Ready, set … recall

Editor’s note: This is part 2 of two-part series on product recall. Part 1 appeared in the May 8, 2006, Western region issue of Insurance Journal.

Losses resulting from a product recall are generally classified as either first-party losses or third-party losses. First-party losses are losses that may be directly incurred or suffered by the insured. Third-party losses are those losses that are suffered by customers of the insured, and for which the insured may be legally obligated to reimburse the customer. Those third-party “recall” liability losses should not be confused with general liability or product liability.

The obvious and initial first-party financial exposure lies in the logistics of the recall and the notification expenses incurred in properly and promptly notifying the public of a safety issue and recall. Communications, warehousing, testing, transportation, employee overtime and cleanup are examples of some of the extraordinary costs that may be incurred.

However, the potential long-term losses from the damage to a company’s reputation and loss of sales are a far greater concern. Unlike the expense of the physical recall, the loss of profits and brand rehabilitation expense may continue for months or even years.

Third-party exposure to recall can be more difficult to quantify, as those are largely outside the company’s own control. Third-party losses typically would include losses suffered by customers as a result of a recall. Third-party recall losses are not limited to recall expenses alone. They can include a customer’s loss of profits and extra expenses incurred not only to the affected product, but also to other products the customer may sell. Companies providing component parts or ingredients, as well as contract manufacturers, have the greatest exposure to third-party recall losses. The contamination of an ingredient, however small or insignificant, will affect the entire product rendering it useless.

Companies that use subcontractors or co-packers face a unique exposure that can be difficult to control. In most cases, such companies use stringent qualifying criteria prior to selecting a co-packer and require that co-packers abide by quality assurance standards at least equal to their own standards. However, should a co-packer precipitate a recall, they may not have the financial capabilities to respond to their customer’s losses. While requiring the co-packer to carry recall insurance may provide some level of protection, it is difficult to monitor. Often, the benefit accrues to the co-packer and not the customer. Nevertheless, the company’s brand and reputation are at stake, so those exposures are best addressed through its own insurance program.

Risk management and transfer options
No amount of insurance can replace a loss in customer confidence due to the ineffective execution of a company’s recall strategy. Once an incident becomes known to the media, a company can expect difficult questions from a range of interested parties.

First and foremost, customers will want a clear understanding of the potential danger and measures the company is taking to minimize or eliminate the danger. Likewise, governmental agencies, employees, suppliers, distributors, and other external and internal parties will have questions.

Every company should have a well-documented and practiced crisis management plan. The crisis management plan coordinates all aspects of the crisis including procedures designed to quickly and efficiently identify, locate and recover any suspected products. The plan defines the crisis management team and each person’s role in responding to the crisis. All team members need to be reachable at a moment’s notice.

In many instances, the crisis team is supplemented by outside members that may include public relations and crisis management consultants.

Mistakenly, many companies believe they are protected for product recalls under their general or products liability policy. Those policies provide coverage for liability from bodily injury, but they do not provide coverage for product recalls. In fact, standard ISO forms specifically exclude “damages claimed for any loss, cost or expense incurred by you or others for the loss of use, withdrawal, recall, inspection, repair, replacement, adjustment, removal or disposal of your product, your work or impaired property.”

Although some liability carriers may provide an extension for product recall losses, those are almost always subject to a minimal sublimit and are limited to first-party recall expenses only. Extensions do not cover any first-party loss of income, profits or extra expense, nor do they provide crisis support.

Product recalls are and will continue to be a growing threat to both short- and long-term profitability to companies in a wide range of industries. Properly analyzing the exposure, be it first-party, third-party, contractual or otherwise, is the first step in preparing an effective response.

Developing the appropriate response includes analyzing the exposure and developing the appropriate insurance program response, as well as minimizing long-term damage through pre-incident planning and effective timely response.

The product recall insurance marketplace is a specialized market dominated by a handful of insurers. Aligning the insured with the proper coverage, preparedness and crisis support is key in how well a company weathers a recall storm.

Bernie Steves is senior vice president for Colemont Insurance Brokers in the Chicago office. He is responsible for developing Colemont’s Product Recall Team.

Topics Profit Loss