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Mar 7, 2009

Improving EBITDA by Improving Risk Management Techniques, Lowering Claims Costs, and Implementing Risk Audits

The ongoing downturn in today’s economy, combined with lack of adequate debt and equity financing, has caused even the most successful Private Equity Groups, to lose value in their Portfolio of Companies because of financial related losses. But what about the affiliated opportunities to improve EBITDA by improving and reducing a client’s overall Property and Casualty related losses?

Just how potentially meaningful and substantial are these EBITDA improvements?

Consider this, a recent client company’s EBITDA selling multiple was 8.5x. They were paying $500,000 annually for workers compensation, but had a claims rate double the industry average (200%). By working diligently with the PEG and Portfolio Company to cut their 3 year loss rate by 50 percent, they improved their Portfolio Company’s overall value by $2,125,000. (200% is to $500,000 as 100% is to $250,000), and $250,000*8.5x=$2,125.,000.

Ultimately the Portfolio Company sold for a slightly higher multiple than originally anticipated because of the reliable and consistent improvement to earnings from the reduction in Property and Casualty related losses.

Unfortunately, many PEG’s aren’t aware what the lowest possible claims costs would do towards improving their company’s EBITDA. Having a formal process to identify the organization’s lowest possible claims costs provides a written financial incentive for company managers to improve their company’s overall Property and Casualty related losses. Unfortunately, PEG’S rarely discover this information is readily available from most local rating authorities until after the losses begin to accrue and premiums escalate beyond reasonable expectations.

Understanding The Broker and Insurer Conflict of Interest and Their Role In Communication

Brokers are often compensated based upon the total premium dollars that are charged by the insurer according to the actual risk and prior year’s claims experience of the client company. Very rarely are brokers compensated based upon a reduction in claims and overall premium reductions.

A standard compensation arrangement may call for 10% of the annual premium to be paid to the broker.. Therefore, the higher the actual realized loss costs and therefore resulting premium, the more the insurer charges for insurance, and the more the broker is compensated.

In our example in the beginning of the article, the broker was compensated at $50,000 prior to the time losses were cut in half. After the reduction in losses, his compensation would have been cut to $25,000 had the PEG elected to continue his engagement.

A $25,000 reduction in his compensation, but a $2M improvement to your company’s value. I would argue this is a win/win for both parties, but others may disagree. Especially those who derive their compensation solely from this type of arrangement.

It’s almost a self defeating situation for the broker or insurer to educate the client on how to reduce its losses. After all, when the losses increase, both the insurer and the broker are compensated at higher levels. The PEG, however loses because they are financing these losses through increased premiums and lower EBITDA’s. In addition, company’s who don’t improve upon their Property and Casualty related risk profiles often sell for multiples less than those who do.

Due to revenue models which don’t justify hiring a full time risk manager, PEGS often rely on the experience of an insurance broker to help them identify, control, and manage risk. Although there are many fine professionals in this trade, this can and often does lead to unnecessary added insurance costs, lack of a formal risk audit, lack of formal risk controls, and lack of a formal bidding process for the newly created Risk Management program.

Since insurance expense is a function of actual claims cost and perceived future underwriting expense, it makes sense to identify how claims have and will impact future insurance expenses, and what can be done to reduce the risks that go into the product on a going forward basis.

This is done through a systematic approach often referred to as a Risk Audit. This Risk Audit helps identify what the exposures and cost of claims are. It also provides a written benchmark that the PEG can use for future comparative purposes. By identifying and reducing the current and future risks , you are effectively simultaneously reducing the future probable costs or claims an insurer will have to pay.

Once the new Risk Management plan has been implemented and monitored for a period of time, (whereby enough time has gone by to make certain the plan is functional and will provide the given results it was intended to accomplish), you are ready for the next step. The goal then becomes seeking out new reductions in insurance expense based upon the reduced exposures of the client company’s newly created risk profile.

A new insurance brokerage relationship can then be established with two competing brokers to establish a more competitive broker environment. The competing broker’s services and skills should be evaluated and compared against one another to help better identify their strengths and weaknesses.

In addition, since the new brokers are also going to be responsible for helping communicate the new strategies of the overall risk management program to the insurers., they should have extraordinary relationships with the insurers and exceptional communication skills.

2 brokers should be used for this bid process with each broker choosing their respective markets. Markets should be agreed upon in advance and negotiated whenever possible. Cultures between the buyer (The Portfolio Company), and the seller (The Insurer) should mesh. If the buyer’s new thought process is consistent with managing risk and having an active safety culture, but the seller can’t provide this type of service on an ongoing consistent basis, the buyer should seek an insurer consistent with his/her core beliefs.

By combining the reductions in premium savings from the reductions in future losses, with reducing the actual claims rate to near zero, substantial improvements to EBITDA are achievable.

Colin D. Baird is the Managing Director of Private Equity Risk Managers and helps companies create, implement, and monitor Strategic Risk Management and Related Plans. He often conducts due diligence during and prior to execution of the M and A transaction, and helps companies identify new EBITDA opportunities through changing the way risk is managed at the Portfolio Company. In addition, he conducts risk related audits and reviews for privately held corporations, C-Level Executives, and Corporate Boards of Directors . He also helps clients identify whether economies of scale would help the client and their Portfolio Companies reduce their ongoing insurance expense.