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.
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.
Source: 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."
Source: "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.
Source: 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.
Overtime and expenses for employees
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 use1
Direct costs such as the ones noted above may have been as much as $30 million for Perrier during its recall.2 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.
Source: Heaton, Carla and Guzzo, Rick. "Making Every Employee a Brand Manager."
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.3
There are essentially three types of coverage available that relate to product recall claims.
Malicious tampering/accidental contamination
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.4
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.5
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.6
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.
Source: Power, Stephen. "In Response to Firestone Recall, Senate Passes Bill to Overhaul Auto-Safety Laws," Wall Street Journal, October 12, 2000.
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.
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1 "AIG Offers Coverage for Product Recalls," ABI/INFORM, July 26, 1999.
2 Berman, Barry. "Planning the Inevitable Product Recall," Business Horizons, March 1, 1999.
3 "CNA Broadens Recall Coverage for Food Processors," Rough Notes, January 1999.
4 Barnhart, Sky. "When Things Go Wrong, Product Recall Saves More Than Money," Insurance Journal/West, December 14, 1998.