in Europe, and wasn't adequately covered. "Aon helped them design a travel and accident insurance policy that effectively capped the litigation," he says.
Driving the growth in pending-litigation insurance is, not surprisingly, the robust mergers and acquisitions environment. Mergers or divestitures often spur a company to buy the insurance so that outstanding suits against it won't be a problem in valuation. "Typically, the seller in an M&A scenario that is subject to pending litigation sees the case costing x, while the buyer sees it as x-plus-a-lot-more," says Scott Carmilani, Flood's replacement as AIG's M&A division president. "We come in as the deal facilitator, bridging the gap that can kill the deal."
But even without such a transaction in the works, the insurance can have its uses. "When the company is faced with serious litigation, the treasurer has to carry a large reserve to protect against an adverse outcome," explains Patrick M. Cunningham, vice president of the M&A practice at insurance broker Marsh, in New York. "Rather than tie up assets in a large contingency reserve, many companies are deciding to transfer the litigation to an insurer and take it off the books to protect the balance sheet. That approach enables the company to focus on its core business and priorities."
Other companies may buy the insurance simply to speed up a case's resolution process. "Our experience seems to indicate a much shorter time line for completing litigation when it is handled by an insurer," says Samsonite's Wiley.
"Feel and Experience"
Few litigation-mitigation deals see print. "Those agreements have built into them a confidentiality clause; we can't talk about them to anyone but the client," explains Michael Adler, another former AIG executive in its directors' and officers' (D&O) policy division who is now a vice president at insurance broker Willis, in New York.
Premiums are calculated to exceed the suit's financial outcome, usually by at least 35 percent. "We analyze these cases to determine the most likely worst-case scenario, then tack on about 20 percent to represent a margin of error, and another 15 percent or so for expenses and profit," says Nick Conca, senior vice president in the specialty casualty division of Liberty International Underwriters, a unit of Liberty Mutual in New York. But companies that have bought the insurance often argue that insurers are good at negotiating lower settlement figures, thus helping to keep the total down. "Litigation is their forte," says Wiley. "It's what these companies do."
Projecting the size of a lawsuit requires a painstaking analysis. "A lot of these cases have to do with the type of litigation filed, and how previous similar cases were resolved," according to Axcelera's Mitrovic. "We also take a look at the venue the case is in, and whether or not we've been in front of that judge before with similar lawsuits. We'll examine how those suits turned out, what we think of the plaintiff attorneys in the case, and how successful they've been in that jurisdiction with similar litigation in the past.
"But, really, a lot of this is feel and experience," says Mitrovic. "The risk is that we'll underestimate the cost of pending litigation, with the outcome exceeding the premium we've collected."
Things look good for AIG in the Samsonite suits, although the jury is, almost literally, still out. "We paid $17 million for our risk transfer, exclusive of what we'd already paid out in defense costs prior to buying the insurance," says Wiley. "It was the right deal for us at the time," he adds. "Frankly, it was well worth it."
The federal class-action litigation against Samsonite was settled on July 25 for $24 million. And the federal outcome was recently accepted in a similar state case in Colorado, although a Delaware state court action is still pending. Wiley notes that while AIG paid the settlement figure, it did negotiate a contribution from the carrier of Samsonite's D&O policy, which Wiley declines to name.
The litigation stemmed from shareholder discontent that started in 1998. "Our board had undertaken an effort to sell the company to strategic investors, and that effort ultimately failed," says Wiley. "Subsequently, we releveraged the company. As expected, the value of our remaining shares dropped significantly in price, prompting the lawsuits." (See "Private Dreams.") As the litigation sapped the time and concentration of Wiley and other senior executives, "the weight of this uncertainty had an impact on all of us," he recalls.
"As soon as we bought the insurance, however, there was immediate relief," he says. "We were freed up to focus on the recapitalization." And with its capital infusion, it was able to retire debt, mostly senior and subordinated notes, and defray the premium to AIG.
"They couldn't get the recapitalization done with this case open," says Flood. "Their balance sheet was razor thin on working capital. The insurance gave investors the comfort level to part with their money, knowing this liability was wrapped up and gone."
Wiley agrees. "Uncertainty is a bad thing for the stock and bond markets. The insurance carted it away. Suddenly our future looked bright again." Samsonite's earnings before interest, taxes, depreciation, and amortization last year were $91 million, up from $50 million in 1998.
Since their first AIG litigation deal in 1996, Flood and Mitrovic have emerged as "the guys you go to in the eleventh hour when you've got lawsuits that are threatening your very existence," says Aon's Schoenbach. At Axcelera, they've sold more than half a dozen policies, giving quotes on 40. "At AIG, we were binding three or four deals a month," says Axcelera CEO Flood, 43, who now serves as the firm's underwriting brains, while Mitrovic, 48, concentrates on the litigation.
The two men have also said no to requests for quotes by another 70 potential clients, reflecting the high sensitivity insurers have about entering unfamiliar legal areas.
Their First Client
Flood and Mitrovic took AIG into the litigation game because their clients requested it. "They'd have these open securities cases that were underinsured, at a time when they were looking to sell the company," says Flood. "We'd help them conclude the matter by insuring the pending litigation, thereby creating a clean slate for the buyers or investors coming in."
Their first policy was sold in 1996, to an undercapitalized restaurant concern that was disposing of a food-service unit and its holding company to recapitalize. "Selling the holding company with the subsidiary," says Mitrovic, "would achieve a better tax structure for the deal than if the subsidiary were sold alone." Because of an uninsured securities case against the holding company, though--estimated by the prospective buyer to cost $72 million--the buyer sought a similarly sized price discount. The deal nearly came unglued when the restaurant chain balked, says Flood, but "fortunately, the CFO previously had worked at a client company and knew us."
After examining litigation prospects, AIG and its client calculated a likely cost under $7 million, instead of $72 million. AIG offered $30 million in insurance coverage, with a premium of $7 million, and both the seller and buyer were amenable. When the case finally settled, for less than $7 million, "we made money on the deal," says Flood. The sale of the subsidiary and holding company went through. And an insurance specialty was born. Word traveled fast, and soon the men were getting calls from non-AIG insureds.
"The Unknown Made Known"
Some who buy the insurance bless it for removing skepticism about whether they will survive the litigation. "The investor community is always concerned about the unknown risks a business faces," says James H. Dickerson Jr., president of Caremark Rx Inc., a Birmingham, Alabama, pharmacy benefit management company. "The degree to which you can quantify this risk enhances its comfort level."
Before being renamed in fall of 1999, Caremark Rx, with more than $4 billion in annual revenues, was known as MedPartners Inc. It had weathered a major storm since announcing in January 1998 that it had abandoned a proposed merger with PhyCor Inc., a Nashville-based physician practice management firm. After calling off the merger, "we reported that we'd need to record pretax charges to earnings in the fourth quarter of 1997, bringing these earnings substantially below analysts' estimates," says Edward Hardin Jr., Caremark Rx's executive vice president and general counsel.
MedPartners's stock dropped precipitously, and shareholders sued. The timing could not have been worse. "We were in a restructuring mode, and needed to focus on our core business," says Hardin. "We were all new management, and here we were consumed with this litigation. We had to find a way to put the uncertainty behind us, to focus on executing our business plan."
Enter AIG. Flood calls the MedPartners of that time "a frail company, desperate for reorganization. Shareholder value was completely tied to the resurrection of the company, and the options were limited."
AIG cut a deal with MedPartners, assuming responsibility for the defense and ultimate resolution of about 12 pending lawsuits. "At the time, we had $50 million in D&O coverage from AIG and another insurer, Federal Insurance Co.," says Hardin. "The loss mitigation cover provided unlimited insurance on top of that limit."
The litigation was resolved in August; Hardin says the settlement figure and premium are proprietary. "Suffice it to say this was the right business decision at the time. We did this to focus on our restructuring plan" for the newly named Caremark Rx. "Our management team was able to move forward on our restructuring, and we did so without material adverse financial risk," adds Dickerson. "The unknown was made known at what we believe was a reasonable cost. We put the problem behind us."
The Cost Drawback
At Inso Corp., a Providence-based Web content management company recently rechristened eBT International Inc., a restatement of earnings in February 1999 led to a drop in stock price and to securities litigation, just as it was trying to regroup. "Even though we were righting the ship, we were fighting this losing battle against a perception that the lawsuits would eventually sink the company," recalls Jonathan Levitt, eBT vice president and general counsel.
Inso also turned to AIG. The premium: $15 million with a $1 million "retention," taken as a net charge against earnings in the third quarter of 1999. AIG assumed financial responsibility for the lawsuits that September 29--and Inso's stock price jumped three points. The case was recently settled for $12 million.
CFO Chris Burns of eBT calls the insurance the "critical step" in regaining confidence in eBT. "Once we were able to definitely state that class-action lawsuits wouldn't have any further negative financial consequences," he says, "we were able to convince employees, customers, and the investment community that we could succeed."
Russ Banham is a contributing editor at CFO.
About to Be Totaled by a Recall?
The recent Bridgestone/Firestone Inc. tire recall has companies scrambling to reevaluate their own preparedness for catastrophe. One option is recall insurance. But, unlike pending-litigation coverage--for which the company pays a premium that includes the expected costs--when recall coverage is needed, it's too late to buy it. And even when companies buy insurance in advance for recall costs, they can't figure out a meaningful, affordable amount to carry.
Estimating how much insurance to buy is tricky, says James T. O'Reilly, a University of Cincinnati law professor. For one thing, categorizing the elements of a recall is hard "because accounting systems are not set up to do the reverse of the logistics." It's like "putting the toothpaste back in the tube."
That's one reason the market for recall insurance, which has been offered only since the mid-1980s, is still small, probably garnering less than $1 billion in premiums annually for insurers, according to Robert Hartwig, vice president and chief economist of the Insurance Information Institute, in New York. Another reason is its high cost--"several hundred thousand dollars" for a $10 million policy for an original-equipment auto-parts manufacturer, Hartwig estimates. Some companies choose to self-insure; others forgo any coverage at all.
Pick Your Premium
Recall costs include the notification of customers and acceptance of the returned product, repairing or replacing the product, employee and factory downtime, advertising and crisis control, and punitive damages or fines levied against the company. Coverage can be found to compensate for nearly all these expenses, as well as the cost of subsequent plunges in product sales and market capitalization--for the right price. (Five states prohibit punitive-damages insurance in product-liability cases, however.) "You can insure just about any element of a recall if you're willing to pay the premium," says Arthur Crowe, a product-line manager at Swiss Reinsurance Corp., based in Zurich.
"Premium development is all over the place," he says. Some insurers base the price on a derivative of the customer company's product-liability rate. Sometimes there's a due-diligence-style review of the potential insured, examining manufacturing and quality-control processes as well as the potential for products to cause catastrophic injury or death. Deductibles can mitigate the premium, and many recall policies require copayments. "Most insurers want their clients to have a little skin involved so they have a vested interest in keeping costs down," says Crowe.
The "Aversion Factor"
Not surprisingly, the most severe recall pain is often the lost-revenue, stock-price, or brand-damage hit that lingers long after products are off the shelves, according to O'Reilly. As a lawyer with Procter & Gamble Co. in the early 1980s, he was involved in negotiations with the Food and Drug Administration after P&G's Rely tampons were linked to toxic shock syndrome, and later recalled.
"There's no fixed number for the damage to a firm's reputation from the 'aversion factor,'" he says. But even when a recalled product is replaced by one verified to be perfect, "aversion occurs and sales drop, resulting in loss of opportunity to market the product and build a loyalty arrangement with customers."
In any event, companies even suspecting problems "should immediately issue a recall and get the information public as quickly as possible," says Bill Marler, a Seattle attorney and co-founder of Outbreak Inc., a nonprofit consulting firm that helps handle recalls. "Their chief concern should be to limit exposure to the product. Blow your own whistle. It's the best thing a company can do." —Kris Frieswick