Direct impact of recall versus business decision based on a recall

Over the last three years, everyone has formed an opinion on the impact that the pandemic has had on businesses all over the country and the world. How did it impact businesses? From a product and supply chain risk perspective, around the same time, we started to consider the impact on the supply chain and the impact on product quality, control and manufacturing operations, and in turn the impact on the product recall insurance industry.

Along with inflation, supply chain issues, and labor-related concerns, there has certainly been no shortage of issues to consider. However, what happens when all of these issues begin to impact the business concurrently, and we see the cumulative impact on business? How does a business respond? How does the blend of economic pressures impact their decision-making?

The pandemic may be drawing to a close, or we are certainly dealing with it differently than in those first 12 months, but these issues remain. What we are seeing increasingly in recall-related incidents is a clear problem related to how businesses are responding to the product recall in question.

Product recall-related insurance policies are in place to cover losses occurring “solely and directly related to the recall.” The challenge faced is drawing a distinction between the losses that are “solely and directly” versus losses that result from operational and business decisions made by the insured. Are those decisions a direct consequence of the recall, or are they further removed from the event that is deemed to have triggered the policy? Was the decision necessary, and a direct result, or was it one of several options and responses that would have been appropriate?

As an example, an insured’s facility was impacted by a food-born illness leading to an operational shutdown. This production shutdown caused further strain on an already struggling business, which was dealing with increased production costs, an overwhelmed workforce and labor shortages. In response to the production shutdown, the insured decided to move their entire production process to a co-packer. In presenting the loss of business income due to the food contamination event, the insured claimed that the whole period between the agreed date of loss, and a date at which it considers the new co-packer arrangement was generating production at a level similar to that preceding the loss event.

This shutdown period was extended by the decision to shift production to a co-packer. Restoring the insured’s own production line could have been completed in a shorter timeframe. Losses included in the claim were therefore impacted by this business decision and extended claim period. Given the economic strain on the supply chain, establishing a co-packing relationship and getting the right production process established was extended even beyond normal pre-pandemic timetables.

In this particular situation, insurers argued successfully that the recall losses to be measured should be the losses in reasonable timeframe under which production lines and the supply of products could be returned to pre-loss levels. While the insured considered that the losses should include the sales losses in the period during which a co-packer was established, the decision to move to a co-packer was seen as a business decision and not directly resulting from the loss event. Arguably, the decision to move to a co-packer was driven, certainly in part, by labor shortages and capacity issues at the insured.

Of course, manufacturers face economic pressures that go beyond the challenges faced in 2020 and 2021. In damages modelling and the measurement of financial loss, it continues to be important to understand what their position will be on issues like the one detailed above. It is also important for risk professionals to consider how these economic issues and decisions in the post-loss period impact the financial loss resulting from a recall event.

These issues will exist in situations where an insurer is being asked to respond, as well as more litigious commercial disputes between companies in a supply chain. Situations like the one described above occur in other lines of business, under other policy types. A discussion of the issues and, where appropriate, agreement on a notional recovery period, has removed surprises and conflict, leading to a sensible resolution. In insurance matters, one would hope that transparency and communication on the recovery plan and post-loss decision-making will exist. In litigious matters, however, that may not be the case. But it remains important for those involved in the risk management process to pay attention to these issues and respond appropriately to resolve issues.

This article is part one of four of the Hot topics in product recall series. Read part two, “Inflations impact on recall risk”, to learn more.