In an increasingly risky world, insurance should be a vital means of protection. However, recent changes to insurance legislation as well as conflicts of interests between brokers and policy holders, when combined with the complex structure of private equity holdings, mean that many firms could be putting themselves at even greater risk.
Typically, it’s the CFO’s responsibility to manage risk, and with that, most will oversee insurance policies - whether for deals, portfolio companies, investors or individuals working within the firm. But taking out insurance in whatever form it is used for has become a devilishly complex undertaking - one that few will have fully understood.
The first characteristic of insurance that any policyholder ought to be conscious of is how it is brokered. It has become common practice for private equity firms to work exclusively with one broker, who is paid on a fixed fee basis. While from a cost perspective, this arrangement might seem the most efficient, the reality is much different.
“In recent decades, brokers moved to a fixed fee model, however, they also receive lots of other commissions from the insurance companies.” explains Bruce Hepburn, CEO of Mactavish - an expert in insurance law. “In our experience, for every £10k of fees made by brokers, they make another £20k from services they sell to insurance companies where the pricing is premium linked.”
In 2020, Mactavish published a whitepaper on broker conflicts. It said: “This misalignment of incentives remains irrespective of ‘pay to play’ and is drastically more pronounced in a hard market. FCA statistics suggest that across the market nearly 80% of broker income is derived from insurers as opposed to client fees.”
“It’s a perverse system if you are appointing brokers exclusively.” says Hepburn, who urges private equity firms to think of brokers as traders, as one would when buying any other product or service.
Another vital aspect to buying insurance that many in private equity will likely be unaware of is the change to what a buyer must disclose to its insurer, brought about by recent amendments to the law.
Until recently, insurance was regulated by the Marine Insurance Act 1906. Under these rules, it was the policyholder’s responsibility to disclose all material facts that would affect the assessment of the prudent underwriter.
The Insurance Act 2015, which came into force in 2016 reframes the policyholder’s duties. “Now, the policyholder has to investigate its risk and disclose to the underwriters what was found. Then the underwriters have to ask the questions,” explains Hepburn. “For example, for a professional indemnity policy in, an underwriter would look at the file and ask the relevant questions. For the first time the underwriters have specific responsibilities under the statute.”
While insurance law was updated to put more responsibility on underwriters, for those not fully up to speed with what is required, the new rules have in effect created more risk. “The Insurance Act 2015 requires you to conduct a risk assessment, and you have to disclose that assessment to the insurer. If you do that, your rights are protected. However, if you don’t then you are in a worse place - your defence will be shot by way of process defence failure,” says Hepburn.
Under process defence, if a policyholder makes a claim, a judge could rule against it if the original risk was not properly assessed. “Instead of the court just saying the claim isn’t valid, you end up losing on the basis that your risk assessments were inadequate and you failed to follow a reasonable process,” explains Hepburn.
Evening Standard business columnist Antony Hilton wrote at the time of the new rules coming into play: “The Act puts a raft of new responsibilities on the buyers, on the board and even beyond into the realms of shadow directors or private equity owners.”
The sPEcific problem
According to Katherine Quoroll, technical director at Mactavish, private equity often misses vital areas when conducting risk assessments. “They need to look at the risk of the private equity house, as well as the portfolio company. Even if the PE house has good disclosure of their own risks, they will likely have much less for the portfolio company - for example the composition of the board.”
Quoroll also explains that often insurers will put forward a statement of fact; a run down of the facts they assume about the insurance buyer’s risk. “We’re working on a case at the moment where the statement of fact said the company was making a profit, but it wasn’t. We questioned the statement and it was re-issued, but it came back with the same statement. A lot of portfolio companies will assume they are not responsible for questioning the statement because it is sent as part of the overall policy documents and they are not aware they have a duty to question what is contained within.”
Regardless of who is responsible for the statement of fact, what is clear is that if a claim arises, it will ultimately be the private equity owner who suffers if the claim fails.
Another troubling feature of today’s insurance market is Directors and Officers insurance (D&O), which is intended to provide coverage for a company and its management, protecting them from claims arising from their decisions and actions.
Says Quoroll, “D&O covers any suit that names a director, including employment practices, workplace discrimation, through to investigations by regulators - anything where they are personally named for duties of directorships. Policies are typically written on a broad basis to cover any suit where someone is named, and often the cover is just for defence costs, which can be huge.”
As fiduciaries, directors and officers are personally responsible for their behaviour, but Hepburn is surprised at how little attention private equity professionals can pay to it. “Given the current market conditions, you would expect heightened concerns around these protections. The wealthier the person, the more likely they are to be sued. They are sitting ducks.”
The final area private equity ought to pay close attention to is repudiation risk. Hepburn explains, “When you buy insurance there are two main risks. One is that you can’t get it because it’s too expensive or not available. The other - repudiation risk - is that it doesn't work.” According to Hepburn, repudiation risk is often underestimated by private equity.
And this is a problem because, according to Hepburn, “The scale of repudiation risk in this climate is huge. We’ve never seen repudiation risk on this scale. The scale of disruption we’re dealing with today following multiple concurrent crises related to the pandemic, Brexit, war in Ukraine, supply chain disruptions and inflation is more severe even than the Great Financial Crisis. Insurers will have to respond to this, which means they will be very selective on the claims they pay out on.”
Taking all of the above into account - broker conflicts, disclosure requirements, procedure defence, knowing who is responsible for what, personal liability and repudiation risk - what should private equity firms be doing to ensure their insurance is doing what it’s meant to be doing?
First, stop using brokers exclusively, and create competition in the market.
Second, a shift in mindset is needed, which could lead to a change in how insurance is dealt with. Insurance is typically the responsibility of CFOs because it is seen as a cost. But Hepburn believes the general counsel should also be involved in arranging insurance policies. “These are contracts that could be very expensive if they go wrong, but they’re often put solely under the finance department’s remit. The money they save each year is immaterial versus the money saved when not focused on just premium cost. It should also include in-house counsel overseeing these contracts.”