Private Equity Portfolio Risk Management Programs: Effective Strategy or Insurance Broker Marketing Tool?

May 08, 2012

by Kevin D. Connelly, Vice President, James P. Marquet, Producer

It’s inevitable. Every private equity firm hears the Siren song of the private equity specialist insurance broker at some point. The message: if you aren’t aggregating the insurance programs of your portfolio companies, you’re leaving money on the table.

At first glance, the basic assertion makes sense: drive value by leveraging collective buying power across your portfolio of companies. But a closer examination reveals a number of pitfalls and complicating factors that call into question the true effectiveness of the approach for many, if not most, portfolios.

Are You Really Achieving Leverage?

If commercial insurance were a commodity, the opportunity to achieve cost savings through bulk buying would be significant. A portfolio of homogenous companies in terms of risk profile, size and historical losses would present a buying opportunity worth exploring, especially on certain lines of coverage such as property and umbrella.

Unfortunately, most portfolios do not consist of homogenous companies. With heterogeneous portfolio companies, every insurance program is, by definition, unique in its required terms, conditions and pricing. Likewise, every risk picture is different in terms of its exposures, size and historical losses.

The impact of this situation reveals itself in different ways. First, it is a virtual certainty that the companies with “vanilla” operations and excellent loss histories will subsidize those members of the portfolio without these positive attributes. Likewise, the difficult exposures and poor loss histories of the “non-vanilla” portfolio companies will negatively impact the excellent performers.

Second, there are many exposures that cannot be placed with the standard insurance markets that make sense for a portfolio play. These might include difficult products for general liability or property exposures such as coastal wind or earthquake. These restrictions are often part of reinsurance treaties that cannot be overcome by the simple application of marketing clout. The result is a need for a “stand alone” policy to address a unique need. This begins the dilution of any leverage that might have existed in the first place.

Are You Limiting the Marketing Efforts of Your Broker?

A difficulty related to the aforementioned pertains to the impact of aggregation on effective insurance marketing.
Attempting to find a single insurance carrier or group of carriers to write the coverage for 10 dissimilar portfolio companies will necessarily entail eliminating from consideration insurers that might only be willing to write one or two companies or lines of coverage. What if the eliminated insurers are that year’s “hot” markets that will provide quotes at 25 percent below market rates? As every insurance broker knows, those markets are often available, and the trick is to find them. If your program is such that marketing is limited to four or five of the “mega-insurers,” you’ll never find the most aggressive players.

The Graham Company recently encountered this exact situation during the placement of a directors and officers liability policy for an individual portfolio company. The general partner presented the portfolio company with a quote as part of a program that would include all of the other portfolio companies. The quote seemed aggressive (a 10 percent discount from the expiring cost). However, we had procured a renewal quote that was 25 percent less than the expiring cost. This quote was provided through an insurance company that, for various reasons, would not have entertained writing a policy for the entire portfolio.

Compounding this problem is that insurance for the “problem” members of the portfolio is the area where these extremely aggressive carriers are often most effective. So it’s possible to end up with the highest-quality members of a group-buying situation being dragged down by the inclusion of the more difficult risks and at the same time taking the “hot” or specialty markets that would be perfect for the tougher risks out of play. The result: Higher costs for both.

Additionally, lender required S&P ratings of insurance companies across a portfolio may be dissimilar. This could create a situation where the carrier most willing to provide excellent pricing and coverage could be knocked out of consideration because its S&P rating is unacceptable to a single portfolio company.

Will Your Portfolio Program Hold Up When Companies Are Bought and Sold?

The nature of a private equity portfolio is that companies are not held forever. From an insurance standpoint, what happens when you sell the company that is your star performer? The impact on the remaining companies could be significant.

A case in point: we were recently faced with a situation where a portfolio insurance program was presented to one of our customers. The insurance broker presenting the program provided a Property Insurance program that came with the requirement that all portfolio companies participate. A portfolio program that cannot be sustained without the participation of every member of a portfolio is a house of cards and does not make much sense for an active private equity fund.

Likewise, be skeptical of the suggestion that acquired companies of the non-vanilla type can simply be “rolled in” to the program at pre-set rates. These pre-set rates generally come with caveats relating to exposures, losses, etc. In other words, they are not really pre-set at all. Additionally, to the extent that a pre-set rate is honored, in the current soft insurance market you may simply be locking in a punitive rate that was negotiated six months ago!

Can A Common Broker Provide the Appropriate Services to All Insureds?

A significant danger of the portfolio aggregation approach is the transformation of the insurance broker from risk management advisor to each portfolio company into a centralized “procurement” expert whose only focus is the insurance buy as opposed to overall risk management. The downside to this should be obvious as it relates to an unyielding insurance truth: the ultimate cost of insurance for any business or group of businesses over time will have a high degree of correlation with the loss histories of those businesses. So concentrating on the procurement of insurance over the basics of risk management is an undesirable tradeoff.

Obviously, an insurance broker who places a portfolio program will theoretically be equipped to provide risk management services as well as, or in some cases better than, the current broker. However, this is a question that requires scrutiny, particularly with regard to the portfolio member companies with strong risk management programs. You will want to consider a few questions:

Will a portfolio broker be able to simultaneously assume the risk management duties for eight various portfolio companies effectively?
Is the excellent loss history of the star members of the portfolio due in part to an in-place insurance broker who is particularly effective?
If so, is this effectiveness due to long hours of work analyzing, understanding and addressing the exposures of the insured, and can this institutional knowledge be easily dismissed?

A related problem is the need for more personnel and costs at the general partner level. If the insurance buy is done at the GP level, the personnel needed to bring this function in-house from the portfolio companies could be a new and significant expense that will probably not be offset by expense reductions at the portfolio company level.

A final consideration is the motivation of your broker. Once a single broker “locks-up” all the portfolio companies under a single program, will you get the same level of attentiveness and service? A portfolio that includes different brokers with the implicit threat of competition can be useful to focus the attention of the individual brokers involved.

Does Portfolio Aggregation Create a Morale Hazard?

Morale Hazard refers to the tendency of companies and individuals to develop an indifference to losses and risk because of the existence of insurance. Most companies understand that the insured losses that they suffer are the factor that will have the single largest impact on the cost of their insurance in the future. Therefore, their motivation to control losses is significant. In a group-buying arrangement, each portfolio company is told that its insurance costs are controlled and driven down by the size, performance and economies of scale generated by the group.

This implies that the individual performance of each company is no longer of any particular importance since it will be overcome by the weight of the group. This is a dangerous dynamic to introduce into a group of companies for obvious reasons. Among the most obvious: the insurance loss history of a portfolio company will be scrutinized as part of the due diligence process leading up to a sale. Members of your portfolio who have taken their “eyes off the ball” in the area of risk management and have a poor history of insured losses will be less attractive to potential buyers.

Be Cautious

Any decision to aggregate the insurance buy of private equity companies needs to be carefully considered beyond the marketing assurances of the broker attempting to sell the deal. In many of these arrangements, the only party truly assured of reducing its costs is the insurance broker placing the deal, who has picked up a number of customers in one fell swoop.