From the May 2010 issue of Treasury & Risk magazine

The Art of Buying Insurance

Much analysis goes into any company's decision about whether to self-insure or buy coverage, whether the insurance at issue is property, workers compensation, directors and officers or business interruption, and often there is no one right answer when choosing among self-insurance, a captive insurer or an outside underwriter. You have to wonder what they were thinking or not thinking, the folks in the risk management department at Massey Energy Co., owner of the Upper Big
Branch Mine in West Virginia, where a huge methane gas explosion last month killed 29 miners and halted production at one of the big coal company's main production sites. They have to be kicking themselves over the decision, according to published reports, not to buy business interruption coverage this year.

Analysts say the explosion, at a mine that had received 53 safety violation citations in the month before the accident and 495 in the prior year, could end up costing the company as much as $50 million in lost production, according to Standard & Poor's. The rating agency recently placed Massey Energy's already low BB- rating on a downgrade watch.

What to insure, how to insure it and how much coverage is needed are some of the most important decisions a risk manager has to make. Yet, even though many of today's risk management departments originated as insurance departments, in the wake of 9/11, the Enron and WorldCom scandals and the advent of Sarbanes-Oxley compliance issues, they've expanded to deal with the broader area of enterprise risk management. Insurance, some experts say, can end up getting short shrift.

"Risk management is like everything else in a company," says Bill Myers of RWH Myers, a claims management company with offices in New York, Atlanta and Chicago. "There's a budget for the department and you have to work within that budget. And with insurance, it can be a lot of work determining what you need."

In the case of business continuity insurance, for example, Myers says risk managers have to determine what the potential loss could be. "Most insurers want an estimate of one year's income. Well, fine, but what do you use?" asks Myers. "A forecast? Or last year's numbers? If every year you use a forecast, and every year your forecast is too high, then every year you're paying too much for your insurance. But if you use last year's actual performance, you may be too low."

Similarly, with property insurance, Myers says many risk managers will use some kind of property index to assess property values, "but those indexes can be way off." His advice: "The only good way to make sure you are buying the right amount of property insurance is to do updated appraisals, and at many companies, this just doesn't get done regularly."

"Most risk managers are good at identifying the risks, but they're not all so good at quantifying those risks, and that's what you have to do when you're talking about insurance," says Garry Coulter, executive vice president of USA Risk Group of South Carolina, in Greenville, S.C., which manages captive insurance companies.

"You aren't just going out and buying insurance the way you'd buy insurance for your house or your car," Coulter adds. "You need to get actuaries, engineering consultants and appraisers, and look at all the issues. Some people will pay lip service to this approach, but then they don't really do it."

At $30.9 billion Humana, which is primarily a health insurer, Carolyn Snow, the director of risk management, says insurance issues are a significant part of her job. But she says that even so, it can be necessary, when it comes to buying insurance, to be able to drive a hard bargain with the underwriter.

"As a risk manager," she explains, "you need to understand your industry and your company, and be able to show your underwriter why you are different from the rest of your industry."

For example, Snow says, in buying D&O insurance, she has to explain to underwriters why it would not be appropriate for them to regard Louisville, Ky.-based Humana as "just another financial services company." Snow says she tells them, "We're primarily a health insurer, which makes us different, and our claims record is particularly good."

Myers agrees that if it helps risk managers make a case for lower rates, they should highlight how their company stands apart from its industry.

"Underwriters tend to set rates in an industry based on their actuarial experience with that industry," he says. "But say you are a manufacturer, and say most of your competitors may have one or two suppliers and are vulnerable to supply disruptions, but you have made a particular effort to diversify your sources of supply. You may be able to demonstrate that and argue for a lower premium."

Snow, who also serves on the board of the Risk and Insurance Management Society (RIMS), suggests risk managers take advantage of turnover or an expansion of their department to have new hires "put a new set of eyes" on the whole process.

When she joined Humana, Snow says, she was asked to do a review of the company's insurance.

"I suggested we make a change so that we'd pay the deductible on our outside property insurance from our captive insurer," she says. "That way, we were able to arrange for a higher deductible on our Florida property insurance, where there is a big risk of hurricane damage. That allows us to plan for and smooth out our losses, while paying a lower rate for our coverage."

Snow adds that she currently has a new hire whom she has tasked with reviewing the company's current program. "It's kind of an informal audit," she says. "I'm waiting to see what she comes up with."

In the case of Massey Energy, new eyes might not have changed the decision not to buy business interruption insurance for the Upper Big Branch Mine, which is operated by a subsidiary called Performance Coal Co.

"I can only imagine the cost of insuring a mine like that could be quite high," says Sherwin Brandford, a mining analyst at S&P. "So it could have made sense at the time to decide that buying that insurance was just not worth it."

Brandford notes that some mining firms choose to buy such insurance and others don't. "Remember that mining firms generally own a number of mines. It matters whether a mine represents 10% of earnings or 50% of earnings. Also, sometimes a company can shift production from one closed location to another," he says. "Considerations like that will go into the mix in deciding whether you need insurance or not."

Calls seeking comment from Massey Energy were not returned.

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