CHAPTER 11

Insurable Value

The world of insurable value considers the value of a business or business interest to be covered by insurance.1 Business insurance is required in a variety of circumstances. In the insurable world, as in other valuation worlds, a business interest should be valued using a process specific to this world. By better understanding how value is determined in the world of insurance value, owners are better prepared to purchase insurance to protect their businesses. Although numerous instances require valuation for insurance purposes, this chapter focuses on three main reasons:

This world has dual authorities. Insurance companies determine value in many circumstances, such as business interruption claims. The involved parties also may authorize valuation actions, such as the formation of buy/sell agreements. This world employs its own lexicon of terms, including “provisions,” “triggers,” and “yardsticks.” Some terminology used in this world is similar to that of other value worlds. For example, many buy/sell agreements use market value terms to describe the valuation process. However, insurable value then deviates and employs a unique process to derive ultimate value. This world is mutually exclusive from the other value worlds because it must carve out processes specific to its goals. The value conclusions from this world have meaning specific to this world and may have very little applicability beyond it.

A snapshot of the key tenets of this world is provided in Exhibit 11.1.

EXHIBIT 11.1 Longitude and Latitude: Insurable Value

RISK AND INSURANCE

Most medium-size business owners are deluged with ever more sophisticated insurance alternatives. Often it is difficult to judge how much insurance is appropriate. With proper valuation methodology, owners can treat purchasing insurance like purchasing any other business asset, without the fear of over- or underinsuring. Owners of private companies have several goals in managing risk in their companies:

• Lessen their personal investment risk in the company by reducing the cost of capital
• Diminish operating risk
• Help control risk so that it is more likely for the return to exceed the riskiness of the investment
• Protect the company's ability to generate returns

Business insurance protects the company by reducing both owner's and investor's perception of risk. Investor's perception of achieving specific returns determines the cost of available capital. Controlling risk controls not only cost of capital but may impact capital availability as well.

Also, business insurance assists business owners in planning for liquidity to themselves and their families. Liquidity becomes increasingly important with age as often significant portions of business owners’ net worth is represented by an illiquid business ownership interest. Insurance also assists the business entity with solvency concerns in the event of some type of loss. Business entities must attempt to protect and insulate as much as possible the day-to-day operations from extraordinary events.

BUY/SELL AGREEMENTS

Planning for the continuity of the enterprise is a critical task for every owner-manager. Buy/sell agreements are one tool used to achieve this goal. A buy/sell agreement is a binding contract between the various owners that controls when an owner can sell an interest, to whom, and for how much. The primary purposes of these agreements are to:

• Provide for transition while continuing to operate the business.
• Provide liquidity and create a market to sell a business interest.
• Determine the “triggering events” that will activate the buy/sell.
• Establish a price, or pricing formula, for the business interest.
• Protect against unwanted new partners.
• Provide dispute resolution procedures prior to such events occurring.
• Determine payment terms once the buy/sell is triggered.

A well-constructed buy/sell is similar to a premarital agreement because it is uncertain when one of the partners will want to leave the company. Every business with multiple owners should have a buy/sell agreement in force. A decision hierarchy can be used to construct a buy/sell agreement properly. Exhibit 11.2 shows this process.

EXHIBIT 11.2 Buy/Sell Decision Hierarchy

As this hierarchy depicts, the type of buy/sell is chosen before decisions are made regarding the buy/sell provisions. Provisions are negotiated between the parties to reflect participant's intentions. As a practical matter, the provisions should be reviewed periodically to ensure that the original provisions currently reflect the intentions of the parties relative to the business. Valuation mechanics are then constructed to support the provisions. Finally, buy/sell triggering events are defined, which may influence the appropriate funding technique.

The type, provisions, and funding techniques descriptions of buy/sell agreements are discussed in detail in Chapter 31. Only the valuation and triggering events part of the hierarchy is discussed in this chapter.

VALUATION MECHANICS

The valuation process is a key element in the buy/sell agreement. Because this is an unregulated world, parties have wide latitude to choose a valuation process. It may help the process to include a business appraiser in the discussions who is experienced in these matters. Most price-setting mechanics in these agreements employ one of three methods:

Negotiation

Many buy/sell agreements contain provisions defining a process by which an ultimate price could be determined for the shares in question. In the absence of such a provision, negotiation between the parties is generally the best way to set a price. Current owners understand the risk of the investment and future prospects of their company better than anyone. Many companies set the buy/sell share price at the annual meeting and fix this price for the coming year. If no consensus is reached at the meeting, then another method is used to set the price, such as a formula or outside appraisal.

Formula

A formulaic approach may be used to value interests in a buy/sell agreement. A common method is to use the book value, or net asset value, of the company. This is unfortunate, since book value is generally not a surrogate for market value of most companies. Net asset value may be appropriate for distressed small companies or companies with exceptionally high asset value.

One approach gaining popularity is to employ a series of price-setting methods and use the highest derived value. One formula might be asset based, such as the net asset value at the time of the triggering event. Another formula might be income based, such as capitalizing the company's earnings before taxes. This method requires some up-front agreement by the parties on the definition of pretax earnings and the capitalization rate or selling multiple to be used. Finally, insurance might be in force for the triggering event. For example, assume for PrivateCo:

In this example, the highest value of $5.5 million is derived using the capitalization of pretax earnings method. The pretax earnings average over the past three year-ends, using data for PrivateCo from Chapter 5, is $1.4 million, and is applied against a multiple, in this case 5. PrivateCo has long-term debt of $500,000 at the time of the triggering event. This is subtracted from the capitalized pretax earnings to reflect a debt-free value. It is preferable to select an earnings base that is an average of several years’ results rather than a single period. The pretax earnings might also be adjusted for controlling owner compensation. The multiplier should be appropriate to the company in question. For example, some branded technology-based companies might be better suited with a 10 multiple, or higher. The deal databases introduced in Chapter 6 can assist in this selection.

The insurance in force assumes the triggering event, such as death of an owner, is covered by $2 million worth of insurance. If an insurable triggering event occurs valued beyond $2 million, the company must make up the difference between the required payout and the insurance coverage in effect. Normally the buy/sell establishes a note for a multiyear period so the company is not debilitated. This fact once again points to the need to maintain a proper level of insurance.

There are several advantages in employing a greater-of-several-methods approach to valuing a buy/sell agreement. First, the parties agree on the formulas at the buy/sell formation. This enables advance planning, which is always important when insurance is concerned. Second, since only the “greatest” valuation number is chosen, no party should feel as if it has been treated unfairly. Finally, the parties can engineer this approach to include methods they believe best fit the circumstances. For instance, if net asset value is considered too low to include in the mix, the parties may opt for a multiple of net asset value or some other measure that better suits the circumstances.

Outside Appraisal

An outside appraisal may be used to determine the price of the stock in question. Of course, the proper value world needs to be stated in the agreement. All instructions to the appraiser should be written. This is important since the buy/sell may stipulate how the stock is to be valued: as a minority interest; as a pro rata share of the enterprise value with no discounts, or at a percentage of the pro rata value. (See Exhibit 4.6 for a discussion on this topic.) The valuation is performed using an independent appraisal process. An outside appraisal agreement usually provides the appraisal is subject to agreement when it is updated. Appraisers are then brought in only if the owners have allowed the mutually agreed valuation to fall out of date. O’Neal and Thompson provide these guidelines regarding the selection of appraisers in a buy/sell:

If the price of shares is to be fixed by appraisal, the names of the appraisers or a method of choosing them must be specified; and a statement should be made that the decision of a majority of the appraisers will be binding. . . . A typical appraisal provision states that the optionee or purchaser, as the case may be, shall select one appraiser, the offeror or vendor a second, and that the two appraisers shall choose a third. . . . Occasionally an independent third party, such as a corporate fiduciary, is given the power to appoint the third appraiser; or the third appraiser is designated by office. . . . Sometimes the appraisers are selected in advance and designated by name. . . . If that is done, provision must be made for a method of appointing substitutes should the designated appraisers die, become incapacitated, or refuse to serve.2

Although O’Neal and Thompson do not say it, only certified business appraisers should qualify for the pool. All of the certifying bodies require their certified appraisers to take an oath of independence; therefore, no certified appraiser can advocate a client's position, only his or her own. Noncertified appraisers are free to take sides without fear of any governing oversight. This appraisal approach can be very expensive to implement, involving tens of thousands of dollars. To minimize costs, the parties to the agreement should be explicit in their instructions to the appraisers, identifying which standard of value and what premise of value will be used.

TRIGGERING EVENTS

The drafting of the buy/sell agreement is often on friendly terms. When certain triggering events occur, however, the interests of the parties involved often diverge and may become adversarial. A buy/sell agreement might sit idle for years until a triggering event occurs. There are a variety of triggering events that activate the buy/sell, some of which are listed in Exhibit 11.3.

EXHIBIT 11.3 Possible Buy/Sell Triggering Events

1. Death 2. Long-term disability 3. Voluntary termination 4. Involuntary termination 5. Third-party actions, such as personal bankruptcy or divorce

Other than death, these events need some further explanation. Typically someone is deemed to be disabled on a long-term basis according to the definition used in the disability insurance contract in force at the time of the disabling event. A typical disability insurance policy pays as long as the insured cannot perform the material duties of any occupation for which he is suited by training, education, or experience for some continuous period of time, say six months. For example, if a night stockperson in a grocery store suffers injuries preventing him from performing that function, he will collect disability payments only if he takes a position at less than 60% (this varies) of his predisability income within 12 months of returning to work. This is called the “any occupation” definition, and many policies have provisions limiting payments in a variety of ways. In many cases, legal advice is necessary to create a disability definition appropriate to the user's circumstances.

An insurance policy that covers individuals who become disabled and are unable to perform the majority of the occupational duties that they have been trained to perform are called “own-occupation.” This type of insurance policy is contingent on the individual being employed at the time the disability occurs. Persons not working at the time of disablement will not be able to claim insurance under an own-occupation policy, but they will if they are covered under a modified own-occupational policy. Under a modified policy, the definition of “disabled” includes persons not working at the time of their disablement. These types of insurance policies apply to highly trained individuals, such as surgeons. Because the definition on own-occupation is very flexible, persons covered under an own-occupation policy may find another job and still receive full benefit payments.

Retirement with notice means that a retiring shareholder gives at least 12 months’ notice. This much notice should be adequate time to find a replacement without doing damage to the company.

In a voluntary termination, the employee-owner decides to quit or retire based on individual free will. In any case, the company's board of directors may vote to purchase the shares of the exiting employee. The ownership agreement of the company controls the latitude of the board regarding this purchase option.

In the case of an involuntary termination, the owner, who is also an employee, is terminated against her will. This termination can be for “cause,” meaning the owner violated her employment agreement, or “at will,” meaning the employee was terminated without a specific reason. In either event, the ex-employee also becomes an ex-owner. This makes business sense because the employee probably became an owner due to efforts while an employee and once these contributions cease, all attachments to the company also cease.

Third-party actions, such as a personal bankruptcy or divorce, may also trigger a buy/sell action. Most company owners do not wish to have outsiders as owners; this trigger protects them and the company against those events. Once again, it is typical for the board to vote whether to call the shares, and the tenets of the ownership agreement help guide the decision.

Triggering actions are also important because they may help determine value for the shares. For instance, when an employee-owner decides to quit without notice, thereby triggering the buy/sell, should he receive full value for his shares? Many companies link the triggering event with total value received as well as payment terms. Here is one method for handling this issue. Assume a 10% owner triggers PrivateCo's buy/sell and the “greater of three methods” approach calls for an $6.5 million enterprise valuation. The valuation in each triggering event could be:

PrivateCo Buy/Sell Valuation
Event	Discount	Value
Death	No discount to pro rata value	$650,000 ($6.5MM × 10%)
Disability	Same valuation as death	$650,000
Retirement with notice	Same valuation as death	$650,000
Voluntary termination	35% discount to pro rata value	$422,500 ($650k × (1 – 35%))
Involuntary termination	50% discount to pro rata value	$325,000 ($650k × (1 – 50%))
Third-party action	Same as involuntary termination	$325,000

By linking discounts with some of the triggering actions, PrivateCo is attempting to penalize actions not in the company's best interest. Notice that there are no discounts associated with an owner's death or disability. A voluntary termination triggers a 35% discount, with the thought that someone should not be able to walk off the job and receive full value. In this example, involuntary termination receives a 50% discount because it is assumed that the owner has violated a major covenant of an agreement or this trigger would not occur. Finally, for this example, third-party actions are treated as involuntary terminations for valuation purposes.

PrivateCo's ownership agreement might contain a great deal of flexibility regarding the discounting issue. For instance, the agreement might let uninvolved owners decide the level of discount in the triggering events rather than enforce a hard-and-fast rule. Life insurance payable to the company also provides business continuity in case of the loss of a key person, which is covered next.

KEY PERSON INSURANCE

A key person insurance policy may be taken out on any employee whose contribution is considered uniquely valuable to the company. Most business failures occur because of management weakness or the loss of a key person. Although key person insurance will not replace a key manager, it gives the business financial flexibility as it deals with the loss. Valuing a key employee is difficult. Companies usually cover this need only for the owner-manager, and this typically is tied to life insurance without much thought to the quantification of the key person loss.

Key person insurance may serve five purposes.

Three different methods are presented to help shareholders estimate the worth of an employee to the company:

Multiple Compensation Method

The multiple compensation method is the simplest method of calculating the value of a key person. It assumes an employee's value is accurately reflected in his or her total compensation. Many companies multiply the total compensation by the number of years it takes to train someone to step into the role of the lost person. For example, if a key person was making $150,000, and it will take three years to hire and train a replacement, the proper amount of key person insurance is $450,000.

Contribution to Profits Method

This method estimates the impact an employee has on the company's profit. The company calculates the expected profit and considers excess profit as the result of key employees. The percentage of profit attributable to each key employee is estimated and then multiplied by the number of years it will take to hire and train a replacement.

This method works best when used to measure the value of key salespeople. For example, if a salesperson had a special relationship with a customer and was generating $1 million in business that generated a $200,000 profit, it might take two years to replace this individual. In this case, $400,000 of key person insurance is appropriate.

Cost of Replacement Method

The cost of replacement method calculates the direct costs required to interview, hire, and train a replacement. It also includes an estimate of opportunity costs due to the loss of the key employee. For example, assume a headhunting firm will be hired at a cost of $50,000 to help fill a key executive job. Training will take several months and cost $35,000. Finally, the company will be without this key executive for the three-month training period, at a cost of $50,000. In total, it will cost the company about $135,000 to replace the key person.

Many businesses use permanent life insurance to fund key person needs. These policies build cash value that appears as an asset on the company's books. Often the cash value is used to fund benefit plans for the owner or key individual in the event there is no death prior to retirement.3

Term insurance is an alternative life insurance product. While less expensive than permanent insurance, most companies use this only for short-term needs, such as an employee hired to perform duties for a specific, short time period.

As with all life insurance, death proceeds are received income tax free. This can be highly attractive to a business, as the earnings of the key person would have been taxable. This after-tax element is already built into the valuation methods outlined earlier.

There are two other important points to consider:

Once the value of the key person is derived, a key person plan can be created in a variety of ways. The most common is corporate ownership. With corporate ownership insurance coverage, the company is the owner and beneficiary of the policy. To the extent there is excess coverage, the death proceeds provide corporate-paid salary continuation benefits to the surviving family. Alternatively, if death does not occur before retirement, the cash value can be used to fund a nonqualified deferred compensation plan.

A properly established key person plan ensures the continuity of the business. Another threat to every company is business interruption from some external event.

BUSINESS INTERRUPTION

Unexpected disruptions to normal business operations may occur, often without warning. These interruptions may result from many sources, including contract violations or torts committed against the business. Incidents of casualty may also cause business interruptions. Protections against business interruptions may cover either the loss of business earnings or the loss of income sustained and costs incurred to resume normal operations. Business interruption insurance protects the prospective earnings of the insured business.4 It is also designed to do for the insured, in the event of a loss, what the business would have done for itself if an interruption in the operation of the business had not occurred. If the interrupting cause is insurable, coverage is triggered by the total or partial suspension of business operations due to the loss of use of business assets.

Once a possible claim arises, the insured must follow the procedures laid out in the coverage. Many insurers have adopted procedures defined in the Insurance Services Office (1990), which describe the steps required to make a claim. Steps involve things like notifying the police, taking reasonable steps to protect the property from further damage, and cooperating with the investigation.5

The first issue in any business interruption claim is to determine whether the insured's loss arises out of an interruption of its business. Most policies use the phrase “necessary suspension of operations” to describe this precondition to coverage.6 While this language is ambiguous, according to Chesler and Anglim, the insured must establish these elements in order to trigger coverage: a necessary suspension of operations due to physical damage to covered property and caused by a covered cause of loss. These elements must form a causal chain in order to establish coverage under the policy. The insured cannot recover merely by establishing the existence of a suspension of operations, covered property damage, and covered cause of loss; rather, the insured must also prove the requisite causal relationships.7

The causal chain requires two distinct steps:

If a covered event directly causes both an interruption of the insured's business and property damage, it is not covered because the property damage, not the covered event, must cause the interruption. This area of the law is sufficiently complex that readers should seek professional guidance. The remainder of the chapter assumes the insured qualifies for interruption insurance.

Loss of Income

In addition to establishing a suspension of operations, an insured must also show it has suffered an actual loss of income. It is not enough to show just a loss of sales or capabilities; rather, the insured must establish it would have earned profits without the suspension of its operations. Without this proof, there can be no recovery. This can lead to the problem of a money-losing business or an emerging yet unprofitable business to successfully claim a recovery. This lack of record keeping and profitability was problematic after the BP oil spill in 2010. Fishermen in the Gulf of Mexico could not prove they had operated profitably prior to the spill, which prevented standard insurance policies from paying. Key court cases have held the promise of profitability is not enough.8 It is the insured's responsibility, through proper accounting, to prove they deserve to be compensated for a business interruption.

Valuing the Claim

In quantifying the claim, reasonable certainty must exist as to the amount of the lost profits or the loss of business value. The valuation must be reasonable and likely to occur, given the facts and circumstances of the business's operations. There is no predetermined method for deriving the actual loss of profits and business expenses covered by business interruption insurance. The selected method should consider several aspects, including history of profitability, the nature of the business, and probabilities for the future. A key consideration is the intention of the parties. For instance, if the insured had just landed a large customer and was in the process of investing to meet the new sales demand, there is reason to believe that the profitability of the company was about to increase.

Under a business interruption policy, the insured's books and accounting system are tools to help determine the loss. The policy may be either valued, in which case the value of the loss is agreed on in advance and fixed by the policy, or open, in which case the amount of any loss sustained is to be determined by competent proof.9 It is also possible for a policy to be partially valued and partially open.

It should be noted that businesses have a duty to keep damages as low as possible rather than allowing them to compound with time. Causation (or proximate cause) must be proven. The interruption must be shown to be caused by the wrongful party's actions.

Lost Profits Analysis

Because of the peculiarities of this type of appraisal, a specialized area has developed in business valuation called lost profits analysis. It deals with commercial damages due to business interruption. Essentially, lost profits equals what the business would have made minus what the business did make. The next overview of lost profit analysis is taken from the viewpoint of the court system, which ultimately settles these disputes. The courts seem to prefer the before-and-after method over the yardstick approach, each of which is discussed next.

Before-and-After Method

The before-and-after method compares revenues and profits before and after the business interruption.10 This method is heavily influenced by past performance of the business. It assumes data is available to construct a reliable forecast and that economic and industry conditions are similar during the loss period and the period prior to the loss.

Gaughan, a leading author in this area, claims that the plaintiff must exercise discipline in applying this method or the courts will not rule favorably. He cites the example of a lack of rigor on the plaintiff's behalf in the case of Katskee v. Nevada Bob's Golf.11 In this case, a lessee sued a lessor for lost profits on sales of merchandise resulting from the failure of the lessor to allow the lessee the right to renew a lease. The expert assumed the location in question and the replacement location were the same in all relevant aspects except for their square footage. The court ruled against the plaintiff because the expert used oversimplistic assumptions and did not undertake a serious analysis of the possible differences in the plaintiff's market position.

Yardstick Approach

The yardstick approach involves a comparison with similar businesses to determine if there is a difference in the level of the plaintiff's performance after a business interruption. This method is used if there is an insufficient track record to apply the before-and-after method.12

Difficulties of comparing one business to another are discussed earlier in this book in a private-to-public comparison. For this reason, the yardstick approach is used mainly for new businesses.

Because of the complexities surrounding these valuation issues, readers are encouraged to seek a text dedicated to business interruption.13

Period of Restoration

Business interruption policies generally use the term “period of restoration” to describe the period during which the coverage is triggered.14 The period of restoration is the reasonable amount of time it theoretically should take the insured to repair the damage and resume operations. This period is somewhat hypothetical, since it might not be the same as the actual amount of time that it takes the insured to resume its operations at the damaged site. For example, if an insured wants to rebuild a destroyed facility larger that it was before the casualty, the additional time to rebuild falls outside the period of restoration and is not covered.

Readers who require a more detailed understanding of the issues are urged to seek a professional in this field.

TRIANGULATION

Insurable value is a hybrid world. This world is in the empirical regulated quadrant when viewed from one authority, the insurance industry. Insurance policies can be purchased in a heavily regulated marketplace; premium costs and benefits are known. This world is empirical unregulated when viewed from the perspective of the other primary authority, involved parties. Within a buy/sell, provisions are set by the involved parties. In other words, value in this context is whatever the parties say it is.

Funding in this world may include life insurance, a cash purchase, a seller's note, or a combination. When certain triggering events occur, the buyer may want a low price while the seller may want a high price. Further, the buyer may want lenient terms including payments over a long time horizon and low interest rates. The seller may want aggressive terms including cash up front, payments over a short time horizon, high interest rates or collateral, and security from the buyer.

This world is directly tied to the capital leg of the triangle. Various funding mechanisms exist, such as self-insurance and pledges of outside assets. This chapter focuses mainly on insurance companies to fund insurable events. For example, the death or disability of covered shareholders causes a business valuation, which ultimately is funded by insurance proceeds. The company and involved parties capitalize shareholder buyouts. For example, if the triggering event involves an employee-shareholder termination, the company usually takes on the liability of purchasing the stock. Typically the buy/sell agreement stipulates how the shares are purchased, which normally involves a financing period. In any event, the purpose of this world is to ameliorate capital as a constraint.

Likewise, insurable value is linked to business transfer. In some cases, the insurable event interrupts a business to the point that an insurance company pays to the shareholders the total value of the business. Also, triggering events in a buy/sell lead directly to a transfer. Once again, parties’ interests may diverge in the future, so it is important that plans are kept current and funding mechanisms are instituted to effect the transfer.

PrivateCo's value in this world is $6.5 million.

World	PrivateCo Value
Asset market value	$2.4 million
Collateral value	$2.5 million
Insurable value (buy/sell)	$6.5 million
Fair market value	$6.8 million
Investment value	$7.5 million
Impaired goodwill	$13.0 million
Financial market value	$13.7 million
Owner value	$15.8 million
Synergy market value	$16.6 million
Public value	$18.2 million

NOTES

1. This chapter does not cover valuation of specific assets for property and casualty insurance purposes due to the broad scope of that topic.

2. F. Hodge O’Neal and Robert B. Thompson, O’Neal's Close Corporations, 3rd ed. (St. Paul, MN: West Group, 1996), pp. 134–135.

3. Anthony J. Capobianco, “Insurance Helps Compensate for Key Person Loss,” Business Review (October 1997).

4. Rick Hammond, “Underlying Principles of Business Interruption Insurance,” 1999, http://library.findlaw.com/1999/Jun/1/127909.html.

5. Ibid., p. 3.

6. Robert D. Chesler and Alexander J. Anglim, “Essentials of Business Interruption Insurance Law,” Mealey's Litigation Report (December 2001): 18.

7. Ibid.

8. The most often cited case involves Dictiomatic, Inc. v. United States Fidelity & Guaranty Co., 958 F. Supp., 594 (S.D. Fla. 1997).

9. Hammond, “Underlying Principles of Business Interruption Insurance,” p. 4.

10. Patrick A. Gaughan, Measuring Commercial Damages (New York: John Wiley & Sons, 1999), p. 39.

11. Ibid., p. 40.

12. Ibid., p. 41.

13. The Gaughan text cited in note 10 is considered a good text on this subject.

14. Chesler and Anglim, “Essentials of Business Interruption Insurance Law,” p. 20.