Daniel G. Lentz is the Americas leader of the Dispute Services team within Ernst & Young's Fraud Investigation and Dispute Services practice. Ryan D. Pratt is a senior manager in the Insurance Claims team within Ernst & Young's Fraud Investigation and Dispute Services practice.
This article originally appeared in the January 2008 edition of the Law Journal Newsletters – Insurance Coverage Law.
The catastrophic losses resulting from the terrorist attacks of 9/11 and Hurricane Katrina highlighted many of the issues that face policyholders in the wake of a disaster. Many companies have taken lessons from those events and developed business continuity plans to protect their people and assets and to restore operations as quickly as possible.
While these plans are instrumental in restoring a company’s operations, many miss an important aspect of any continuity plan — the programs and protocols that must be in place to prove losses related to the incident and recover funds from an insurance company.
Having appropriate insurance policies in place is only part of the equation. Properly proving the claim is crucial to maximizing the benefit from the policy for which the company has paid premiums. Several common obstacles arise that can hinder a company’s efforts to establish proof, so planning ahead and communicating often can be the difference between negotiating and litigating a complex insurance loss.
Documentation
If it is a Miracle, any sort of evidence will answer, but if it is a Fact, proof is necessary. — Mark Twain
Any claim manager or adjuster will tell you they are not miracle workers. If a policyholder’s claim documentation is incomplete or suspect, the claim will be at a distinct disadvantage from the start. The adjuster and his advisers (accountants, engineers, etc.) are responsible for building the claim file, documenting the loss, and turning it over to the insurers for payment. It is imperative, and the burden of the insured, to provide organized and responsive claim documentation to the adjuster in order to substantiate a claim to insurers.
Insurance claims are based on facts — property was damaged, inventory was destroyed, business income was lost. Proof is required to support those facts. The type of documentation required depends on the item that is the subject of the claim. For example, documentation of inventory may depend on the state of that inventory. Typically, raw materials, work in progress, and finished goods are valued differently in the policy; therefore, it is likely that the documentation for each will be different. Where cost and production data may be required for raw materials and work in process, retail value and selling expenses may be required for finished goods or merchandise.
When Is Simple Proof Not Enough?
In some cases, proving a loss goes beyond documentation. Proving the cost to repair property often can be complicated because the reporting of assets for premium purposes typically occurs before there is a reason for a claim. In some cases, if a building is severely damaged but still structurally sound, the cost of repairing it may be higher than the cost of building the same building in the same location from the ground up. For example, many of the buildings that were severely damaged in Hurricane Katrina were repairable after the storm passed. However, the buildings were not compliant with the current building code. Many of these buildings were reported to the insurers at rebuild cost assuming a clean slate, but the cost of bringing a damaged structure up to current code was much higher than that.
Proving the actual cost of repairing a building can also be a challenge if the market fundamentally changes. After Hurricane Katrina, repair costs in the Gulf Coast region increased markedly because of intense demand for labor and materials. Materials shortages in the region forced contractors to obtain materials from much farther away, adding significant shipping expenses to the cost of repairs.
While a rise in construction costs is not grounds for denying an insured’s claim, it does add work to the claims process. The claimant must explicitly document that the work performed was to replace what was damaged and the reasons for the increased cost. This can be a challenge when work is expedited and the documentation comes late, but claimants should work with their contractors to help prove the increased costs.
The bottom line in proving an insured’s property damage claim is to base it on real-world experience. A policyholder should not rely on a repair or replacement estimate formed in a vacuum using theoretical, historical — and in some cases, outdated — cost information. Taking the time to do it right, i.e., by obtaining a bid from the contractor who will be doing the work, will assist the policyholder in supporting its claim and recovering the right amount from insurers.
Procedures For Capturing The Proof
When a disaster strikes, whether it is the scale of Hurricane Katrina or an incident at a single location, companies understandably start to act immediately to contain the damage, protect property, and re-establish operations. In many cases, the costs incurred to do so are recoverable under the policy. To recover them, the insured must know about them and have documentation to support the claim.
When property is in jeopardy and the pressure is on to repair, replace, and restore operations, those in the trenches can forget to track and/or report would-be recoverable expenses. In some cases, the proof may be available, but employees may not know where to charge these costs, leaving them in maintenance or petty cash accounts or charging them through to location-specific profit and loss statements.
In such cases, an insured’s entire claim becomes more complicated. First, and most obvious, proving the out-of-pocket costs will be a costly and time-consuming endeavor, as it could require hundreds of man-hours to search out and weed through data and information that have been misplaced or misclassified. Worse, the insured may leave dollars on the table because those preparing the claim are unaware of the incurred costs.
As an example, a national retail chain with multiple locations affected by a hurricane responded quickly to restore its operations. Using local employees and regional maintenance managers to assist with the cleanup, verify inventory, and make temporary repairs, the company was able to bring 90% of its operations back on line within one week.
Unfortunately, the regional maintenance managers did not have a consistent means of reporting the expenses they incurred in repairing the affected locations. Local employees manually recorded the number of hours spent on claim-related tasks, but did not document what they were doing. Out-of-pocket costs were charged to corporate credit cards with no mechanism in place to attribute the cost to the hurricane. As a result, there was no clear way to distinguish normal operating costs from those that could be recoverable as related to the hurricane. Those preparing the claim had to review thousands of transactions line-by-line to assess the purpose for each expense and then locate the proof for those found to be relevant.
In addition to the time and money spent backtracking to establish and document a claim, measuring the insured’s business-interruption loss becomes immensely more challenging when claim-related expenses are charged to the income statement. When measuring the business interruption loss, the insured must demonstrate the normal operating costs that continued during the period of indemnity. Attempting to measure the business-interruption loss using profit-and-loss statements littered with misclassified property repair and extra expenses is an exercise in futility. In some cases, insurers may perceive that the insured is trying to "double dip" by claiming the expenses twice.
Policyholders must have a process in place prior to a loss to effectively capture the costs incurred because of an event. This process must define for its employees a way to record loss-related expenses as they are incurred and require employees to submit documentation for all such expenses. The accounting department should have a standard set of accounts to capture expenses related to an insured incident that separates those costs from normal operating expenses. Ultimately, a program must be put in place to feed the information and documentation to those who are preparing the claim. Companies that have policies and procedures in place — and that clearly communicate them — have a means to bring some order to the inevitable chaos happening on the ground.
Communication
To effectively communicate, we must realize that we are all different in the way we perceive the world … — Anthony Robbins
In the insurance world, Robbins’ quote is never more true than during the claim process. Each party to an insurance claim has a different view of the world, a different goal and sometimes a different agenda. Policyholders want to be paid yesterday and insurers are happy to wait for extensive proof before payment; risk managers may be concerned about the effect the claim will have on premiums while senior executives are focused on the effect on share price; operations managers may be focused on meeting current demand while sales managers continue to drive future growth. In each of these instances, communication is paramount to the insured in proving its claim.
Internally, those managing the departments most directly involved in the recovery effort must remain in close contact throughout the process to make sure their efforts are coordinated. These departments may include risk management, operations, corporate real estate, accounting, sales, budgeting and planning, and legal. The policies and procedures established to track expenses and document losses must be further communicated throughout the company so that any employee at any level knows what he or she must do to help the company support its claim.
Additionally, communication to company executives is important to manage their expectations of the claim process. To fully document, negotiate, and settle a large, complex loss can take 12 to 18 months or longer, depending on the magnitude and complexity of the insured’s business and the incident. In addition, an insurance claim is rarely cut-and-dried and is usually a series of negotiations between the insured and insurers, even in the well-documented claims. Communication of these concepts with senior management is crucial to manage their expectations of how the claim will proceed, when the insured may realistically settle the loss, and ultimately how much the insured can expect to recover on the claim.
Communication between the insured and insurers is critical to avoid obstacles in proving that expenditures resulting from the event were reasonable and necessary. In many cases, policyholders may take action and document the resulting costs, only to find out that the insurance company will not consider them as covered under the policy.
For example, suppose a manufacturer has to restore a facility that is heavily damaged in the wake of a hurricane. In the meantime, the company pays overtime and retention bonuses to employees, establishes temporary operations and shelter for its employees, and invests in temporary equipment. In this scenario, it is possible that the insurer would object to some of the expenses, possibly deeming the bonuses unnecessary and refusing to reimburse costs for employee housing, expecting the employees’ own homeowners’ insurance to cover those costs. If instead the insured informs the insurer of anticipated costs in advance, fewer objections may arise. Of course the insured also may decide to alter its plans based on feedback from the insurer.
In another example, a large employer hit hard by an event decided to pay all employees for a period of time to retain goodwill. After that time, it intended to lay off a portion of its work force but retain a predetermined list of essential employees who would be more expensive to rehire later. For companies with ordinary payroll coverage, this cost should be covered; however, in proving and supporting this cost, the plan should be discussed with insurers to obtain their feedback, allow them to review the employees who will be retained, and provide input as to how this portion of the claim will be paid under the policy. If the insurer accepts that plan, always in writing, the policyholder can proceed with confidence that it has proven its loss prior to incurring it.
In some instances, it may be possible to set up a pre-approval process with the adjuster for all expenses that reach a certain threshold. While good communication from both the policyholder and insurers is essential to making this work, the insured can push for this type of arrangement in order to mitigate risk. Through this process, the two sides can establish up front what constitutes a covered cost versus one that will be borne by the insured.
Unforeseen Catastrophe
We are ready for any unforeseen event that may or may not happen. — Dan Quayle
Even the most sophisticated policyholders encounter incidents or events that are difficult, if not impossible, to foresee. Significant catastrophic events such as 9/11 and Hurricane Katrina can destroy records, displace employees, and bring an insured’s operations to a halt, making the generation and location of proof a significant challenge.
In these cases, problem solving is the key to substantiating the claim. In constructing claims for losses sustained in the 9/11 attacks on the World Trade Center, many companies faced the challenge of proving losses for which records no longer existed. Inventories of equipment, supplies, and furniture and documentation of leasehold improvements were, in some cases, destroyed. This presented a challenge in measuring and documenting the claim to insurers.
These situations require creativity in establishing the proper measurement of the loss. Some policyholders looked to their other operations to approximate the assets in a "typical" office. Others relied on interviews of personnel familiar with the contents of these locations and offsite records to build a composite picture of the assets lost as a result of the event. All of this was done in communication with insurers to inform them of insureds’ limitations as a result of the event, while demonstrating their recognition that their claim must be documented and proven.
The results of some unforeseen events may be recoverable under the policy. For example, after Hurricane Katrina, many companies had to hire new or temporary employees to assist with cleanup or simply to run the business. In the post-Katrina environment, this labor was more expensive, as the average hourly wage in New Orleans increased substantially. No one could have predicted the impact that Katrina had on the labor market and the cost of doing business in New Orleans. However, some companies were able to recoup these costs from their insurers as continuing, mitigating, or extra expense.
In the end, while some issues may arise that cannot be fully incorporated into the contingency plan, preparation is critical to proving and recovering all that is due an insured through its insurance policy. Establishing and communicating plans that spell out processes to document the claim, track expenditures, and communicate both internally and externally are critical to the success of proving an insured’s claim to its insurers. If those who will be in a position to help the company build its claim through proper information and documentation are aware of their responsibilities in advance, they will be able to incorporate that knowledge into their actions and reactions in the hours and days immediately following a crisis.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.