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Safe and sound by design.

As floods, hurricanes, even bombings fill the news, some businesses are suffering because they misjudged their vulnerabilities. Does your company's insurance coverage fit its attitude about risk?

Not long ago, operating asset insurance was a simple matter. Coverage was easy to understand, insurance prices were affordable and settling claims was straightforward. Some firms established relationships with their insurance companies that lasted generations of top management.

No longer. Today, every firm has to build an operating asset insurance program that guarantees protection against potential losses at the best possible price. But that's not as easy as it sounds. You have to understand your potential losses, develop a concrete set of risk and insurance objectives and broker these objectives.

Often, an accounting or finance employee gets the job of dealing with insurance, but he or she doesn't always know as much about operating assets as the people responsible for them. So, if you're trying to assess your asset values and their associated risks, for starters rely on the operating manager in charge of those assets.


When you're developing your list of risk and insurance objectives, you'll need to look at three loss areas: the operating asset, the associated loss from operating interruptions and the losses to third parties who suffer as a result of the operating asset loss.

Operating Assets -- To understand what you might lose, find out what you have. Good accounting and physical plant records won't tell you all you need to know. Taking physical inventories and inspecting assets will fill in the blanks. First, imagine how different calamities will affect you. For example, even modest water damage may destroy your brand new mainframe but will leave relatively undamaged the $200,000 of facility modifications you capitalize as mainframe costs, too. Then again, a serious fire would destroy both.

Second, determine the asset value you'll lose as a result of these mishaps. Accounting book values are just about worthless here because they reflect historic cost. Focus instead on replacement cost or some measure of "value in use," like appraised values.

Operating Interruptions -- Be explicit here. With the help of operating managers, quantify your potential unit output losses and then convert them into financial estimates. Don't settle for "ball park" financial estimates. And test the reliability of the estimates by questioning your managers' assumptions.

Look at operating recovery schedules, too. Will you restore operations at once, or will you return to service in segments? Beware of such items as time estimates you can't reliably assign to recovery activities, exact recovery time estimates for activities that contractors must provide, and complex recoveries that have exact time estimates rather than minimum and maximum time ranges.

Also, decide what you'll do with employees during the recovery period. You can save the payroll through layoffs, but your employees may go elsewhere, leaving you with a smaller labor pool of untrained workers when you resume operations. On the other hand, you can retain all your workers during a reconstruction period, but that may be just too expensive. One alternative is to insure payroll through business interruption coverage; others are to shorten work schedules, rotate short layoff periods between employees, or implement long-term layoffs of only unskilled workers or those with skills in plentiful supply.

Third-Party Losses -- Decide how each potential calamity will affect employees, customers, suppliers and other third parties. This starts by having a sound understanding of laws, government regulations and agreements. Your firm's legal counsel can interpret the relevant regulations and agreements, while the operating managers can assess how any operating casualties will affect your ability to meet vendor and customer obligations. Health care specialists and government agencies can give you information on meeting employee obligations resulting from mishaps. Just remember, don't assign an expertise to yourself that you don't have. Ask for help from experts if you need it.

It's important to thoroughly consider the term "other third parties." Operating managers sometimes have difficulty identifying the impact of casualties beyond their immediate span of control. You need to draw a manager's thoughts beyond his assigned duties. For example, when you discuss potential fire losses, ask about neighboring structures, their contents and their use. Indeed, the loss to an adjoining business caused by your fire could be far worse than your own loss.

Also, survey foreseeable changes in operating assets, production rearrangements or activity levels. Most businesses make constant changes in their operating assets and activities. You're responsible for guaranteeing the firm's insurance policies provide adequate protection throughout the policy period.

Usage and recovery plans may affect your insurance planning, too. For example, a replacement value policy is the wrong choice for a factory that would be drastically changed after a major casualty loss due to either choice or changes in building and safety codes. Likewise, operating interruption coverage would be a good idea for a previously little used building that would soon store an important operating supply.


You have to define in writing your firm's exposure to operating calamity losses because your uninsured exposure can affect your operating and strategic decision-making. For example, if a firm has high uninsured exposures to calamity risk, management may opt for less aggressive operating and financial leverage positions -- which ultimately may mean lower unit costs and higher equity returns.

An ideal group to develop your objectives list will consist of people who have insight into your operations and potential losses and also have a material influence on your firm's operating strategy. Some good candidates include the risk manager, who knows about insurance; the CFO, who supplies the funds for casualty losses that go unprotected by insurance and who must have the cash to pay premiums; operating managers, who have reliable information and perspectives on the operating implications of different objectives; and the CEO, who has the best possible strategic perspective and skills for reconciling the competing interests of risk management, finance and operations.

The group should first evaluate the casualty loss information compiled by the risk manager in the initial phase of the insurance program development. This includes challenging estimates by comparing the current value of prior years' claims and industry data. (Your insurance broker can supply information for industry comparisons.)

Once the group scrutinizes the expected losses, the members should list the potential losses they think they can absorb each year based on their current operating asset and activity configurations, remembering that the expected losses measure only the average losses the company anticipates and not the actual losses it may have to absorb. For example, even though a 5 percent chance of a $1,000,000 casualty yields an expected average annual loss of only $50,000, you periodically will probably incur the full $1,000,000 loss.

In their broadest sense, your risk and insurance objectives should establish an exposure to uninsured operating calamity losses that adequately protects your firm's financial vitality, assures only acceptable operating disruptions, and promotes continuing effective operating and strategic decision-making. How you adapt this broad objective depends on your circumstances.

For instance, a firm led by conservative management may opt for more extensive insurance coverage so executives won't be overly risk-averse in making financial or operating decisions. Or a firm that can easily shift production between locations may be comfortable with insurance from a company with lower rates but a slower claims-settlement process. Or a firm that consistently enjoys a strong cash position may select higher deductibles. It's up to you to carefully balance the strategy you choose to protect your firm from calamities, your managerial character and your strategy for operating in ordinary business conditions.

Profile of a Well-Insured Company

The Farm Equipment Corporation is an established, vertically integrated manufacturer of farm machinery with two final assembly locations and several parts manufacturing locations throughout the Midwest. While fiscally conservative, the company's management also is forward-thinking when it comes to operations and marketing. FEC's long-term strategy is to become a research and development and final assembly operation, eliminating its parts and subassembly divisions through both domestic and foreign contracting.

In establishing its risk and insurance objectives plan, FEC defines separately the coverage it wants for its two operating divisions. But the policy objectives still complement FEC's long-term operating strategy and its managerial character. The company chooses replacement-costs asset coverage for the facilities it wants to reconstruct in St. Louis and appraised-value coverage for the Topeka assets, since FEC ultimately will contract out parts and assembly production.

FEC elects to only partially insure interruption losses in St. Louis since some final assembly can be shifted to another final assembly location. But the company will fully cover the Topeka assets because, if operations are interrupted there, no immediate alternative source of supply exists and interruptions longer than 60 days will increase losses as pulley inventories begin to run out. Also, the Topeka interruption coverage must provide indemnification even if FEC opts to contract out new output rather than replace the current production.

So how does FEC define the coverage to third parties that it needs? With St. Louis, the company has no unique third-party obligations. In Topeka, however, where the company's only supply of pulleys is produced, the company may be liable to its dealers in extended interruptions. So the firm's risk and insurance objectives must consider this.

Finally, when defining deductible levels, FEC takes this risk attitude: Topeka has a lower deductible since FEC can't immediately replace operations there and a major loss could mean a radical change in operations if the firm were to permanently replace the facility with contracted output.

Here's a closer look at FEC's risk and insurance objectives as of July 1993. (The Farm Equipment Corporation is a hypothetical firm.) Note that a good plan has two general parts -- a brief statement of the company's objectives and a definition of the insurance characteristics for each segment of the business' operations.


To provide insurance coverage on operating assets, operating interruptions and other third parties affected by operating mishaps as follows:

* Deductibles and self-insurance will be kept at minimum levels to protect internal cash flows and potential capital market funds.

* Replacement cost coverage will be used only on assets of final assembly, service and administrative operations except where recovery from calamities would include changes to existing operations due to new technology. All other operating assets will be covered at appraised values.

* Operating interruption coverage will be adequate to provide coverage for return to existing operations except for major calamities at parts and subassembly divisions. Insurance for those divisions will be adequate to cover the period necessary to acquire contracted production.



Final assembly division and corp. headquarters -- St. Louis


FEC's largest assembly operation and headquarters location


Assets: $25,000,000 Interruption: $100,000 per day Other Parties: $5,000,000 Total Deductibles: $250,000

Operating assets will be insured at replacement value except for production, R&D and administrative computer equipment, which will be upgraded in replacement. Interruption losses of less than $100,000 per day will not be insured. No unusual liabilities to other parties anticipated that would require nonconventional coverage.


Parts division -- Topeka


Only location of pulley subassembly manufacturing used in final production


Assets: $9,000,000 Interruption: $50,000 per day (1 to 60 days) $100,000 per day (60+ days) Other Parties: $15,000,000 Total Deductibles: $100,000

Operating assets will be insured at appraised values. Interruption losses will be fully insured until adequate temporary or permanently contracted production can be obtained. Protracted interruptions may require special attention to dealer sales obligations in defining coverage for other third parties.


Once you have your risk and insurance objectives in writing, you need to translate them into cost-effective insurance coverage. You do that by negotiating. Here are seven tactics to use with insurance companies that want your business:

1 Know your operation, the risks it faces and your risk and insurance objectives. You can't get effective insurance coverage if you don't intimately understand your business.

2 Know the insurance game. Insurance companies have their own vocabulary, and they know types of coverage, terms and insurance law inside out. This skill is one of their best negotiating tools. The better you speak their language, the more effective you'll be at diminishing this negotiating advantage. One caution: The insurance company will always know more about insurance than you do. If you can't understand an oral or written communication, force the insurer to explain it in plain English.

3 Make your insurance broker work for you. If you use an insurance broker, he can interpret the insurance jargon for you and explore coverage options and companies that offer products that match your strategies. Some brokers also can help you decipher the insurance company's negotiating tactics. Ask the broker for a play-by-play analysis of the insurance firm's moves so you can respond appropriately.

But never forget that the broker isn't your partner -- he's the middleman in the negotiations. Your goals aren't his goals. He wants an agreement between you and the insurance company, and he won't care if the agreement meets all of your goals unless you make it perfectly clear that there won't be an agreement unless you meet all of them.

4 Stick to your negotiating strategy. You'll find you literally have to negotiate claims before they ever occur. Focus the negotiations on claims settlement by keeping these kinds of questions on the table: If we have this loss, how much will we get? What will we have to do to substantiate the claim? When will we get compensated?

If you lose control of the negotiations, the insurance company will try to sell very broadly defined coverage, avoiding questions about specific claims and their settlement.

5 Control the timing and pace of the negotiations. If negotiations move too quickly, you're more apt to agree to items you don't fully understand. Also, if you don't begin negotiations early and monitor their progress, you may force yourself into hasty negotiations because you can't go without insurance coverage. Watch that the insurance company doesn't intentionally drag its feet to force you into this position.

6 Scrutinize proposals carefully. First, compare each proposal to your risk and insurance objectives plan and any potential loss information you've gathered. Ask yourself, "If we suffer each of our possible losses, will we be covered and will the claim be satisfactorily settled?"

Second, don't accept verbal embellishments of the proposed policy. If the insurance company's explanations of policy provisions extend or modify the written contents of the proposed policy, then have the proposed policy changed to include them.

7 Be prepared to go elsewhere. Fortunately, there are many insurance companies. If negotiations with one company go nowhere, tell the company you're prepared to do business with others. If they don't respond, approach another firm. But don't wait too long to go elsewhere. The longer you wait, the less time discretion you'll have as your current insurance approaches expiration.

Dr. Roof is director of the Center for Research in Accounting Education at James Madison University in Harrisonburg, Va. Mr. Fraser is divisional controller of ROCCO Enterprises in Harrisonburg.
COPYRIGHT 1993 Financial Executives International
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1993, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

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Title Annotation:Risk Management; includes related articles; operating asset insurance
Author:Fraser, Daniel F.
Publication:Financial Executive
Date:Sep 1, 1993
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