As all claim executives know, much of the real work comes long after insurance policies are sold and the brokers' celebratory signing lunches have faded from memory. The ultimate test of how well policies were underwritten — and how profitable any given book of business will be — is not only the number and nature of the claims handled under those policies but also the management of those claims and their related expenses.
Insurance companies and claim personnel are accustomed to "incurred but not reported" (IBNR) liabilities arising from injuries that occurred in the past but were slow to result in claims. These are often called "long-tail" liabilities or claims and can be addressed in the same manner as more immediate "short-tail" claims. That is to say, an insurer can resolve long-tail claims as they actually appear in the tort system over time through litigation and/or settlement, which is something of a traditional insurer response. The elongated time horizon of long-tail liabilities, however, offers other opportunities to resolve, contain, or diminish costs via alternative efforts undertaken before the claims actually come into being and are filed in the tort system. Such advance efforts to contain liabilities is referred to as "ring-fencing."
Rundown on Ring-Fencing
When successful, these ring-fencing efforts can save both insurers and insureds significant money, time, and trouble by heading future claims off at the pass. The point at which claim personnel detect a pattern that might be consistent with an emerging long-tail liability claim is the most opportune time to consult with the insured. Particularly if the insured is not a large, sophisticated corporation, it is crucial to determine if all parties could benefit from ring-fencing efforts at that point.
Of course, not all insureds have the same corporate structure, and the actual steps taken to ring-fence long-tail liabilities can vary depending upon the facts of any individual situation. However, many ring-fencing efforts are quite simple and relatively inexpensive to enact. They can be useful in many different situations.
These efforts are best understood in the context of an example. Assume that ABC, Inc. is a medium-sized company with annual sales of $50 million and four smaller subsidiaries (with separate annual sales ranging from $5 to $10 million each). One of these subsidiaries, XYZ, Inc. has been a small widget manufacturer for a long time. The Heroic Insurance Company has continuously provided primary and excess insurance to ABC and its subsidiaries through master policies for the last 25 years. Heroic's claim department notices that different claims related to alleged bodily injury due to paint used on XYZ's widgets years ago have recently been filed.
At this point, different assessments must be made. In turn, let's discuss each of them briefly. The first assessment is to determine how to minimize the risk that XYZ's future potential liabilities arising from widget paint will result in substantial liabilities for ABC or for its other subsidiaries. For example, has ABC observed all of the corporate formalities for XYZ corporation in operating it? Has XYZ's board of directors held annual meetings? Are there minutes for such meetings? Does XYZ's board have mostly outside directors, or are the same officers of ABC the directors for all subsidiaries? Does ABC's accounting department treat XYZ as a separate corporation when dealing with inter-company transfers, payments, loans, and purchases among ABC and its subsidiaries? Or, is all of the money just sloshing around in one big pot?
Making Assessments
The answers to these questions can affect a court's determination as to whether XYZ is truly a separate company — thus ordinarily limiting the payment of XYZ's liabilities to its own assets and insurance — or if it must be considered a division of ABC. The latter case would greatly expand the pool of available assets to pay future claims, which would include XYZ's sister subsidiaries owned by ABC. The more indicia of corporate separateness there are, the harder it will be for underlying plaintiffs to reasonably attempt to pierce the corporate veil separating XYZ from its parent, ABC and/or its sister subsidiaries. While the past cannot be altered, it will be possible to follow proper practices that enhance the indicators of true corporate separateness in the ABC companies moving forward.
In our experience, plaintiffs' counsel for early claimants often do not bother with the substantial work and expense involved in actually trying veil-piercing claims because the relevant defendant company's assets and insurance are sufficient to fully compensate their clients. Thus, there is often a substantial lag between the time claims begin to be filed and the time that corporate veil-piercing claims are seriously asserted. Consequently, the long-tail nature of the widget claims in our example might allow the ABC companies to expand upon any past history of legal identity and corporate separateness before later widget claimants attempt any veil-piercing arguments.
A different example of a proactive step could take place if ABC was about to start manufacturing a new and promising product. If ABC has a limited number of shareholders, then they may want to consider forming a totally separate company — Newco, Inc. — that would be unrelated to ABC in any way. Newco could make and sell the product under license from ABC, thus arguably protecting some portion of the future profits from this new product from exposure to any veil-piercing claims involving ABC and XYZ. Another potential proactive step for ABC would be to "spin-off" XYZ to different investors (after appropriate disclosures) in the hope that many years of future, wholly separate operation of XYZ would help blunt any future veil-piercing claims against ABC.
Finally, ABC and XYZ might opt to buy additional liability insurance to retroactively cover XYZ's past liabilities. Such coverage is sometimes available from credit-worthy companies. Alternatively, if ABC spins off XYZ, it can make a substantial capital contribution to XYZ as part of the transaction in exchange for substantial indemnification against future veil-piercing claims from the new corporate parent of XYZ. Such a transaction is essentially a risk transfer arrangement that differs from traditional insurance policies.
Of course, helping ABC understand and improve its relative risks regarding veil-piercing or investment issues will not necessarily reduce Heroic's direct financial exposure under its policy limits for past policies. The effect of these efforts on Heroic's exposure will depend on how the ABC liability insurance program was structured. But it is usually good business for an insurer to help its clients proactively deal with liability issues and to consider the insurer a reliable and helpful partner in this area. After all, a healthy ABC or Newco can continue to buy insurance in the future, whereas a bankrupt ABC will buy no future insurance at all.
A second assessment should be made when a potentially significant long-tail liability starts to emerge. It is imperative to determine what the insurer can do — if anything — to moderate its relative exposure to financial loss. With respect to past policies already issued, Heroic can decide whether it wants to obtain or amplify existing reinsurance on the ABC account, particularly for older policy years in which some reinsurers may be in run-off or defunct. Buying new reinsurance early in the game, when uncertainty is greater, may well lead to significantly better pricing than waiting until actual, annual claim filings start to rise substantially. With respect to future policies for ABC and XYZ, Heroic should certainly be interested in ABC's corporate structure — and the strength of its defenses to veil-piercing claims — when designing liability program offerings for ABC. For example, Heroic may want to institute separate policies for each company or aggregate sub-limits of liability for each subsidiary, if such aggregate sub-limits do not already exist.
A third assessment is whether Heroic and/or ABC should commission any valuation work for the widget-related liabilities when they first start to emerge. When performed properly, valuation work can allow an insured's management to plan appropriately for future corporate operations, risk transfer, and corporate transactions. It can also be used to minimize the chances that subsequent ABC investors would later argue that they were not fairly advised of the relative risks of widget-related future losses to XYZ and/or ABC. The same work can provide Heroic with useful information for future underwriting and/or reserving purposes or assist Heroic in purchasing reinsurance.
Settlement Options
Aptly performed long-tail liability valuation and estimation work is expensive, particularly when performed by outside consultants. Further, such estimates can have a relatively short shelf life because they are based on past claim data. If the annual number and/or expenses of later claims vary significantly from those estimated in the valuation analysis for the same years, then overall estimates of the subject company's future financial exposure will appear to be considerably less reliable. Therefore, experience and judgment are needed when deciding whether a particular account warrants immediate full-scale evaluation. An account may instead require monitoring to see if the number of claims associated with a particular product or operations of an insured dwindle over time rather than continue to increase.
While sometimes useful, transactional and corporate management efforts of the kind described above are not the only tools available to claim personnel outside the tort system. During the past two decades, insureds and insurance companies alike have made increasingly sophisticated efforts to control dispute resolution costs via alternative dispute resolution methods, such as mediation.
As a firm, we have been very open to trying alternative dispute resolution methods to achieve cost-effective closure for disputes early on. For example, we have found that one avenue for such efforts is the work of the International Institute for Conflict Prevention and Resolution, better known as the CPR Institute or just CPR. The Institute's mission is to serve as a global advocate and resource for alternative dispute resolution. We helped develop certain CPR dispute resolution facilities for insurance matters, and thus understand firsthand the effectiveness of efforts and outside facilities of this variety in real-life situations.
Developing mediation protocols with plaintiff law firms, with the help of neutral groups, such as CPR, offers an alternative way to contain costs and manage liabilities on an ongoing basis outside of the court system. Mediation need not be confined to one-shot cases. Long-tail liabilities, which usually involve substantial numbers of very similar claims over time, can offer an excellent opportunity to institutionalize ongoing mediation agreements with the stakeholders and/or plaintiff law firms that are relevant to a particular situation. Smart plaintiff law firms know that swifter and cheaper dispute resolutions leave more money potentially available for settlements and result in faster compensation for legitimate claimants. Similarly, experienced claim managers know that building good working partnerships between their insureds and underlying plaintiffs' counsel, through use of consistent standards of proof and claim valuation and combined with an element of flexibility on both sides, can create a large measure of predictability and stability to annual resolution costs for long-tail liabilities.
By providing a transparent process that emphasizes early disclosures and good-faith efforts to resolve claims, mediation may prevent or reduce the amount of negative emotion that can otherwise cloud each party's assessment of its real economic interests in either continuing or ending a liability dispute. Too often, the emotions generated by aggressive litigation positions and strained factual allegations can overshadow the parties' mutual interests in reaching a swift, negotiated resolution of underlying claims. For defendants, mediation offers an opportunity to efficiently allocate resources among dispute resolution and core business goals. If mediation does not work, then experienced neutrals can serve as arbiters of any remaining claims, often at much less cost than traditional litigation.
James T. H. Deaver is a partner at Wilson, Elser, Moskowitz, Edelman & Dicker, LLP. He may be reached at james.deaver@wilsonelser.com.
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