Claims Blame: Quantifying Subrogation Claims
Article, World Insurance Report – March 2007
Insurance / Quantification / Disputes
Tony Levitt looks at the issues that should be taken into account when an insurer settles the original insurance claim to increase the prospect of recovery in a subsequent subrogation action against a third party that caused damage.
Subrogation is where one person or entity (usually an insurance company) assumes the legal rights of another person for whom the first entity has paid money on their behalf. So, the insurer who paid out the claim to their insured will subrogate (take legal action) against the entity that actually caused the damage.
Claims arise from natural or man-made disasters such as fire, flood, explosion, machinery breakdown, or negligence. These claims are usually indemnified by insurers to restore the company to the same financial position it would have been, but for the damage.
However, the claim may not have been the fault of the insured. What of the person or organisation which caused the damage in the first place? If there is someone to blame, then there may be claim against him. For example, a factory is destroyed by fire, which was caused by an explosion at an adjacent petrochemical company.
In the example, the insurers of the factory will try to recover the amounts they paid to their insured from the petrochemical company which caused the damage.
The insurance company will sue on behalf of their insured against the third party. In practice, the subrogated claim is often contested by two insurance companies disputing the responsibility for the loss.
Potential for subrogation
Where the damage is caused by a natural disaster, without human intervention, there will be no prospect of subrogation; but if the damage was caused by a person or company, then the situation may be different. It is essential, early on in the claims investigation process, to consider the prospects of subrogation, as this may affect the way in which the claim is handled.
The cause of loss needs to be determined with sufficient certainty that the insured will be able to demonstrate to a court what occurred and who was responsible for the damage. All documentation, including reports and other physical evidence, needs to be preserved for use in the subsequent recovery action.
Quantifying the claim
Often the physical damage issues are considered in some detail, although without much attention to quantum until sometime after the date of the loss. The prospects for a successful subrogation action will be improved if quantum is addressed early on.
Instead of focusing only on the amount of the loss for the purposes of the initial insurance claim, we should anticipate what will be required for the subrogation and take this into account. It is often too late to address the quantification of the claim for subrogation after the original loss has been adjusted and settled.
The effect of not anticipating subrogation at an early stage in the claims process is that it may not be possible to prove the amount of that loss. Also, the ultimate recovery may be less than the damage is worth, or less than was actually paid by the insurance company.
It is incorrect to assume that the amount claimed in the subrogation action will match the insurance settlement. The entire basis of each calculation maybe different. The settlement is based on the insurance policy whereas the claim in a subrogation action is likely to be for economic loss. There might be, for example, losses not paid in the settlement of the original claim, which may be claimed in the subrogation. These could include deductibles, underinsurance, policy exclusions, or policy limits.
Documenting the claim
It may seem obvious that if there is a potential subrogation action, all relevant documentation should be retained. However, the manner in which the adjustment and quantification of the loss is approached might also need to be changed to account for this. In checking the material damage, for example, it may be the adjuster’s procedure to check only a sample of invoices submitted in support of the cost of repair or rebuilding.
In anticipation of subrogation, all documents – not just a sample – should be retained. It is incorrect to assume that what was adequate as documentary support for the insurance claim will also be acceptable by the defendant in subrogation.
During the time the loss is being investigated and adjusted, all the documents will be available for review and should be retained and organised in anticipation of future disclosure. Moreover, the accounting system should be ‘frozen’ at the date of the loss, to ensure that all current data survives and that nothing is overwritten or deleted by subsequent entries. This is particularly important for real-time order entry systems, or data showing the backlog of orders at a point in time.
Retention of accounting documents is simple to achieve at the time, but much more difficult and costly if undertaken years later. Not only is there a likelihood that documents will have disappeared, but the people who created or were responsible for them may have left, or the company itself could have been taken over or moved to another location.
Even if people have not left the company, there is often a lack of interest by the Insured in the subrogation claim, particularly if there is little to gain from the action. In this situation, the insured may be unwilling to devote resources to the pursuit of the claim. These difficulties can be minimised by ensuring that all documents are retained at the time of the original loss adjustment. It is less time-consuming and far more cost-effective to do this, instead of incurring significant costs at the time of disclosure years later.
The calculation of the business interruption loss is often the most complex and controversial aspect of an insurance claim. This creates additional issues in a subrogation action.
For example, the period of interruption during which the company is financially impacted may not coincide with the policy’s indemnity period. If the policy restricts the indemnity period but the losses continue beyond that date, then there may be uninsured losses to be quantified for subrogation as they would not have been included in the original settlement.
There is enormous variety and choice in how companies insure their risks. The policy may be written for an individual company or for a group of companies, or there may be a local policy with a global policy to cover differences in conditions. The nature of insurance cover could give rise to differences between the insurance claim settlement and the calculation of economic loss in a subrogation action. Some types of business interruption policy may give rise to a difference between the settlement amount and the claim in a subrogation action. The most obvious example of this is if a policy indemnifies the insured for gross earnings, whereas the subrogation claim is likely to be based on gross profits, to establish economic loss.
The gross earnings calculation will typically indemnify the sales value of lost production during which the business is unable to produce at pre-loss levels of production. So, once the business has recovered its productive capacity, the indemnity period ceases.
However, the Insured may have lost a key customer or market share, which may take longer to recover. This will not form part of the insurance claim in this example, but may be included in the subrogation claim.
Business interruption calculations often include forecasts or projections of what would have happened but for the insured event. These are based on certain assumptions, giving rise to, for example, the anticipated levels of sales had the loss not occurred. These assumptions and forecasts need to be investigated and tested during the adjustment process to ensure that they can be justified in the action against the third party.
The settlement needs to be based on valid assumptions, properly documented, and not just a negotiated amount in order to settle the claim. It will be difficult to prove to a third party any settlement which cannot be substantiated, particularly if this is based on ‘commercial considerations’. It is likely that the defendant will reject this as a basis for the business interruption claim.
Insurers and their advisors should always be mindful that a negotiated settlement of the insurance claim often limits the potential for a full recovery in a subrogation action.
If there is the potential for a subrogation action it is essential for forensic accountants to be involved in the claim as early as possible, preferably soon after the loss has occurred. This will enable them to work with the loss adjuster in collating and preserving all the documentation.
The calculations, particularly for business interruption, should be based on well-reasoned arguments leading to a settlement that can be justified in the subsequent subrogation action.
The early appointment should be cost effective as their involvement at the outset should avoid a costly investigation of the claim a second time, often years after the event. The forensic accountants will then be in a position to prepare calculations and an expert’s report earlier in proceedings, which could facilitate a quicker resolution of the case.
The claim against the third party will inevitably lead to blame for causing the loss in the first place. But once a decision has been taken to proceed with the subrogation action, the planning and involvement of the relevant experts at an early stage can play a vital role in working towards a quick resolution of the case in the most cost-effective manner. If there is the potential for a subrogation action it is essential for forensic accountants to be involved in the claim as early as possible, preferably soon after the loss has occurred.
This article first appeared in World Insurance Report March 2007.