Toyota's recent troubles highlighted the damage that can be done to a company when a product is faulty. James Stanbury looks at the issues that reinsurers have to take in account
The Toyota recall, at present estimates, some 8.5 million cars, has dominated the business headlines of 2010.
But the recall of faulty products has not just affected the automotive industry. Unfortunately, recall procedures were invoked for a wide range of products in the UK in 2009 and 2010, ranging from wooden garden hammocks to Choctastic Pop Tarts to Disney Tigger Chime Wigglers (it's true).
In any product recall scenario, the initial focus will rightly be on public safety concerns. Thereafter, a company will begin to evaluate legal and insurance issues, establish cause, determine any contravention of regulations and laws and assess who and/or what was to blame. In this process, it will be necessary to start to establish the actual cost of the recall. If a company has insurance cover for product recall - and not all do - the valuation of what has been lost will be determined by the framework of those policy terms.
Of course, every recall is different but a typical cost qualification process could follow these stages: actual recall, damage control, when the product is not available to the market, when the product is relaunched onto the market and regaining market share and recovering profit margin. For each stage, different valuation issues arise which need to be considered.
Depending on the efficacy of the recall and the effect on long-term profits, this can be the most significant area of cost. Such costs include transportation and logistics, disposal and destruction and warehousing and storage.
A fundamental principle in evaluating such costs is that those claimed should only arise as a direct result of the recall. For example, in the case of FMCGs such as drink products, the recall costs of products that were either past their sell-by date at the incident date or would not have been sold due to over-production and/or lack of market should be excluded.
These costs typically relate to advising customers of the recall and providing reassurance that all necessary steps have been taken to ensure that a safe product is in the market again.
Such costs may include advertising, mail shots or broadcasts to the public. Notwithstanding compliance with legal obligations to advise the public, proportionality is important in assessing such costs - a balance needs to be struck between the cost of restoring the product in the shortest time and the loss of sales that could arise if such costs are not incurred.
When the product is not for sale
Once a product is out of circulation, there may be and indeed needs to be a period when there is no product to sell. Lost sales and increased costs could arise while production is reorganised and restarted. When the recalled product is not available, it is essential to analyse the subject company's other products which have not been recalled.
Such products may be "complementary" to those recalled and customers may switch to them, helping the company to mitigate its sales loss. If there is no "make-up" resulting from product substitution, there may still be reason to credit the claim - where customers wait until product is available again for sale and then make the purchase. This is more likely with high-value products where brand loyalty has generated and retained a customer base. However, the risk for any company experiencing a recall is that the consumer switches not to other products of its own but to a competitor's - hence the need to balance the damage control costs. Case in point is Toyota where, by January this year, its competitors were promoting incentive schemes (General Motors) and elevating their "quality" marque (Ford). Interestingly, fellow Japanese manufacturers, presently at least, have shown restraint in such promotion.
Relaunch of product and regaining market share
In any relaunch, there may be an ongoing loss of sales as the products are brought back to the market. Any loss evaluation will require an analysis of pre-recall trading levels. It is important that any loss reflects not only the direct efforts of the recall but also any factors - such as prevailing market conditions - that would have arisen in any event, a particularly important factor when considering the automotive industry and the general economic recession.
Losses have an ability to carry on. From an insurance perspective, the policy terms will dictate the period of loss. In general, it should end when the product returns to pre-recall levels but this is not always the case. There may be other factors unrelated to the loss which could extend the time it takes to recover market share - for example, a company may decide to use the opportunity to redesign its product, the packaging or production process. This is perhaps especially so in the automotive industry which is currently having to respond to green technology issues.
For the company of course losses may extend beyond the insurance cover period. The impact on brand and longer term sales cannot always be assessed with certainty and should not be underestimated.
In 2009, there were over 80 announcements of product recall. In a recession, where companies are perhaps struggling in any event from the global economic downturn, the need to recall faulty product is no doubt one of the last things they would want to have to respond to - with or without the cover of a (re)insurance policy.
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