ABA Section of Business Law

ABA Section of Business Law
Business Law Today
September/October 1999

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Can you risk a recall?

Insuring against product liability

By MICHAEL R. LEMOV and JASON I. HEWITT

Lemov is a partner at Winston & Strawn in Washington. Jason I. Hewitt, an associate at the firm when this article was written, assisted in the research and writing.

You receive a telephone call from a frantic district manager informing you that a retailer has had complaints from customers identifying your product as the source of widespread illness. You turn on your TV to see breaking news coverage of consumers being hospitalized. Your company is named as the source of the problem.

Almost immediately, you are called to a hastily arranged meeting of your management team. Officials are deciding how to respond to the situation. As legal counsel, you must assist in making decisions that, in a matter of hours, will balance the costs of an expensive recall of the product, against the risks of not taking action, such as product-liability claims, government penalties and seizure.

The decisions you make will affect your company’s bottom line this year, and, perhaps more important, its reputation in the future. Coca-Cola, for example, lost almost 10 percent of its stock value between the time Belgian consumers became ill after drinking its products and the date the company chairman apologized in full-page ads in European newspapers.

So what is the role of insurance in the context of a company’s crisis-management plan? Product-recall insurance can be important in such a crisis. It can allow the company to recover defined costs involved in the recall, as well as insuring that the company has the resources to get outside assistance.

Product recalls may involve industrial or consumer products, such as tools, machines, cars, foods, drugs, household appliances and children’s products. Recalls may be caused by a design defect, contamination or misbranding. The losses can mount up; in addition to the direct costs of the recall, they may include loss of customer goodwill and the company’s good name.

Most companies are aware of the need to maintain some type of product-liability insurance coverage. What they may not be aware of are the limitations of this coverage when a product recall is required to contain an emergency, as well as the major variations in the terms of recall-specific policies. Many companies have discovered the hard way that insurance covering general product-liability risk does not usually cover the costs of implementing a recall of an unsafe or contaminated product. While recall insurance does not eliminate all the risks that a company faces when dealing with potentially defective products, it can significantly minimize those risks.

The recall of a product is the most extreme action a company can take in responding to a defect or contamination. Whether a company decides to recall depends on a number of factors, including the nature of the problem, (that is, minor defect vs. design defect that affects safety); the potential harm to consumers because of the defect (that is, inconvenience vs. health hazard), the potential role of federal, state or international regulatory agencies (see sidebar below); and the overall cost of the recall in lieu of less expensive alternatives. In today’s business climate, it is sometimes tempting for companies to focus on the direct costs of a recall without considering indirect costs, measured in terms of consumer confidence and company credibility.

Product recalls occur all the time. In some cases, they are well documented in the media, such as the recent Coca-Cola recall mandated by several European countries, the recall of 1.2 million pounds of E-coli contaminated beef patties by Hudson Foods, or Intel’s recall involving problems with its Pentium processor. A review of the Consumer Product Safety Commission (CPSC) and Food and Drug Administration (FDA) Web sites demonstrates the frequency of product recalls. For example, the CPSC’s June 1999 release lists 11 recalls in the month of June, including 618,000 units of Hasbro’s Star Wars Lightsaber and 19 million dive sticks manufactured by 15 different firms. The FDA lists 17 product recalls from January to July of this year that include food products, from macaroni and cheese to spiced dry tofu. (See, http://www.cpsc.gov/cpscpub/prelel; www.fda.gov; www.dot.gov/oc/po/financial/archives..)

Whether through self-insurance or coverage obtained from an outside underwriter, insurance is one method used by companies to manage a broad variety of risks. Many types of commercial insurance are available and most companies have a wide range of coverage for different contingencies. Obviously it is important for a company to review periodically the limitations of its coverage, exclusions and any applicable conditions. Product-recall insurance is available from many major insurance carriers as a specialty product.

The typical commercial insurance that most companies maintain provides protection against catastrophic losses that threaten the financial viability of the organization. Insurance companies will generally offer a comprehensive general liability policy, also known as general liability. Under this type of policy, the insurance company will pay all damages that the insured becomes obligated to pay because of bodily injury or property damage caused by its product. However, as noted above, these general-liability policies do not typically cover product-recall expenses.

A lawsuit that arose following the Tylenol-cyanide incident illustrates the consequences of being unaware of your insurance coverage. In McNeilab v. North River Insurance , a federal judge held that Johnson & Johnson’s excess-liability insurers were not obligated to reimburse the company for expenses resulting from the recall of 31 million bottles of Tylenol. The judge stated that "at no time until counsel became involved following the recall was there any thought, belief or intent on the part of Johnson & Johnson or of any party that recall and expenses related thereto . . . were covered . . .  Johnson & Johnson, which at one time carried recall coverage, knew such coverage could be purchased and elected not to purchase it because the cost was prohibitive."

Product-recall insurance policies take the form of extra-expense coverage rather than legal-liability coverage. Here are two representative product-recall policy-coverage clauses from different carriers:

Policy A:

We will pay for expenses you incur for the withdrawal of your product or impaired property, when such withdrawal is made necessary by reason of determination by the insured or by any ruling of any governmental body that the use of such product or property could result in bodily injury or property damage, because of any known or suspected defect, deficiency, inadequacy or dangerous condition in it. This insurance applies only to expenses incurred from withdrawal of such product or property, initiated during the policy period and within the coverage territory.

Policy A defines expenses to include only the following:

• The cost of telephone and telegraphic communication, radio or television announcements, newspaper advertising;

• The cost of stationary, envelopes, production of announcements and postage thereof;

• The cost of remuneration paid to regular employees of the insured for necessary overtime;

• The cost of hires by the insured of persons other than regular employees of the insured.

Policy B:

The company shall reimburse the insured for loss arising out of the recall of an insured product during the policy period from a distributor, purchaser or user of such product, which occurs as a result of any of the following insured events:

• Accidental omission of a substance in the manufacture of the insured product; or

• Accidental introduction or accidental substitution of a substance in the manufacture of the insured product; or

• Error in the design, manufacture, packaging, blending, mixing, compounding, labeling or storage of the insured product; or

• Intentional damage to the insured product by an employee or by a third party.

Provided, that the use of the insured product has resulted or would result in widespread physical injury or widespread property damage caused by or because of the four points above and that insured adheres to the recall plan in responding to the recall.

Policy B defines recall costs more broadly than Policy A, as:

[A]ny reasonable and necessary costs incurred by the insured to inspect, withdraw, destroy, repair or replace the insured product. This may include, but is not limited to the following:

• The cost of communications to notify others of an insured event resulting in a recall, including but not limited to radio or television announcements and Internet or printed advertisements;

• The cost of shipping the insured product from any purchaser, distributor or user to the place or places the insured designates;

• The cost to hire additional persons other than the insured’s regular employees;

• Renumeration paid to the insured’s regular employees, other than salaried employees, at basic wage rates, necessary straight time or overtime;

• Expenses incurred by employees, including transportation and accommodations;

• The extra expense to rent additional warehouse or storage space for a maximum period of 12 months;

• The actual cost of disposal of the insured product, but only to the extent that specific methods of destruction other than those usually employed for trash discarding or disposal are required to avoid bodily injury or property damage as a result of such disposal;

• The actual cost to redistribute any recalled or restored insured products;

• Reasonable and necessary fees and costs of independent security, public relations or recall consultants to assist insured in responding to an insured event, provided that the company has given prior consent to the use of such independent specialist companies. These fees and costs are not subject to any deductible under this policy.

The two policy examples illustrate common elements, as well as major differences in recall insurance policies.

Both policies allow for reimbursement of standard recall expenses:

• the cost of informing the public of the recall,

• the cost of having the product returned or destroyed,

• overtime expenses for regular employees necessary to effectuate the recovery, and

• the cost of hiring outside persons to assist in the recall process.

Some major differences:

Coverage. Policy A bases coverage on the insured’s determination of necessity. Policy B’s coverage is narrower because it is limited to the occurrence of specific events.

Reimbursement. Policy A includes a listing of specific costs covered by the policy. Policy B bases reimbursement on "any reasonable and necessary costs" and also lists covered costs.

Scope. Policy B’s list of reimbursable costs is more realistic and inclusive.

Recall plan. Policy B, however, requires prior approval by the insurance company of an insured’s recall plan and requires adherence to the plan by the insured.

The requirement in Policy B to follow a recall plan approved by the insurance company could be significant to a company implementing its procedures. Policy B defines the recall plan as "the insured’s written product recovery document submitted to and approved by the [insurance] company, which forms part of the policy."

Many considerations will affect a company’s decision whether to purchase product-recall insurance and which type to purchase. These include the size of the company, its available resources, whether it has a high profile, the popularity of the product and an overall evaluation of its exposure.

Companies should also consider whether similar products have been targets of product-liability claims, tampering or extortion. Such manufacturers face special risks, particularly if they are dependent on a single brand or product line. Smaller companies may not have adequate reserves to finance a recall, or may not have a crisis-management plan in place to handle unanticipated recall problems.

In deciding whether to purchase product-recall insurance, a company will first want to engage in "exposure identification," that is, the evaluation of potential loss areas. This can be done by putting together a checklist that includes an inventory of assets and potential losses from property damage and personal exposure, as well as an examination of the corporate financial structure and resources.

The premiums for product-recall insurance products tend to be product and company specific. Insurance companies have, for many years, issued recall policies for food and cosmetic products as well as simple manufactured items. They are also beginning to issue policies for more complex products such as chemical, pharmaceutical and high-tech products. In response to questions about the scope of products for which policies would be issued, several insurance companies expressed concern about issuing recall policies for products where there is little experience in quantifying the risk associated with the product or industry.

Most product-recall policies include a limit on reimbursable costs. One insurance company indicated that it would issue policies up to $10 million. While this may sound significant, the cost of many major product-recalls has far exceeded this amount — almost $500 million in the Intel pentium-chip recall. More recently, Casablanca Fan Co.’s recall in 1997 affected 3.3 million ceiling fans with a retail value of $700 million. Similarly, Black & Decker’s recall in 1997 of 750,000 coffee makers affected retail sales of approximately $49 million. Recall policies generally contain deductibles of 1 to 2 percent. Some policies require co-insurance.

In deciding how to price product-recall policies, insurance companies look at a number of factors, including the nature of the industry, the size of the company in terms of product revenue, the nature of the company’s product and the manner in which it is manufactured or processed, the testing procedures for the product at issue, and corporate procedures in place for responding to an emergency situation. One insurance representative noted an instance where a company claimed to have a crisis-management policy in place which, on closer review, was just a package from the company’s trade association that was still in its shrink-wrap.

[An alternative to product-recall insurance is self-insurance. In many cases, self-insurance might be necessary to supplement product-recall insurance because of the dollar limitations that most product-recall policies contain. Generally, exposures that are either predictable or frequent are good candidates for self-insurance. A company that chooses to self-insure should reserve retention amounts, that is, allocate funds to pay for probable losses produced by particular exposures. Calculating the correct amount of reserved funds can, however, be a complex undertaking.]

Whether or not your company purchases product-recall insurance, loss prevention remains of paramount importance. Proper management of recall situations requires organizing a corporate team in advance. Prevention and preparation allow the company to avoid or minimize recalls, litigation and adverse publicity, all of which are time-consuming, expensive and damaging to the company’s reputation.

A corporation should have a crisis-management plan in place before it is ever confronted with the decision of whether to conduct a product recall. Having procedures in place in advance will allow a company to act quickly and efficiently when time is of the essence. Commitment to the plan is a continuing process that requires revision and examination.

The following suggestions highlight some of the important issues to consider in setting up your company’s plan or in assessing your existing program.

• Organize a formal product safety committee. It should meet monthly, before problems arise. Representatives of the major departments within the company, including engineering, manufacturing, marketing, public relations, insurance and legal should be an active part of this committee. This is particularly important because each department has a unique perspective and something to bring to the table. The committee should be chaired by a senior corporate official.

• Target potential problems. To eliminate unforeseen situations, the first role of the product safety committee is to identify all potential problem areas regarding your company’s product. This normally would involve reviewing the company’s product line for problem areas and analyzing the number and nature of consumer complaints. The key to successfully managing a product recall is preparedness. Making hurried decisions during the confusion of a crisis introduces significant risk that can be easily avoided.

Of crucial importance is the use of realistic pre-market testing of the company’s products. That is the area in which research and development is most useful. The R&D team can do much in terms of loss prevention by analyzing the product in terms of performance, safety, useful life and aesthetics.

• Know the rules. The representatives of the committee should have a general knowledge of the government regulatory and reporting requirements and notification procedures of relevant agencies (see the sidebar). Depending on the nature of your company’s products, it may be important to maintain an "open" relationship with the relevant government agencies. Having an existing relationship with an agency where your company has demonstrated flexibility and responsibility on small issues can help when a major product-recall situation occurs.

• Enlist management support. An important aspect of a company’s product-safety policy is the support of top management as shown by a written policy statement outlining the safety goals of the company. Among such goals, consider including compliance with applicable laws and government regulations, protection of shareholders and commitment to the removal of unsafe products from the market.

• Communicate with employees and customers. There should be a well-defined system by which employees can promptly report problems to an individual with the authority both to make decisions and collect information. This reporting system should be published by management, and be well known to employees.

In addition, the product safety committee should review prior problems in the product line as well as monitor customer complaints, which if left unaddressed could be sources of potential liability. The team should also research problems that may be unique to the company’s product line. One way of accomplishing this is to see what other companies in the industry are doing. This is an area where the use of outside consultants may be helpful for a fresh perspective on issues that may not have been uncovered in the company’s research.

• Develop an information system. It is important for a company to have an information system through which it keeps abreast of current product-safety issues and the state of the art. Often, an industry trade group or an insurance company can provide information about the general techniques being used within a particular industry.

• Conduct regular audits. If there is a problem with a product, audits should be conducted after a recall or potential recall situation. A company should evaluate what was done correctly and what could be improved. It will want to learn how other companies in similar lines of business have successfully or unsuccessfully handled recalls. A company should be constantly striving to improve its crisis-management even when it has handled a situation successfully.

Is product-recall insurance necessary? The purpose of insurance is to provide protection against unexpected or catastrophic loss. The cost of conducting a product-recall can include lost profits, business interruption, and direct costs of the recall (including transportation, communication, notification of customers and hiring of additional staff, warehousing and destruction cost of replacing the product, cost of product rehabilitation, hiring public relations personnel and advertisers, and attendant legal costs). As Coca-Cola, Ford, Johnson & Johnson and other major companies have learned, recall costs can be very substantial.

Ultimately, prevention through implementation of a crisis-management plan in advance is the best remedy. Prevention will not always avoid product-recall problems. To be fully prepared, a company must consider purchasing product-recall insurance. Be thorough in identifying all insurance options available and carefully compare coverages, limits, co-insurance, deductibles and cost. Comparison shop to get a full understanding of what is available. Advance planning now can pay off in a big way if your company is faced with an emergency decision regarding a product-recall problem.