The costs associated with purchasing adequate insurance coverage and providing employees with competitive health and welfare benefits may be a significant portion of a company's annual operating expenditures. For a private equity firm, the ability to understand and accurately forecast these costs post-transaction can be an important factor in the success or failure of an investment.
Preparing accurate projections of ongoing annual insurance and employee benefits costs should be done by your advisors as part of the due diligence process. The basic formula that drives insurance and benefits premiums is quite simple: Rate x Exposure = Premium. However, there are very few things in life that fit neatly into a simple formula and insurance costs are not among them. In practice, there are enough factors and variables that go into the derivation of these costs that projections will always be the result of as much art as science.
The first question to be answered is how will the deal structure affect the insurance and benefit programs?
The above notwithstanding, certain insurance coverages almost always contain change in control provisions that require them to be replaced regardless of how the transaction is structured. Directors & Officers Liability and Employment Practices Liability are the most common examples of this. For these coverages, the go-forward costs will be determined by the underwriter using such factors as the make-up of the new Board, business plans, pro-forma financial projections, and prior claims activity.
Once the effects of the deal structure are understood, consideration should be given to the costs associated with correcting existing coverage gaps or deficiencies. In some cases, the company's operations may present exposures to loss that simply are not insured. Examples might include pollution, employment practices liability, or foreign exposures. In other cases, all of the appropriate coverages are there but not in amounts sufficient to adequately protect the company. With employee benefits, the risk to the company of missing or inadequate offerings is often one of competitiveness. Your insurance and benefits advisor should be able to identify what is missing or deficient and provide estimates of the costs to plug the holes. Your advisor should also provide you with benchmarking data to illustrate the types and amounts of coverage being purchased by other companies with similar size, operations, and geography.
It is important that your advisors are aware of any planned changes in operations or organizational structure post-transaction. Changes such as staff downsizing, plant closings, and inventory reductions all have potential impacts on underlying insurance and benefits exposures. Some planned operational changes require a very close look to fully understand the potential cost impact. For example, closing a manufacturing facility in the Midwest and expanding capacity in another facility located in the Southeast, where the risk of a catastrophic windstorm is much greater, could result in a significant increase in the cost of property insurance. Similarly, if a planned post-transaction staff reduction will disproportionately impact less experienced, low seniority (i.e. young) workers, the surviving workforce, while smaller, may be older on average and therefore more expensive to insure for medical and other benefits. An important area where even small changes can have large cost implications is employee vs. employer benefit contribution rates. Opportunities for cost savings by shifting more of the burden to employees need to be carefully weighed against the potential impact on morale and the company's ability to attract and retain talent.
Finally, another important factor influencing costs is the company's historical claim experience. The larger the company, the greater the emphasis underwriters will place on that company's own historical experience versus general industry and geographic trends and statistics. While historical claim experience can be among the most influential cost determinants, this data is typically among the most difficult information for advisors to obtain given the tight time constraints posed by most transactions. When examining past claim costs, trends are as important as absolute amounts. Have claim costs been improving or deteriorating in recent years? Is there enough historical data to forecast claim costs for the coming year?
Given all of the complexities involved, the best way to ensure timely and accurate insurance and benefit cost projections is to select advisors with experience and extensive market knowledge. Then, get those advisors involved early in the process and provide them with complete and up to date information.
Robert Zenoni is President of Equity Risk Partners, Inc., the only insurance and employee benefits brokerage firm dedicated exclusively to the needs of the private equity industry and its portfolio companies. Over the years, Equity Risk Partners and its professionals have provided meaningful analysis and advice on more than 500 transactions.