Protecting the Balance Sheet
July 2002
An uninsured loss drains cash, the lifeblood
of any business, and erodes net worth. Rolf Neuschaefer explains what surety
underwriters are looking for from their principals in the current market.
by Rolf A. Neuschaefer
Robert E. Harris Insurance Agency, Inc.
It has now been widely reported that the surety market is tightening for
a variety of reasons including mega losses growing out of the Enron debacle,
the bankruptcy of K-Mart and Global Crossing, and generally worsening results
from the contract surety line. Obviously the events of September 11 and other
large losses sustained by the reinsurers have also played a role in constricting
the market for surety bonds.
Managing Risk
The contract surety analyst focuses much of his or her underwriting attention
on the applicant's operational and financial history, the business plan and
capacity to execute that plan successfully, the existence of continuity and
buyout plans, and of course the character of the people involved. Underlying
the entire underwriting process is the question: How well does the applicant/client
manage risk? Stated somewhat differently: How well does the applicant protect
and preserve the balance sheet?
Insurance Risk Transfer
Risks that you cannot pass on to others have the potential to adversely affect
you financially. That is why most individuals and businesses purchase insurance
so that the risk of loss (including the obligation to defend) will be transferred
to a third party, called an insurance company. Therefore, the surety underwriter
will first want to focus on what insurance you carry to protect yourself from
a variety of property and liability losses. The underwriter will then want to
examine how effectively you transfer risk to others vis-à-vis your contracts
and what risks are you assuming by contract.
Shielding the Balance Sheet
Given the tightening insurance market underscored not only by higher pricing
but also the availability of limits or coverages, the surety underwriter can
be expected to more closely examine your insurance program and confirm that
you are obtaining evidence that others have adequate insurance to back-up their
indemnity/defense obligations to you. Nothing could knock a hole in your financial
armor as quickly and completely as an uninsured loss. The insurance you carry
on your own business or that others carry for your benefit is really a shield
around your balance sheet. Simply put, an uninsured loss drains your cash, the
lifeblood of any business, and erodes your net worth.
Financial Stability
Before moving on in this discussion, it is important that everyone understand
why the principal's financial stability is so important to the surety underwriter.
The surety underwriter approves the bond based on certain representations, including
the financial condition of the principal. Once the bond is issued, the bond
cannot later be recalled if the principal's financial condition deteriorates
because of an uninsured loss. If the surety suffers a loss, it is entitled to
be indemnified by the principal and any guarantors, which are usually the owners
of the business. Thus, an uninsured loss may not only adversely impact the principal's
financial condition but also that of the guarantors.
Risk Management Tools
The focus of this article is not an in-depth examination of all the various
forms of insurance or the nuances of policy language. It also is not intended
as a legal analysis on the finer points of hold-harmless or indemnity agreements.
The focus instead is in the context of insurance and indemnity agreements as
tools to manage risk and protect the financial base of the principal. Without
the stability these risk management tools can provide, the surety would not
be able to enter into a meaningful or long-term bonding relationship, and the
principal would always be exposed to unplanned financial setbacks that could
imperil the entire business.
Limiting Indemnification
With regard to indemnity or hold-harmless agreements, perhaps the first advice
is that you should only agree to indemnify another party for those events that
you can or should be able to control. You cannot control the actions of the
Indemnitee (the party being indemnified) and should avoid indemnifying for the
indemnitee's sole or contributory negligence.
Also, avoid assuming liability for "everything and anything" resulting from
or growing out of the contract. It is simply too broad and does not track with
the liability insurance you carry. Your liability policy responds for property
damage and bodily injury resulting from your negligence or the negligence of
persons whom you control or for whom are responsible.
Be Realistic
The insurance requirements imposed on you or that you impose on others exist
primarily to back up the indemnification provision in the contract. Remember
that your own liability insurance will only respond to defined "insured contracts."
Therefore, be realistic in what insurance you agree to furnish or what you ask
others to provide to you.
For example, you could request $10 million of commercial general liability
(CGL) coverage from everyone, but is it commercially feasible? You probably
would be better to seek more realistic limits but ask that the aggregate be
per project. This way, you know the limit is dedicated for your specific project
and not an aggregate that would have to be shared among all contracts.
Grade the Risk
Another fallacy is thinking that only large value contracts can cause large
losses. This is analogous to someone thinking they need less automobile liability
coverage if they only drive short distances. It would be better to grade the
risk potential of certain type work and seek commensurate liability limits.
To illustrate, a steel erector or concrete contractor at your job site poses
more risk potential than the contractor who installs the doors or carpeting.
How much in liability limits should you seek? Since you are requesting the insurance
to protect your balance sheet, you may want to consider how much you have to
lose. Again, if your balance sheet were substantial, e.g. $50 million, it would
not be realistic to ask everyone to provide you with $50 million in liability
limits because it would not be commercially available and/or be cost prohibitive.
Other Exposures
When it comes to your own insurance program, are you only purchasing the
"usual" coverages: CGL, workers compensation, business auto and a package policy
on the office? Is your balance sheet not also exposed to loss due to employee
dishonesty, flood, earthquake, employment practices, environmental/pollution
liability, fiduciary liability in managing your benefit plans, possible errors
and omissions, directors and officers liability, and/or computer/cyber liability?
If you truly do not have an exposure, do not buy the insurance. However,
many businesses have some or all of these exposures and choose to ignore them,
failing to assess the real potential financial damage. Many of these coverages
are needed today because they have been specifically excluded from the "usual"
coverages. Also, most insurance policies agree to defend you in the event of
a claim or suit in addition to the policy/indemnity limit for covered losses.
What To Insure
One of the axioms of insurance is that you should insure what you cannot
afford to lose. You need insurance for the big losses relative to your own financial
condition and not the nickel and dime losses. Many buyers purchase insurance
with small deductibles when in fact they could absorb or self-insure more of
a given loss. You would be better served in most cases to assume more of the
first-dollar losses.
Frequency of loss is generally penalized more severely than severity of loss.
The more losses the insurer pays above the deductible the higher your experience
modification. Therefore, consider the largest deductible for each line of insurance
that you can afford and apply the savings to purchasing higher limits and/or
those coverages that you have been totally self-insuring.
Conclusion
In conclusion, purchasing the appropriate coverages in adequate limits and
maintaining comprehensive but reasonable indemnification provisions in your
contracts will help to provide financial stability for your business and make
you a more attractive prospect for surety credit.
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