This content is independent of any content coming from insurance brokers or insurers or law firms. Commercial insurance is rarely taught in schools, and when it is it’s mostly done through the lens of brokers or insurers. There are many misconceptions around Liability Risk, just like many topics in risk management and commercial insurance, due to bad habits acquired through over reliance on insurance brokers or insurers or information providers who are lobbied by them. It is also important to note that insurance has both an operational aspect and a legal aspect, on which we put weights of 95% and 5% respectively in terms of importance to protecting a business and its investors (the point is that going to court to enforce coverage defeats the purpose of buying insurance, so you want to make sure that whatever insurance you buy protects your business right and pays out fast on large losses).
The video above shows a real life example of a company taking another to court (Liability Risk) over accounts receivable that had not been paid (Credit Risk). Business insurance plays a major role in reducing losses for both companies. On the one hand, the plaintiff, that is the business that was not paid its receivables, should have bought well structured credit insurance in order to avoid the hassle of payment delays and ensuing efforts to pursue its business partner through litigation. On the other hand, the defendant, that is the business that had to pay its bills but failed to do so in a timely manner, should have bought well structured professional liability insurance in order to avoid any defence and settlement related expenses. Let's dive deeper into both types risks and corresponding insurance.
What is Liability Risk?
It is a type of Operational Risk specifically the risk of being held liable or responsible for an action or inaction, whether or not at fault, resulting in a direct or indirect financial loss. This is the definition we use as there are various definitions that exist (you may have noticed that while searching online), some of which referring to standard liabilities on a firm’s balance sheet. Do not be alarmed that there is not one standard definition on what liability risk means, as this is fairly common across various definitions within the fields of risk management and insurance due to various reasons.
Liability Risk Types
There are various types of liability risk in the sense that there are various causes and allegations tied to liability risk, depending on whether we are looking at things from a legal standpoint or from an operational standpoint. We will therefore categorize types of liability risk into two: Legal and Operational.
The legal type of liability risk has to do with the allegation(s) being brought forth in a claim (Ex. a claim for negligence versus a claim for strict liability, etc.). The operational type of liability risk has to do with what is causing the liability risk in relation to the operations of an organization (Ex. a liability risk stemming from HR issues versus a liability risk stemming from shareholder or product issues, etc.).
It is important to note that there are a lot more operational types of liability risk than there are legal types, and the operational types are almost always tied to one or more legal types of liability risk. Different jurisdictions will enumerate and interpret the legal types of liability risk differently. However operational types of liability risk are inherent within the operational risk of an organization, most of the time regardless of jurisdiction yet their probabilities of occurrence and measures of severity may very well depend on the jurisdiction in which an organization operates (ie. it is not the operational type of liability risk that is dependent on jurisdiction, but rather its measurement or quantification).
Legal types of liability risk include:
- A claim for negligence
Ex. a shareholder lawsuit against the management of a company claiming management was negligent in certain strategic decisions resulting in a loss to shareholders.
- A claim for strict liability
Ex. a customer lawsuit against a manufacturer claiming their product was defective and caused injury.
Operational types of liability risk include:
- D&O risk: shareholders presenting a demand for monetary damages to a company they have invested in due to management errors
- E&O risk: customers forming a class action lawsuit against a company for a faulty service (aka. professional liability)
- Cyber Liability: customers or regulators suing a business as a result of a data breach
- M&A Liability: shareholders of an acquirer sue management for faulty acquisition due diligence resulting in a dilutive transaction
- Liability that arises due to a Business Interruption or a supply chain issue
- Liability that arises due to a materialized Fraud Risk
- Product Liability whereby liability arises due to a faulty product that causes injury to persons
- Employment or Employer Liability (ex. an employee bringing a lawsuit against their employer)
- Fiduciary Liability arising from the management or administration of pension fund assets and obligations
- Environmental Impairment Liability arising from pollution or environmental damage caused by one's actions
- General Liability that is common across industries and geographies (ex. a customer slips on business premises and sues for injury)
- Liability that arises due to any other type of Operational Risk
Keep in mind that there are millions of liability risk examples that can be specific to either a certain industry or geography.
Liability Risk and Insurance
Because there are various types of liability risk as mentioned above, this typically creates confusion within the risk management and insurance communities. A common mistake that organizations make is ignoring the operational types of liability risk and focusing on the legal types. This is evidenced by the many organizations that get their in-house or outside legal counsels’ advice on insurance policy wording as a form of due diligence on their insurance prior to the occurrence of a claim. This is simply wrong. Let’s take a look at why that is.
Statistically, the causation of an operational risk event such as a liability risk event is much more frequent than its transformation into a legal event such as a monetary demand or lawsuit. In other words, the occurrence of a loss scenario is much more probable than its transformation into a legal claim. As an example, simply google the percentage of business disputes that end up being litigated or going to court, it is a very small percentage and lawyers would know that. It is therefore simply incorrect for organizations to prioritize mitigating and managing the legal type of liability risk over the operational type of liability risk, which would in turn harm the efforts of structuring insurance for effective operational protection to the organization.
In terms of importance, we put a 95% weight on the operational types of liability risk versus a 5% weight on the legal types of liability risk.
Another important point of confusion is the type of commercial insurance product that would be effective for protecting an organization against liability risk. Because there are various operational types of liability risk, it is important to note that a specific commercial liability insurance policy will provide protection, if reworded and triggered correctly, only to a specific sub-set of operational types of liability risk. Nevertheless, it is possible that by rewording a specific policy one can provide protection to a wider sub-set of risks than initially intended.
The following is a list of commercial liability risk insurance policies that can hedge different operational types of liability risk:
- Commercial General Liability (CGL)
- Directors’ & Officers’ Liability (D&O)
- Professional Liability (aka. Errors & Omissions or E&O) - discussed below
- Employment Practices Liability (EPL)
- Product Liability
- Cyber Insurance Liability
- Environmental liability
- Transactional liability or Rep and Warranty Insurance (M&A insurance)
- Other liability risk insurance – more information is available on our products page
To summarize, one or more of the liability risk insurance policies outlined above may be used to hedge against different operational types of liability risk (ex. general liability risk, cyber liability risk, product liability risk, etc.) and across different industry segments (ex. lender liability risk, construction liability risk, etc.).
Professional liability insurance
Professional liability insurance (also known as Errors and Omissions or E&O insurance) is an important hedge against customer lawsuits or monetary demands especially since it pays out for defence costs, which total the majority of liability risk costs. Even if the business is not at fault and faces a written or verbal monetary demand, it can trigger its professional liability insurance for payout. Nevertheless, the methodology by which the commercial insurance policy is triggered is of high importance in order to ensure a high insurance payout ratio, therefore minimizing Insurance Risk (i.e. the risk that the insurance does not pay out or delays payout).
Professional liability insurance can also be used as a second line of defence, within the context of business insurance, in the event of non-recovery from a specific insurance policy, whether this is due to bad faith insurance or an error on the part of the business (the insured) in structuring and triggering its commercial insurance. That said, even if it is used as a second line of defence, clinical navigation through the policy's terms and conditions is required for effective payout.
Many professionals think that this type of insurance is for individuals only, however it is important to note that the business as a legal entity, along with its employees and contractors or other specific parties, can be protected through professional liability insurance. It is therefore a form of protection on the income statement of a business.
Liability Risk Assessment
Identifying and measuring the liability risk exposure of an organization is part of liability risk management, which falls under the operational risk management function of such organization. Generally speaking, liability risk can be assessed as having a low frequency occurrence yet a high severity of impact if ever materialized. However, every organization will have its unique set of operational data that would lead to a different measurement of its liability risk, the latter depending on factors including but not limited to the nature and size of operations, the industry, and existing controls around contractual obligations and the provision of products or services. While there is no standard format or liability risk assessment template that is used across industries let alone one that is endorsed across risk management communities around the world, organizations may seek the guidance of certain central banks (such as the European Central Bank) on how to measure operational risk and sub-segments thereof, which could then be applied as a base format for any liability risk assessment template to be created.
Our team uses proprietary models that have been backtested with guidance from central banks such as the ECB when assessing liability risk. In other words, we use a liability risk assessment template that gets tailored to every client differently depending on the client’s operational data.
Frequently Asked Questions (Liability Risk)
What are business liabilities?
They are the financial responsibilities of a business. They can be direct or indirect in nature and some are easier to be accounted for than others. For example, it’s easier to account for debt that is due (one form of business liability) than it is for a lawsuit (another form of business liability).
How to reduce liability risk?
First and foremost, reducing liability risk starts with correct identification of the different loss scenarios that can produce liability risk for a certain organization. Each loss scenario should then be measured and analyzed vis a vis the controls that are in place. Depending on the resulting measurements, each loss scenario should then be measured and analyzed vis a vis any form of liability risk insurance that is in place or that is to be purchased. The result should be the minimization of the dollar amount (or other currency amount) of exposure an organization faces from liability risk.
How to mitigate product liability risk?
This entails the same methodology used to reduce liability risk in general as outlined above. Note that as sub-set of liability risk, product liability risk will have its own specific set of loss scenarios.
What is cyber liability risk?
It is a sub-set of liability risk, specifically the risk of liability caused by a cyber event. Cyber risk itself is a form of operational risk that includes various loss scenarios such as data breaches, business interruption, ransomware attacks, etc. In addition to first party damages to an organization, such cyber loss scenarios may also produce third party damages, which are the premise of cyber liability risk.
Credit Risks Insurance
Insurance of credit risks, which includes trade credit insurance, is an important and effective hedge against complete defaults or payment delays (protracted defaults) over 90-120 days by counter-parties on accounts receivable, loans, and other obligations. This type of commercial insurance is recommended for businesses over a certain size with a single large customer representing a substantial percentage of total revenue, or a portfolio of customers with receivables exceeding $1.5 million.
Credit risks insurance coverage can be purchased through numerous commercial insurance brokers, however just like other types of commercial insurance it must be reworded and triggered by risk experts who are independent of any insurance broker or company. Failure to do so can result in severe losses to the organization buying the credit risks insurance, an example of which led to the collapse of Greensill Capital in 2021.
First the organization would need to analyze its counter-party credit risk and the credit risks insurance would need to reflect such risk analysis and measurement. This entails changing the terms and conditions of the credit risks insurance coverage, word by word, and then submitting those changes to the insurance broker for distribution to insurance companies. Second, the organization would need to clinically trigger the insurance when a default or a protracted default event occurs in order to get the promised payout from the insurance company in a timely manner.
Credit risks insurance can also be used by the organization to negotiate with its lenders on loan terms and conditions. Let's think about the bank or lender that will lend money to the business. Wouldn't it be safer for the lender if the organization (borrower) had effective credit risks insurance so that there is no interruption in its ability to pay back the lender interest plus principal? In fact, numerous lenders welcome this and have the ability to reward the organization by advancing a higher loan amount and/or lowering their interest rate on the loan along with softening other debt covenants or loan requirements.
Credit Insurance Risks
Ironically, there are risks to the credit risks insurance coverage that is bought by any organization, this includes but is not limited to the following:
- The insurance company’s unwillingness to pay a claim even if it’s deemed covered
- The insurance broker’s errors in negotiating terms with the insurer
- A low insurance payout ratio (ie. only a partial claim amount is paid at loss)
- Insurance market dynamics leading to unfavourable outcomes to the policyholder
It is therefore important for an organization to hire the services of risk experts (also known as risk management consultants) who are independent of any insurance broker or company. These experts would tailor the credit risks insurance policy, beyond the window-dressing type exercise done by insurance brokers, to match the operational risk of the buyer. Our team does exactly that for our clients, and as a result our clients have performed well during the Covid19 pandemic.
Frequently Asked Questions (Credit Risk)
What does trade credit insurance cover?
It covers the amount of an organization’s accounts receivable that are either in default or protracted default. In other words, the organization will be protected if its counter-parties (ex. customers) owing money have delayed payment beyond contractual obligations or are unable to pay entirely.
How does trade credit insurance work?
First, the insurance needs to be analyzed and reworded vis a vis the buyer’s operational risk profile, which includes the drivers of the buyer's credit risks. The reworded version of the insurance would then be negotiated with an insurance broker who would distribute that version to various insurance companies. Quotations from insurers are received and can then be bound by the buyer in order for insurance to become effective. When a credit event occurs leading to a loss, the buyer must trigger the insurance policy effectively for there to be prompt and meaningful payout.
The insurance policy itself is dozens or hundreds of pages long containing different sections, clauses, terms, and conditions. This includes sections outlining what is covered under the policy (insuring agreements), what is not covered (exclusions), various definitions that are referenced throughout the policy, and various terms and conditions impacting the way, timing, and amount by which a claim is paid out under the policy.
Since the trade credit insurance policy is quite complex, it is of utmost importance to have technical experts who are independent of insurance brokers or companies to reword the policy itself in order for it to be tailored to the credit risk of an organization.
Is trade credit insurance worth it?
Trade credit insurance is not worth it if it is bought directly from insurance brokers or companies without it being reworded to reflect the credit risk profile of the buyer. The transfer of credit risks can certainly be beneficial depending on the measurement of the buyer’s credit risks, which includes quantifying the probabilities of default or protracted default on accounts receivable or other obligations. It also depends on the outcome of wording negotiations with insurance brokers and how the trade credit insurance policy is triggered at loss.