Are You Ready for Total Recall?
A Guide to Product Recalls and the Insurance That Covers Them
November 2000
Brand equity and product recall have received
a great deal of attention in the media lately. This first article in a new risk
management column addresses the various insurance coverages available for business
interruption resulting from a recall. Learn how the choices you make now can
save your company from a hard landing if it ever faces total recall.
by Daniel
T. Torpey
Ernst & Young LLP
This is the first article in the Brand Equity and Product Recall risk management
topic area—a topic that has received much attention in the recent media. Essentially,
many large scale product recalls will result in some form of business interruption.
This article will walk you through the various coverages available for business
interruption resulting from a recall.
The Product Recall Scenario
Imagine yourself receiving a phone call from a government official informing
you of an inquiry in connection with alleged defects in your company's best-performing
product. Just as you're beginning to absorb the news, he pops the question,
"Is your company prepared to execute a product recall?"
As you consider your reply, your mind drifts back to yesterday's treasury
meeting, where you assured everyone that no one loss could materially disrupt
your company's cash flows because of your "comprehensive" insurance plan. Now,
you wonder whether product recalls are covered under your insurance.
When a company is faced with a product recall, its business is often susceptible
to an interruption in the flow of product to its customers. Such an interruption
can mean a huge financial burden on the business. The company will need to recover
from both the out-of-pocket recall costs to physically remove and replace the
product in the marketplace and the potential downturn in sales if customers
go elsewhere during this period of uncertainty.
Certainly Bridgestone/Firestone has been affected both in the long- and short-term
by its most recent tire recall.
Ford and Bridgestone are writing the most important chapter in the history
of product recalls since the Tylenol case. In this case, instead of one
firm, two companies with a long, complex relationship are involved, and
they are struggling to save customers' lives and corporate reputations as
they deal with a suspect product that is out on the road, not on a store
shelf. [Simison, Robert L. and Shirouzo, Norihiko. "A Crucial Layer of Nylon," Wall Street Journal, August 28, 2000.]
The business interruption portion of a product recall (lost profits and continuing
expenses during the event) may be covered by several policies. Some companies
such as Original Equipment Manufacturers (OEMs) may be able to share risks with
suppliers through contractual agreements. Product recall claims are often considered
the most complex claims because so much about them is subject to dispute (e.g.,
coverage, accounting documentation, timeline and indemnity period issues, regulatory
concerns, and third-party claims). The first step is to understand where coverage
may already be afforded under one or several of your policies.
Product Recall Claims
Over the past few years product recalls and product recall claims have increased
in frequency.
A recent spate of product recalls in the United States and Europe, most
notably Firestone's announcement … that it was recalling several million
defective tires, has sparked renewed interest about brand insurance. "Brand
damage is one of the major business risks of the 21st Century," said Julian
James, managing director of Lloyd's North America. "Product incidents—recalls,
boycotts, scandals—can cost companies millions, affect share prices and
even result in bankruptcies." ["Firestone Tire Recall Another Example of
Brand Damage; Companies Need to Consider Reputation Insurance, Lloyd's Says,"
PR Newswire, August 10, 2000.]
Indeed, some of the most respected and well-run companies in the world have
experienced massive product recalls. Coca-Cola, General Electric, Dell Computer,
Nestle, Kraft, Johnson & Johnson, General Mills, Campbell's, and Nike are just
a few examples. Not all recalls are specifically insured for, but many policies
still cover a product recall. In order to understand product recall insurance,
it is helpful to be familiar with the most common product recall scenarios and
what type of coverage is available in each situation.
Types of Recall Claims and Policies
In the food and beverage industry, the two primary recall risks are accidental
contamination and product tampering. Of the two, accidental contamination is
by far the most common.
Coca-Cola, for example, lost almost 10 percent of its stock value between
the time the Belgian consumers became ill after drinking its product and
the day the company chairman apologized in full page ads in European newspapers.
[Lemov, Michael R. and Hewitt, Jason I. "Can You Risk a Recall?" Business Law Today, September/October
1999.]
Another illustration of this type of recall is the withdrawal of Perrier
products from shelves worldwide in 1990, after a benzene contamination was discovered.
The other most common risk is malicious tampering, such as the notorious Tylenol
tampering incident in 1982, where bottles of Tylenol were adulterated with the
poison cyanide, causing 11 deaths. A variation on malicious tampering is fake
tampering, where an individual claims falsely that a product has been contaminated.
The intent in a fake tampering incident is almost always fraud and extortion,
and although no actual tampering has occurred, substantial publicity damage,
and even a costly recall, may still result.
When contamination-related recall occurs, the company's general liability
policy will protect against product-related suits, but will not typically cover
other expenses that can be a substantial portion of a product recall loss. Other
expenses that may require a separate product recall or product liability policy
include the following.
- Communication
- Transportation
- Warehousing
- Overtime and expenses for employees
- Product disposal
- Fines paid to government agencies
- Costs to replace or restore the product recalled
- Redistribution of a recalled or restored product
- Costs to replace a recalled product that has been destroyed or is unfit
for its original use
["AIG Offers Coverage for Product Recalls," ABI/INFORM, July 26, 1999.]
Direct costs such as the ones noted above may have been as much as $30 million
for Perrier during its recall. [Berman, Barry. "Planning the Inevitable Product
Recall," Business Horizons, March 1, 1999.]
The greatest costs, however, often come in the form of lost profits and expenses
incurred to rehabilitate the image of the company or its product following the
recall.
A brand promise can be unmasked as a hollow boast at almost any point
during a customer's experience with a company, product, or service. Each
interaction represents a "moment of truth" that can enhance or erode the
brand, heighten or undermine customer loyalty, and affect business results
for better or worse. [Heaton, Carla and Guzzo, Rick. "Making Every Employee
a Brand Manager," http://www.lippincott-margulies.com/sense/journal14/5-Delivering.html]
For a large corporation, these costs can quickly escalate into the hundreds
of millions of dollars. To be able to recover some of these costs, it is important
to maintain "business interruption" or "lost profits" coverage under your policy
that will cover your product recall claim.
A well-designed product recall plan not only takes into account all of the
things that a company can do to prevent such an event, but also "expects the
unexpected." In the event that a recall does occur, proper coverage can mean
the difference between a challenging situation and a threat to survival. Depending
on the size of the company, insurance limits for product recall are available.
["CNA Broadens Recall Coverage for Food Processors," Rough Notes, January 1999.]
There are essentially three types of coverage available that relate to product
recall claims.
- Product recall
- Malicious tampering/accidental contamination
- Product liability
Any one of these can be a stand-alone policy or an added endorsement to a
company's property policy.
A product recall policy, standing alone, covers the logistical costs of a
recall, such as publicity, transportation and storage of the item, repairing
and returning the items, and other extra expenses necessary to carry out the
recall. This type of policy will not cover the costs of lost profits and rehabilitating
a product's public image, although special endorsements may be available to
include lost profits coverage.
Malicious tampering and accidental contamination coverage are similar, yet
distinct. Malicious tampering coverage, developed in the years since the Tylenol
poisonings, has the higher limits of the two and covers criminal actions to
sabotage a company's products. Accidental contamination policies cover instances
where an unsafe product has been unintentionally distributed by the company
itself.
Both of these cover all of the costs of a product recall, as well as lost
profits and mitigating expenses. A malicious tampering policy would provide
protection in a Tylenol-type situation, whereas accidental contamination would
apply in such instances as the General Mills recall of pesticide-contaminated
grain. Both recalls were valued at over $100 million. [Barnhart, Sky. "When
Things Go Wrong, Product Recall Saves More Than Money," Insurance Journal/West, December 14, 1998.]
A product liability policy, which can be included with or separate from tampering
and contamination policies, is coverage that protects only against any claims
that may arise from injuries caused by a hazardous or defective product. It
does not cover the logistical costs of a recall, nor the associated lost profits.
[Ibid.]
Understanding Your Coverage
In dealing with recall claims you will most likely have to identify coverage
in several different polices, such as your liability policy, your property policy,
and your recall policy, if you have one. Directors and officers liability policies
may also come into play, depending on the claims against your company.
You need to match proper accounting or "loss exposure" of your potential
claim with the policy. A key point will be to determine if there are areas where
coverage is uncertain or nonexistent. Remember that you are not alone when reviewing
your policy. The risk management department should work with the legal department
to map out where coverage exists. You should also be sure to get input from
your broker and claims specialist. Your company or risk professionals in your
company may also belong to trade organizations that could prove helpful. Try
the Risk and Insurance Management Society (RIMS) as a resource. Your local chapter
may have a risk manager who is familiar with previous claims that involved similar
issues.
Once a review of the policy is complete, you will have a better understanding
of what is and isn't covered. Remember that uncovered risk can result from poor
planning as well as purely uninsurable items. It is critical to convey this
to your company's top management on an annual basis.
After the Recall—the Recall Claim
When a product recall strikes, it is important to know the steps to take
to file a successful and effective claim. The most critical step is to clearly
and properly document all losses associated with the claim. A thorough claim
will contain documentation for all of the following costs.
- Investigations Costs: These may include
outside consultants as well as testing and information-gathering undertaken
by the company.
- Loss of Sales: A company needs to identify
not only the lost sales associated with not having its product on shelves,
but also the lingering effects of negative publicity and the corresponding
loss of sales as it continues through the actual recall and beyond. A company
should account not only for its own lost sales, but also for those of its
affected customers.
- Inventory Losses: This includes any company
inventory that has to be destroyed, in addition to any products removed
from market circulation.
- Removal, Transportation, Storage, and Destruction
Costs: These are the expenses involved in taking defective products
back into possession and disposing of them.
- Repair or Replacement Costs: These expenses
are associated with fixing the product itself, or the machinery and methods
used to produce the product in the first place.
- Legal and Professional Fees: These costs
could include defense against lawsuits filed by consumers, customers, or
government agencies. Many policies also pay for the preparation of a claim
by a certified public accountant (CPA).
- Public Relations Costs: Special promotions,
incentives, and advertising are often necessary to win back the confidence
of lost customers, and to return sales to their normal pattern. All such
expenses should be included in the claim.
[Davies, Rard and Higgins, Greg. "When Product Recall Strikes Beware of the
Danger from Within," The Legal Intelligencer,
July 27, 1998.]
Recent Legislation
In response to increased product recalls and claims—and the negative publicity
surrounding them, especially the Firestone tire recall—Congress has approved
a bill to overhaul the nation's auto-safety laws. It imposes new reporting requirements
on auto makers and establishes jail sentences for those who mislead regulators
about safety defects.
This measure, however, did not satisfy consumer safety groups who had been
lobbying for a tougher measure sponsored by Senator John McCain that would have
imposed criminal penalties on manufacturers who knowingly market defective products
that result in deaths or injuries. Senator McCain offered the new bill as a
compromise after his original bill was blocked in Congress.
While conceding that he preferred his own bill, Senator McCain said the
compromise bill would not weaken existing law and includes new safety requirements.
[Power, Stephen. "In Response to Firestone Recall, Senate Passes Bill to
Overhaul Auto-Safety Laws," Wall Street Journal,
October 12, 2000.]
Conclusion
Recognizing the legal, insurance, regulatory, financial, and operational
challenges of a product recall is the first step in treating this exposure as
a real and substantial risk. Defining the risk will help you prepare a product
recall recovery plan that makes intelligent use of the many types of insurance
coverage now available. Being able to quickly answer your customers' questions
about product integrity is also great assurance to the marketplace that you
are on top of the issue. The choices you make now may save your company from
a hard landing if it ever faces total recall.
Opinions expressed in Expert Commentary articles are those of the author and are
not necessarily held by the author’s employer or IRMI. This article does not purport
to provide legal, accounting, or other professional advice or opinion. If such advice
is needed, consult with your attorney, accountant, or other qualified adviser.