M&A Insurance Choices Are Really Investment Decisions

This content was originally published in Crain’s Cleveland and is reprinted here with permission.

Both middle-market CEOs were experienced and savvy, and both pursued strikingly similar acquisitions. Two years later, one of the deals had checked every box and exceeded the buyer’s most optimistic expectations. The other was stumbling along and a constant source of criticism from the board. Would you believe the difference largely came down to how the two CEOs viewed risk and insurance?

The CEO of the faltering deal faced more than their fair share of unpleasant surprises, among them a handful of extraordinary medical claims resulting from worker injuries, a programming error that triggered a costly product recall, and a three-week shutdown of a critical overseas vendor to repair damage from a typhoon.

The other CEO also encountered unanticipated problems large enough to impact earnings. Why didn’t those issues derail the newly combined enterprise’s goals? Although nobody can accurately predict every situation capable of creating headaches for companies, the CEO’s mandate to the acquisition team emphasized both a frank examination of potential risks and the identification of strategies to best address those risks.

The successful CEO sought to decapitalize what the company might otherwise spend on insurance. Armed with a comprehensive look at risk management, the leadership team was able to consider a variety of strategies to best address areas of concern. Those strategies included retaining manageable risks by increasing deductibles, exploring ways to link specific risks more affordably with insurance policies, and using captives and other vehicles.

Taking such a strategic approach to the combined companies’ management of risk allowed the management team to redeploy capital they might have otherwise spent on insurance to fund initiatives supporting growth and a stronger competitive position. Instead of thinking of insurance as just another inevitable expense, the CEO approached the risk management spend as an investment in the companies’ future.

Of course, none of that would have been possible had the CEO not been open to discussing shifting strategies for funding risk mitigation. If leadership intends to spend a dollar in capitalizing insurance, it needs to approach it with the same level of rigor it would assign to capitalizing an investment in a plant expansion.

The business case for risk management demands a detailed analysis of the finances, the expected utility, and its impact on the combined companies’ return on capital. Only with that level of understanding can the leadership team confidently decide to transform the use of insurance into an investment decision that not only drives cost out of the traditional insurance spend but provides an opportunity to increase market leverage and competitive advantages.

The leadership team drew upon the specialized expertise of their risk management consultants to better understand the company’s business risk from an insurance perspective. Because not all risks are created equal, identifying and prioritizing risks is the first step. The newly combined entity would face hundreds of potential risks and could not mitigate them all, so the consultants identified the top handful of risks deserving the greatest focus and funding.

A universal outcome of most M&A transactions is an increase in financial wherewithal. That has the potential to fund a more effective risk management program, but before the company can determine whether it wants to—or should—capitalize insurance or assume risk on its balance sheet, it must understand its financial risk-bearing capacity. Knowing what the leadership team will have available to work with requires the same kind of financial analysis that is a part of other significant investment decisions.

The consultants also created a sensitivity analysis for insurance, which begins by quantifying the expected annual dollar value of losses in each major line of coverage (e.g., general liability, workers’ compensation). By modeling both entities individually and combining the forward-looking exposure base, unit rate averages and volatility, the consultants presented an actuarially sound forecast of future economic impact, giving the leadership team statistical certainty to support decision-making. If the analysis concludes that expected losses in a particular category are well below what insurance carriers would charge, the leadership team can consider alternatives.

Finally, given an actuarial understanding of the combined companies’ prioritized risks, risk-bearing capacity, and likely losses, the consultant identified options for efficiently addressing those risks. Should the team choose to go ahead and purchase traditional insurance, the information gathered through the process will help them determine the appropriate investment amount and negotiate the best rates. Conversely, if leadership recognizes they can instead use the capital to build and grow the business, that’s true risk optimization.

Ultimately, choosing whether to use insurance is an investment decision. By partnering with an experienced insurance risk management consultant, the CEO ensured the leadership team understood all their options to make the best use of their capital, achieve a competitive advantage and create more value.

The above information does not constitute advice. Always contact your insurance broker or trusted advisor for insurance-related questions.