As business structures become more complex, companies often need more sophisticated insurance products to properly manage their business interruption risks. Narrow vertical integration makes risk management more difficult and increases the demands placed on insurers regarding correct risk assessment and loss evaluation.
Vertical integration allows companies to optimise their value and their supply chain’s value by integrating upstream and downstream production processes into their operations. This frequently involves moving production facilities abroad in order to take advantage of lower labour costs or tax incentives. However, the financial benefit of such a move is tempered by the increased complexity it brings to risk management. For example, when evaluating business interruption risks, intercompany transfer pricing systems and interdependencies need to be taken into account. This is true for pre-loss risk assessment, post-loss reserve setting and ultimate loss evaluation. The issues of transfer pricing and interdependency are equally relevant, regardless of whether the loss stems from a physical loss within the insured company or from damage to a supplier or customer resulting in a contingent business interruption loss.
Determining transfer prices
Many large international companies purchase global insurance cover, and transfer pricing only becomes relevant when losses occur requiring accurate assessment and evaluation. However, smaller companies with just a few manufacturing locations will frequently make do with local policies. In this case, the profit and loss account of an insured entity in one country will reflect the profit and loss earned on the basis of the transfer pricing structure in place. The transfer pricing will not take into account the actual business risk of the overall company, i.e. the lost gross profit generated along the entire value chain right through to the sale of the finished products to the end customer. Profits that the affected entity earns upstream and downstream are not included. The added value of the entire value chain is often only known by the insured’s head office. In order to calculate the appropriate sum insured, it is vital that underwriters fully understand the structure of the company and how goods and services are sold between the different legal entities of that company.
Take as an example an international company that manufactures food products for sale to retailers. The company owns several meat and milk-processing plants across Europe, which are all legally independent companies making finished products. These products are first supplied on the basis of an intercompany transfer price to various distributions centres, which then sell the product to the retailer. The intercompany transfer prices are based on the full manufacturing costs, which consist of about 85% variable costs and 15% fixed manufacturing overheads plus a small profit margin of 2% for the production plant. Each European location is insured separately. The final selling company takes a mark-up of about 30% for its own fixed costs and profit margin.
A Business Interruption loss at a manufacturing facility based on the transfer prices would thus produce an indemnity value less than the true business interruption exposure, as a significant portion of the actual gross profit is achieved through sales to retailers. If this risk is not adequately insured through coverage of the interdependency risks or a global master policy, the overall financials of the group and the manufacturing facility will be materially affected.
In conclusion, the individual financial accounts of various group entities may not reflect the true business interruption exposure of the whole production chain resulting from the failure of an individual entity. Only a detailed understanding of how products and services are accounted for within the same group, and how and where the gross profit is generated, can bring meaningful risk and loss evaluation.
Problems involved with interdependencies
In cases where not all entities of a group, or potential joint venture partners, are insured under the respective local and global Business Interruption policy coverages, the risks to upstream and downstream operations can be addressed by way of an interdependency extension. This ensures that cover for a loss resulting from business interruption is extended to other related entities in the production chain. A typical interdependency extension may read as follows:
Extension of cover for interdependency losses
“Where the insurance provided by Section 2 – Business Interruption of this Policy insures Gross Profit, such insurance shall also apply in the event of interruption of or interference with the Business carried on by the Insured in consequence of loss or destruction of or damage to property at any other premises owned, leased or occupied by the Insured or any company standing in the relationship of subsidiary to parent to the Insured or subsidiary to parent to any company who are themselves a subsidiary of the Insured for the purpose of the Business (i.e. those not stated as Premises in the Schedule) and such loss, destruction or damage shall be deemed to be Damage at the Premises”
Take for example a printer who produces labels for an affiliated company that is insured under the same policy and acts as the trading company to the end customer. In this example the printer’s margin is low but the trading company earns a considerable gross profit which is taxed at a lower rate in the country where it is based. A business interruption loss at the printing company will also affect the financial results of the trading company. If the trading company’s gross profit is not adequately insured and its dependency on output at the printing company not taken into account, a considerable gap in cover will exist.
The official and even internal financial statements of the individual locations frequently do not reflect the financial exposure of the group resulting from a business interruption event at one location. The risk for the group can be a multiple of the risk at any individual location. This creates problems for the insurers in conducting a proper risk and loss evaluation and in their efforts to achieve early and accurate loss reserving. Ideally, they should work in close cooperation with the insured and possibly other external advisers to establish how the various group entities depend on each other and how a loss at one location can impact on the whole group.
An interdependency extension, which is common in some markets, is a good idea for businesses with a high degree of vertical integration and thus a high degree of internal interdependencies. Furthermore, such an extension can close a possible gap in cover in cases where a global master cover is not available or desired. Some interdependency extensions even insure the upstream and downstream losses of group companies which are themselves not insured under a local or global policy cover.
The more complex the structure is as a result of vertical integration, the more difficult it is to determine the actual risk profile in the event of business interruption. It is therefore essential to establish absolute clarity regarding transfer pricing and interdependency, as this helps to identify the need for business interruption cover. It also aids early and accurate assessment of the loss for reserving purposes. Close cooperation between everyone involved throughout the entire process is essential. This allows insurers to work through general loss calculation methodologies, explain what will be needed, address potentially difficult loss evaluation areas and manage expectations to everyone’s satisfaction.
By Markus Heiss. Published in Munich Re Schadenspiegel Magazine – June 2016.