CHAPTER THIRTY-TWO

Insurance and Legal Considerations

THE CFO SHOULD be familiar with insurance and law. Insurance coverage protects against fire and theft losses, product liability, and contract repudiation. Federal and state laws deal with the relationship between the employer and employee.

INSURANCE PROTECTION

In a large company, a risk manager position should exist to handle insurance issues. The risk manager should report directly to the CFO. In a smaller company, the CFO may be responsible for insurance matters him- or herself.

Insurance protection minimizes the risk of loss. Insurance may be mandated by law, such as workers’ compensation. Insurance coverage may be required by contract, such as fire insurance in order to adhere to the provisions of a loan agreement. The CFO must understand insurance requirements and procedures, and must monitor and control insurance costs while maintaining sufficient insurance coverage. The CFO has to consider the limits for risk assumption or retention, self-insurance, and uninsurable risks. Furthermore, suitable documentation of insurance procedures is needed.

What are your duties in the insurance area?

The CFO has many responsibilities in insurance protection, including:

• Identifying and appraising risks
• Monitoring changes in the corporate environment as it affects insurance
• Estimating the probability of loss
• Maintaining insurance records
• Keeping abreast of new developments in insurance
• Ensuring compliance with federal and local regulatory laws

In evaluating insurable hazards, the CFO should examine properties and related contractual obligations (e.g., leases, mortgages) in detail. Each structure should be listed along with its condition, safety, location, and replacement cost.

In insignificant risk areas, deductibles should be established to satisfy company needs and result in premium savings. Tip: A new business should have higher deductibles until experience of loss incidences and their financial effect is gained.

Insurance policies should be reviewed periodically to avoid uninsured losses. As the company changes in size, products, geographic areas, and so on, it may have to alter the type and amount of insurance. There may have to be a revision in policy limits and deductibles based on the company’s current situation. If the deductible is increased, the premium will be decreased. When reviewing insurance, the CFO has to consider new risks, trends in litigation, changes in inventory policy, sale or purchase of fixed assets, switch in distribution channels, and fair market value of property.

What insurance records are needed?

Many insurance records should be maintained, including:

• Records of premiums, losses, and settlements. The ratio of premiums to losses should be computed.
• Expense distribution records, including information about payments, refunds, accruals, write-offs, and allocation amounts and bases to segments.
• Claim records, including the names of claim representatives, claim procedures, documentation, claim information (e.g., date), and status of the claim.
• Records of the values of insured items.
• Binder records of pending insurance.
• Location records of insured items.
• Transportation logs for corporate vehicles, including delivery trucks and automobiles. Information includes miles driven and to be driven, condition, and location.
• Other files, including due dates for premiums, notice of hearings, and inspections.

An insurance manual should be kept detailing the procedures to be followed on all aspects of insurance coverage by type, including obtaining insurance, filing claims, financial reporting and presentation, allocation bases to allocate premiums to reporting units, and settlement issues.

All insurable losses must be reported and documented immediately. The CFO must know what types of losses have occurred, where, and of what magnitude. The damaged items must be segregated until the adjuster has made a review. The CFO should determine the reason for the loss and recommend remedial steps.

At year-end, an insurance report should be prepared containing a description of the types of insurance and coverage, premiums paid, self-insured items, and the adequacy of established reserves.

The insurance record (Exhibit 32.1) lists the insurance policies, policy dates, annual premium, and coverage.

The CFO should keep records of the use and sale of property. Insurance claim information should be maintained for such items as cash, securities, inventory, and fixed assets. The CFO should check the track record, support, and documentation for all claims.

EXHIBIT 32.1 Insurance Record

How do you know what insurance broker to use?

In choosing an insurance broker, these points should be considered:

• Insurer’s financial condition
• Types of coverage, insurance products available, and rates
• Timely and full resolution of insurance claims
• Services provided and expertise of staff

TYPES OF INSURANCE

The types of business insurance include product liability, commercial property, umbrella excess policy, marine, contingent business interruption, automobile, and aircraft.

To what extent are you affected by product liability?

Insurance coverage is needed for losses arising from damages suffered by other parties because of defects in the company’s products, services, operations, or employee actions. An evaluation should be conducted of contracts, leases, and sales orders. What federal and state product liability statutes apply? What is the probability of loss, the degree, and the frequency?

What is covered under commercial property insurance?

The commercial property policy is a comprehensive one insuring inventory on the premises, warehouses, and in transit. It also covers property damage, personal injuries, product liability, advertising liability, fire damage on rental premises, flood and earthquake losses, and loss of valuable records. The coverage excludes certain items, such as cash and securities, property sold under installments, precious metals, aircraft, and imports or exports. These are covered under other types of policies.

The commercial property policy is the prime “all-risk” policy of the company. Losses exceeding policy limits are recoverable under the umbrella policy.

How do you determine the insurance reimbursement?

Casualty insurance covers such items as fire loss and water damage. The premiums are typically paid in advance and debited to Prepaid Insurance, which is then amortized over the policy period. Casualty insurance reimburses the holder for the fair market value of lost property. Insurance companies usually have a coinsurance provision so that the insured bears a portion of the loss. The insurance reimbursement formula follows (assumes an 80 percent coinsurance clause):

Insurance reimbursement is based on the lower of the face of the policy, fair market value of loss, or possible reimbursement.

Example 32.1

Insurance reimbursement follows:

A blanket policy covers several items of property. The face of the policy is allocated based on the fair market values of the insured assets.

When there is a fire loss, the destroyed asset must be removed from the books. Fire loss is charged for the book value of the property. The insurance reimbursement reduces the fire loss. The fire loss is an extraordinary item shown net of tax.

What is boiler explosion insurance?

Boiler explosion insurance covers losses of property arising from an explosion.

What is an umbrella policy?

The umbrella policy insures against all risks not covered under another policy. For example, if the commercial property policy covers up to $15 million, the umbrella policy would provide coverage in excess of $15 million but not to exceed $40 million. It is an “excess coverage” policy taking effect after another policy has paid its limit. The umbrella policy is essential in a comprehensive insurance program.

How does marine insurance work?

Marine insurance applies to the importing of merchandise on terms of FOB (free-on-board) shipping point. The policy covers goods in transit. Insurance coverage is required because the company obtains title when the goods are shipped. Each shipment is covered separately, and the premium is based on the value of that shipment. The marine coverage should be to the receiving warehouse dock. Once at the warehouse, the commercial property policy is in effect.

What is business interruption insurance?

Business interruption insurance applies when operations are disturbed or cease because of an unforeseen or infrequent event, such as fire, flood, tornado, earthquake, and vandalism. This policy covers the loss in profit during the shutdown, continuing fixed costs, incremental costs to replace equipment, overtime, or the cost of having the product produced elsewhere. There may also be coverage for losses arising from a supplier’s inability to deliver goods due to an unexpected occurrence.

What does insurance on vehicles involve?

Insurance on vehicles applies to a company’s owned vehicles. The insurance for corporate planes includes normal property damage and liability insurance to insured parties.

How are insurance bonds helpful?

There are several kinds of insurance bonds, including comprehensive, miscellaneous, and performance. A comprehensive bond is fidelity coverage for employees due to theft of cash or property. If your company sells to a municipality, it may be required to have miscellaneous bid and performance bonds. The bid bond is usually in place of a certified check, which has to accompany government bonds. The performance bond insures against the company’s failure to perform under the government contract.

MEDICAL AND CATASTROPHE COVERAGE

Many employers provide medical and catastrophe insurance for current and retired employees.

What is Workers’ Compensation?

Workers’ Compensation reimburses the employer for liability arising from occupational health hazards falling under state law. It usually covers the employer’s liability for employee lawsuits alleging personal injuries. The premium is based on the total dollar payroll. The Department of Labor’s Office of Workers’ Compensation Programs (OWCP) administers four major disability compensation programs that provide wage replacement benefits, medical treatment, vocational rehabilitation, and other benefits to federal workers or their dependents who are injured at work or acquire an occupation-related disease.

Does the state require disability insurance?

Some states require that employees be covered for accidents and disabilities occurring off the job. The premium is dictated by state law and paid for by the employee. The employer may opt to pay the entire premium as a fringe benefit. If a state does not have a disability law, private insurance may be carried.

How does life insurance work?

The lives of key executives may be insured. The insurance may provide cash to buy the deceased’s common stock.

The cash surrender value of life insurance is the sum payable upon cancellation of the policy by the insured; the insured will of course receive less than the premium paid. Cash surrender value is classified under long-term investments. It applies to ordinary life and limited payment policies. Typically it is not applicable to term insurance. The insurance premium consists of two elements: expense and cash surrender value.

LIABILITY INSURANCE COVERAGE FOR CFOs

In today’s litigious environment, CFOs need coverage for their activities, which could result in losses to investors and creditors. Liability exposure exists for corporate financial problems due to the default of junk bonds, failure of an initial public offering, governmental action (e.g., by the Securities and Exchange Commission), and so on.

BUSINESS LAW

A brief discussion of business law follows. The CFO should consult with legal counsel about all legal issues.

Laws involving the employer–employee relationship include:

• Federal Insurance Contribution Act (FICA), commonly referred to as Social Security, requires a FICA tax to be withheld from each employee’s salary with an equal matching contribution by the employer.
• Fair Labor Standards Act (FLSA) deals with wages and hours. A minimum wage is specified, and employees must receive equal pay for equal work. Thus, wage discrimination is prohibited due to race, sex, age, and so on. Certain employees must receive time and one-half for overtime. An employer cannot hire a child below a certain age, typically 16.
• Occupational Safety and Health Act (OSHA) mandates that the employer provide a safe and healthy working environment.
• Employee Retirement Income Security Act (ERISA) requires pension plans to be in conformity with specified requirements including vesting, funding, participation, and disclosure.
• Workers’ Compensation applies to on-the-job injuries. The employer pays a specified amount into an insurance fund.
• Title VII of the Civil Rights Act of 1964 prohibits discrimination based on color, gender, national origin, pregnancy, race, religion, and sex, including sexual harassment.
• Age Discrimination in Employment Act (ADEA) protects employees who are 40 years of age or older from discrimination on the basis of age.
• Antitrust laws exist regarding restraints of trade and monopoly

The following agreements are illegal:

• Price fixing
• Division of markets
• Requiring the customer to buy a second product if he or she orders a first one
• Sale of product to retailer only if the retailer contracts not to resell the product below a certain price
• Group boycott of a customer

The CFO who files a registration statement for a public offering of equity and debt securities must have some familiarity with security laws and regulations.

The legal ramifications of a manufacturer’s potential liability cause the CFO to assume responsibility for risk assessment in contracts. A major consideration is controlling payments and receipts when contracts are canceled and in estimating liquidated or consequential damages for product failure.

Environmental laws must be conformed to; otherwise substantial fines may be assessed. Environmental obligations may include cleanup costs, civil and/or criminal litigation over injury and damage claims, constraints on future operations, and uninsurable accidents. Reference should be made to the regulations of the Environmental Protection Agency and proper insurance carried. The CFO may have to prepare annual reports under the Superfund Amendments and Reauthorization Act. The CFO continually must appraise the company’s internal procedures to monitor and conform to federal, state, and local dictates. Besides complying with existing regulations, why not plan ways to comply with proposed regulations? Tip: Undertake an environmental audit to measure the company’s environmental performance against internal company policies and procedures and external environmental requirements. Such an audit is also of assistance in valuing a potential targeted company.