It Happened Here
Disclaimer: The events depicted in this scenario are fictitious. Any similarity to any corporation or person, living or dead, is merely coincidental.
A Promising Prospect
Hal Landis walked into the boardroom at Stratton Bank headquarters in Chesapeake, Va. with a glow building inside of him.
The chairman and CEO of the bank, he carried in his briefcase paperwork that detailed the possible acquisition of Stratton by Manhattan-based Global Corp.
Global Corp., with about $100 billion in assets, liked the look of the mid-sized Stratton, which held about $30 billion in assets.
With its roots as a lender to the conservative farmers and fishermen of the Middle Atlantic, Stratton had a reputation for producing modest, steady returns and never taking unnecessary risks.
“Shall we get started everyone?” Landis said with a confident grin.
At 63, Landis was in good shape physically and financially, and with what Global was offering on a per-share basis, he couldn’t help but fantasize about the sort of retirement he might now be able to afford if this deal went through.
Two hours later, the rest of the board of directors was won over. They voted to accept Global’s offer, conditional on the approval of that corporation’s board of directors.
The Global board meeting to discuss the Stratton acquisition did not go quite as smoothly.
The audit committee had barely completed its report on Stratton’s financials when Augie Desmond, a junior staffer in the bank’s risk management department, spoke up.
“Mr. Bedford,” Desmond began, addressing the bank’s chairman, the formidable Alan Bedford.
Eyebrows were raised. It wasn’t common for junior employees to punctuate Global meetings with unsolicited remarks or questions.
“Nice working with you kid,” the CFO said to himself.
“Yes, Mr. …” Bedford began.
“Desmond, sir, Augie Desmond, from risk management,” Desmond said.
“Yes, Mr. Desmond?” Bedford said, throwing a questioning look at Desmond’s boss, CRO John Fairmount.
“I have serious concerns about this acquisition, sir,” Desmond said.
“There was a piece in the Journal today on a steam-generating solar plant in Nevada,” Desmond said.
Fairmount shot Desmond a look.
“Sorry John,” Desmond said. “I didn’t have time to tell you.”
“According to a report from Stanford, the heat from the plant is killing wildlife — lots of it — including the state bird,” Desmond said.
“Wha….?” Bedford began.
“The solar company, Daedalus, is based in Virginia,” Desmond said. “Stratton is the primary advisor on the company’s upcoming IPO. Daedalus is applying for a second permit, an even bigger plant with about $30 million in investment. If the politicians get hold of this thing, and they will …”
“What thing?” Bedford said.
“The bluebird thing sir, that’s the state bird. If this second plant application goes south, that solar company is at serious risk and so is Stratton — I don’t like it sir … I don’t like it one bit.”
“Mr. Desmond what is your background?” Bedford asked.
“I have a Master’s Degree in astrophysics from MIT,” Desmond said.
“And how long have you been in the banking industry?” Bradford said.
“Three months sir,” Desmond said.
“I’ll take that under advisement,” Bedford said.
Without much further debate, they followed the recommendation of the audit committee and approved the Stratton acquisition.
The meeting of the Stratton Bank stockholders to vote on the approval of the Global Corp. offer was held in the conference rooms at the Chesapeake Madison Hotel. Before the vote, the floor was opened up for discussion.
As he was at every meeting, Smitty Ackles, a shareholder and crabber from Havre de Grace, was first to the mike.
With his enormous gut protruding from between the bands of his cherry red suspenders, Ackles stood at the mike, smiling with wizened eyes at Hal Landis.
“Good afternoon, Mr. Landis,” Smitty said.
“Good afternoon, Mr. Ackles,” Landis said in what the audience recognizes as their standard opening schtick.
There are chuckles throughout the room.
“What I’d like to know, Mr. Landis, is why in the world the shareholders should accept this deal? We have been doin’ alright for 35 years, nobody’s complainin’ about their returns. Why do it?”
“Well, a 20 percent premium on our shares is one reason,” Landis said.
“Not worth it,” countered Ackles. “These boys from New York will bring more trouble than they’re worth, I guarantee you.”
“I’ve known you since you were a boy, Hal Landis, and I’m here to tell you, you’re making a mistake,” Smitty said before ambling away from the mike.
There are more chuckles, but nobody really listens to Smitty. Stratton shareholders approve the deal 2,010 to 15.
Not even a week later, the Nevada Department of Environmental Protection issues a surprise ruling that condemns the second Daedalus plant.
A study from the University of Nevada confirms what the Stanford researchers found. The plant is linked to the deaths of 1,000 Mountain Bluebirds, the state bird. Deaths of other birds number in multiples of that.
Geddy Hayes, an influential Nevada State Senator from Sparks, picked up the football and ran with it. Hayes, a gifted speaker, worked his magic from the Senate floor and killed any remaining chance the second Daedalus plant had.
The application for the plant, which the solar company spent millions on, went under.
Hayes wasn’t done with Daedalus. He pressured state regulators into burdening the existing plant with new regulations — to the point that it began to lose money.
On a Monday afternoon, Hal Landis sat in his office with CFO Dylan Reed, watching a cable news financial report.
The Daedalus IPO launched the previous week and did fairly well, with the share price rising 17 percent by week’s end. The following week was a different story.
Losses suffered by the Daedalus plant are being reported, along with the losses from the failed application for the second plant.
One week after the IPO launch, Daedalus shares are down 30 percent and are in freefall.
“How bad do you think this is for us?” Landis asked Reed.
“I don’t know, I’ve never been in this position before,” Reed said.
“None of us have,” Landis said.
Within two days, Stratton is set upon in a class action by attorneys for disgruntled Daedalus shareholders, who report millions in investment losses.
The acquisition of Stratton by Global is set to close in the third quarter. In its second quarter financials, Stratton reports a multimillion dollar write down in connection with the Daedalus fiasco.
Weakened by the reputational hit of the Daedalus shareholder class actions, Stratton also begins to notice some alarming revenue declines.
This time, at the Global board meeting where the decision to follow through on the Stratton acquisition will be made, it’s Augie Desmond’s boss, John Fairmount, who speaks first for the risk management department.
“Mr. Bradford, it’s our opinion that we should absorb any frictional costs and abandon this acquisition,” Fairmount said.
“Based on what data?” asked Global’s CFO, Daniel Silberstein, who championed the acquisition from day one.
Fairmount turned to Desmond.
“We’ve run an algorithm that ties share price to reputational damage. Call it a reputational risk index, if you will,” Desmond said.
“Based on what we’re seeing with Stratton, we see share price deterioration tied to reputational problems plaguing the bank for at least the next six quarters,” Desmond said.
Bradford shot Fairmount a look that said, “Again with this kid?”
Bradford and Silberstein aren’t swayed. They like Stratton’s basic book of business a lot. The bank hasn’t had a quarter in 20 years when it didn’t return a dividend.
Global’s board votes 13 to 4 to go ahead with the acquisition.
In the first six months following the acquisition year, Stratton shows a revenue decline of 20 percent over the previous year.
The solar deal in Nevada that went sour is poisoning the bank’s brand with its largely conservative retail banking customers.
A sizable chunk of Global shareholders are fed up. Rather than start an internecine war with their own management, they take action against Stratton.
The allegations are that Stratton failed to disclose the risk of the Daedalus exposure to the Global board and bungled the crisis management of the failed IPO.
Two years ago, if you’d asked Hal Landis who his insurance broker was, he couldn’t have told you. Now he knows him very well.
“You have $10 million in general liability coverage,” the broker explained to Landis over the phone.
“Right,” Landis said.
“Between the Daedalus IPO shareholder actions and the Global shareholder actions, you’re looking at $15 million in potential liability,” the broker said.
“Do you see any indications that your own shareholders could take action against the board?” he asked.
“Not to date,” Landis said.
“You have that much in your favor,” he said. “For the time being.”
“Well, we can self-insure the $5 million on top of the policy if we have to,” Landis said.
“Sure,” the broker said. “But I can’t think of an admitted carrier who will even talk to us next year.”
“What’s an admitted carrier?” Landis said.
“It’s a carrier who’s not going to charge you your right arm in premium,” said the broker.
No longer fantasizing about a rosy retirement, Landis wonders how long he’ll have a job.
Risk & Insurance partnered with Aon to produce this scenario. Below are Aon’s recommendations on how to prevent the losses presented in the scenario. These lessons learned are not the editorial opinion of Risk & Insurance.
1. Risk management requires an open mind: Ignoring stakeholders that voice legitimate concerns carries a double-edged risk. The first risk is the magnitude of the exposure brought up by a colleague or shareholder that’s being overlooked. The second is the fact that an issue was raised publicly, thereby documenting a concern that went unheeded by management.
2. Risk by association: Operational risk is such a pressing risk for financial institutions in part because of the number and variety of business partners and clients they take on as part of their basic operation. An inadequate knowledge of the technology, practices and risk exposures of any given business partner can result in reputational and other damages should that business partner fail or incur a sizable liability.
3. Transparency: Companies that fail to properly assess their risk and report it to business partners face increasingly painful regulatory sanctions. A blunt assessment of an organization’s exposures is the first step in that process. Being forthright in communicating risk factors is the second.
4. Analyze cover: Regulatory pressures and a rapidly changing business environment necessitate that financial institutions assess their insurance coverage more frequently than ever before.
5. Risk management is a process, not a program: There is nothing static about risk management. New processes, products and distribution channels in the financial services industry mean that the nature of operational risk is changing constantly. Risk management needs to keep pace with that change or risk losing relevance and value.
A Paramount Parable
Disclaimer: The events depicted in this scenario are fictitious. Any similarity to any corporation or person, living or dead, is merely coincidental.
Home for the Holidays
Neal Chambers surveyed the holiday turkeys on display at his local grocer on Nov. 23 and mused. Fresh or frozen? Tom or hen? Free range or kosher? Locally produced or from the foothills of the Smoky or the Sierra Mountains?
Chambers threw thrift to the wind and plunked down $52 for a 16-pound organic bird from Upstate New York.
What the heck? After four brutally slow years, the construction company he managed risk for was showing signs of reemergence.
True, the company’s estimators were not happy. Where once they needed to bid 10 jobs to land one, each job now took 30 or 40 bids to land.
Neal’s company, Paramount Construction Co., based in Des Moines, Iowa, worked with larger companies historically.
But in order to land projects, it was now moving down to the middle market and competing against smaller regional operators with local expertise. This was not an easy road to hoe.
But Paramount was doing what it felt it needed to do to compete successfully.
At the office holiday party on Dec. 19, held at the River Bluff Country Club, Neal could see signs that the C-suites were feeling a little better about things. Nice carving station, good wine in the glasses and some generous door prizes. He took in a deep breath and let it out.
Things had been tough for a while. He’d been working hard. He’d been worried.
“Go ahead, have a drink,” he told himself. “It’s free and now is as good a time as any.”
Neal had one glass of wine in him and was waiting his turn to fill his plate at the sushi appetizer table when he saw one of the vice presidents, Tom Murphy, lift his phone to his ear.
As he listened to the caller, Murphy turned and looked at Neal. With his other hand, he gestured to Neal to join him. Murphy’s hand was free because he did not drink at company functions … ever.
“It’s Constantine,” Murphy said in a whisper when Neal got closer. “Something’s up. He tried to reach you but…”
Murphy shrugged non-judgmentally.
Constantine, head of operations. Good guy. No nonsense.
“This is Neal Chambers,” Neal said into Murphy’s phone.
“Neal, it’s Jonny Constantine. We’ve got a bit of a situation.”
“Shoot,” Neal said.
Constantine exhaled audibly into the phone. Neal could tell that Constantine was a little upset.
Neal shot a look of worry at Murphy.
“Look, we just had an accident with an excavator operator on the site here in Mille Lacs. We’ve got one seriously injured employee and some structural damage to a neighboring building.”
“How bad is the injury?” Neal said.
“It’s not pretty. I think this poor kid is going to lose his left leg below the knee,” Constantine said.
“And the building?”
“Well. The wall on the demo wasn’t supported right and the operator knocked it into this neighboring wall. It was a pretty big bump.”
Neal hung up with Constantine and gave Murphy his phone back.
As he turned his own phone on to check messages, Neal Chambers felt any holiday warmth drain out of him. The wine that had been so enjoyable 20 minutes ago now struck him like a cheap depressant.
2014 was supposed to be Paramount’s breakout year. But now Chambers had a significant workers’ compensation and general liability claim to worry about.
Looking around the brightly lit room at his fellow employees, Neal Chambers had an uneasy feeling that 2014 wasn’t going to be that great after all.
No Bench Strength
What worried Neal Chambers were the personnel cuts Paramount undertook to survive during the brutal commercial construction downturn that seized the country during the Great Recession.
The most worrisome cuts came in the area of safety, where some highly paid talent had been laid off. But there were also cuts in estimating, where other senior personnel with beefier paychecks left the company.
You couldn’t put the cart before the horse. Although things were turning around, Paramount was not yet at a place where it could hire big ticket talent to fill the gaps. Not yet.
Yet the company was trying to grow again and take on more projects. The combination worried Neal Chambers.
The accident with the excavator in Mille Lacs wasn’t catastrophic. But it was the beginning of a series of workplace accidents that plagued the company through the first six months of 2014.
Neal’s conversations with finance added to his anxiety.
“We’re just not making the money on these projects I thought we were going to be,” said Tom Murphy’s elder brother Pat Murphy, the company CFO.
Bidding for projects in unfamiliar territories and on unfamiliar scales, Paramount’s overworked estimators were missing the mark time and again.
The combination of an increased injury frequency rate and thinner margins was not making a good impression on Paramount’s surety and insurance underwriters.
Both Pat and Neal feared that year-end premium increases could be in the works.
Paramount’s revenue shortfalls created friction with subcontractors.
Jonny Constantine got into several heated arguments with subcontractors, alleging that they were botching projects by not moving more efficiently.
There were now a handful of legal proceedings underway. In those cases, Paramount was alleging that subcontractors violated the terms of their contracts by not completing the work in time, or completing it in substandard fashion.
Win or lose, those lawsuits meant one thing to Neal Chambers and Pat Murphy. They meant more costs, more margin erosion.
“We’re in a tight spot,” Neal Chambers said.
“I know we are,” Pat said, somewhat impatiently.
“The thing is, I don’t know what we can do between now and 2015 renewals to make a better impression,” Neal said.
“It’s almost like a roll of the dice,” he added. “I don’t know what else we can get out of the safety department in terms of management.”
“We need better talent and more of it,” Pat said.
The question was where.
A Horse With No Name
The answer to Neal’s question, as it turned out, was “nowhere.”
The talent crunch that Paramount was experiencing, and which was causing it so much pain, was not isolated to Paramount. But some of its competitors moved more quickly than Paramount in acquiring and retaining the talent to help them take full advantage of the upturn.
Others moved even less effectively than Paramount. But in a competitive economy, being in the middle was no place to be.
As 2014 moved from the second quarter to the third and fourth, adding to Paramount’s workers’ compensation woes and its sinking profit margins came yet another issue.
That issue was increasing commodities prices. Paramount’s overworked estimators, working in the unfamiliar middle market, failed to take into account a gradual increase in the cost of steel, copper wiring and other key construction materials.
There simply was no place to turn to hire the sort of experience in safety or in estimating that could put Paramount back on track.
As Paramount’s executives looked forward to their year-end renewals for their insurance programs, the company was looking at unpalatable premium increases.
“You’re looking at a 30 percent mark-up with your workers’ compensation premiums and at least a 25 percent increase in the amount of collateral you’re going to have to put up in workers’ compensation and in surety,” said the company’s broker, Ed Scarborough. “You’re also looking at an increase in your general liability.”
The construction market continued to recover. But Paramount now needed to play defense.
Faced with insurance and surety increases and declining margins, Paramount had no choice but to do what it didn’t want to do. Already bereft and hamstrung due to a lack of talent, Paramount undertook more layoffs.
One of the first to go was Neal Chambers.
In November of 2014, Neal Chambers and his daughter Annabelle went shopping for a turkey. Annabelle was fourteen and well versed in sustainable agriculture practices at school.
“We’re getting an organic turkey, right?” she asked her father.
“No, Annabelle, I’m afraid not,” Neal said.
Neal reached into the meat freezer and pulled out a frozen Honeybreast turkey and threw it into his shopping cart with a disheartening “clang.”
Risk & Insurance partnered with Liberty Mutual Insurance to produce this scenario. Below are Liberty Mutual Insurance’s recommendations on how to prevent the losses presented in the scenario. These lessons learned are not the editorial opinion of Risk & Insurance.
1. Value is replacing price: It’s no longer enough to be the lowest bidder. Contractors must now prove to clients that they have the capacity to deliver a project that is the most cost-effective in the long term. That means not only delivering a quality product, but having the risk management program and coverage in place to mitigate potential finger pointing and costly litigation down the road.
2. Keep an eye on commodities: Nowhere are the realities of the global economy more evident than in the area of commodities. Demand cycles for copper, steel, coal and other materials in developing or maturing economies are going to have an impact on prices here at home. Models that take into account commodities fluctuations will be increasingly important. In addition, any new rating programs based on Construction Value should be carefully evaluated compared to a payroll based program.
3. Talent rules: Qualified estimators and safety officers left the construction industry in droves during the downturn. Making sure the talent is in place to take advantage of the upturn in the rebounding commercial construction business is an important consideration. Don’t overlook the added value of a well-documented quality assurance program.
4. Understand new geographies: Competing in this new market may mean having to enter new geographic areas to find business. Trying to compete in New York state without understanding its Byzantine labor laws would be a mistake. So would entering into any new geography without an understanding of local regulations and how they could impact costs. Conversely, demonstrating local experience to a client would be a key selling point here.
5. Delivery methods matter: New markets mean new delivery methods. Whether it is design-build, identifying a construction manager at risk, or the complexities of public-private or international partnerships, insurance and risk mitigation are going to have to be adequate to cover these trending delivery methods. Effective communication amongst all parties including contractual relationships continues to be a vital aspect of any project.
What Is Insurance Innovation?
Truly innovative insurance solutions are delivered in real time, as the needs of businesses change and the nature of risk evolves.
Lexington Insurance exemplifies this approach to innovation. Creative products driven by speed to market are at the core of the insurer’s culture, reputation and strategic direction, according to Matthew Power, executive vice president and head of strategic development at Lexington, an AIG Company and the leading U.S.-based surplus lines insurer.
“The excess and surplus lines sector is in a growth mode due, in no small part, to the speed at which our insureds’ underlying business models are changing,” Power said. “Tomorrow’s winning companies are those being built upon true breakthrough innovation, with a strong focus on agility and speed to market.”
To boost its innovation potential, for example, Lexington has launched a new crowdsourcing strategy. The company’s “Innovation Boot Camps” bring people together from the U.S., Canada, Bermuda and London in a series of engagements focused on identifying potential waves of change and market needs on the coverage horizon.
“Employees work in teams to determine how insurance can play a vital role in increasing the success odds of new markets and customers,” Power said. “That means anticipating needs and quickly delivering programs to meet them.”
An example: Working in tandem with the AIG Science team – another collaboration focused on innovation – Lexington is looking to offer an advanced high-tech seating system in the truck cabs of some of its long-haul trucking customers. The goal is to reduce driver injury and fatigue-based accidents.
“Our professionals serving the healthcare market average more than twenty years of industry experience. That includes attorneys and clinicians combining in a defense-oriented claims approach and collaborating with insureds in this fast-moving market segment. At Lexington, our relentless focus on innovation enables us to take on the risk so our clients can take on the opportunities.”
– Matthew Power, Executive Vice President and Head of Regional Development, Lexington Insurance Company
Power explained that exciting growth areas such as robotics, nanotechnology and driverless cars, among others, require highly customized commercial insurance solutions that often can be delivered only by excess and surplus lines underwriters.
“Being non-admitted, our freedom of rate and form allows us to be nimble, and that’s very important to our clients,” he said. “We have an established track record of reacting quickly to trends and market needs.”
Lexington is a leading provider of personal lines coverage for the excess and surplus lines industry and, as Power explains, the company’s suite of product offerings has continued to evolve in the wake of changing customer needs. “Our personal lines team has developed a robust product offering that considers issues like sustainable building, energy efficiency, and cyber liability.”
Most recently the company launched Evacuation Response, a specialty coverage designed to reimburse Lexington personal lines customers for costs associated with government mandated evacuations. “These evacuation scenarios have becoming increasingly commonplace in the wake of recent extreme weather events, and this coverage protects insured families against the associated costs of transportation and temporary housing.
The company also has followed the emerging cap and trade legislation in California, which has created an active carbon trading market throughout the state. “Our new Carbon ODS product provides real property protection for sequestered ozone depleting substances, while our CarbonCover Design Confirm product insures those engineering firms actively verifying and valuing active trades.” Lexington has also begun to insure new Carbon Registries as they are established in markets across the country.
Lexington has also developed a number of new product offerings within the Healthcare space. The Affordable Care Act has brought an increased focus on the continuum of care and clinical patient safety. In response, Lexington has created special programs for a wide range of entities, as the fast-changing healthcare industry includes a range of specialized services, including home healthcare, imaging centers (X-ray, MRI, PET–CT scans), EMT/ambulances, medical laboratories, outpatient primary care/urgent care centers, ambulatory surgery centers and Medical rehabilitation facilities.
“The excess and surplus lines sector is in growth mode due, in no small part, to the speed at which our insureds’ underlying business models are changing,” Power said.
Apart from its coverage flexibility, Lexington offers this segment monthly webcasts, bi-monthly conference calls and newsletters on key risk issues and educational topics. It also provides on-site risk consultation (for qualifying accounts), access to RiskTool, Lexington’s web-based healthcare risk management and patient safety resource, and a technical staff consisting of more than 60 members dedicated solely to healthcare-related claims.
“Our professionals serving the healthcare market average more than twenty years of industry experience,” Power said. “That includes attorneys and clinicians combining in a defense-oriented claims approach and collaborating with insureds in this fast-moving market segment.”
Power concluded, “At Lexington, our relentless focus on innovation enables us to take on the risk so our clients can take on the opportunities.”