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Risky Business

Risky Business

The pharmaceutical industry has undergone a transformation in the past decade, with continuing merger and acquisition activity and globalization that has combined with a steep decline in the image of the industry.

It is perhaps no wonder, therefore, that an analysis of pharmaceutical companies' key performance measures by Wayne Guay, associate professor of accounting at The Wharton School of the University of Pennsylvania, showed during the past 13 years that pharmaceutical companies in the aggregate have become as much as "50% riskier" than the overall Standard & Poor's 500.

He analyzed the volatility of data such as cash flow, net income and return on investment, among other factors, in his 2005 study.

"Positive and negative events in this industry are extraordinarily pronounced, with dramatic effect on shareholder value and reputation," Professor Guay's report concluded.

A KPMG L.L.P. report, "Pressure Points: Risk Management in the Pharmaceuticals Industry," concluded that the risk profile of the pharmaceutical industry has changed dramatically during the past decade. By looking at risk factors disclosed by 18 major pharmaceutical companies and medical device manufacturers in their 2003 Securities and Exchange Commission 10-K filings, KPMG found that 100% of the companies cited both legal liability and price controls as risks--vs. 88% and 63%, respectively, in 1998--followed by an underdeveloped product pipeline, product supply and changes in their competitive environment.

Other important risks faced by the industry from an insurance perspective include intellectual property (covering legal costs and business continuity), directors and officers liability, environmental risks and trade credit risks. However, two of the most important insurable risks are product liability and business interruption.

Product liability

Product liability is the industry's key insurable risk and yet it is, paradoxically, the one for which the insurance industry is failing to provide the best solution, experts say. Product liability is an area for which many pharmaceutical companies either cannot buy insurance or won't buy it because it is prohibitively expensive.

Bruce Belzak, Marsh Inc.'s life sciences practices leader in the United States, based in Philadelphia, says: "As far as product liability is concerned, what has happened over the last five years is that losses continued to occur with increasing frequency and severity, and underwriters basically said that they did not know how to underwrite this risk, so they began increasing deductibles or retentions, raising rates, reducing limits and started excluding actual products that the companies make.

"As a result, premiums and retentions have gone through the roof and the limits have gone down, so a significant number of the jumbo pharmaceutical companies--those with more than $10 billion in annual revenue--are going completely self-insured," Mr. Belzak said.

The self-insured route

Going self-insured means a variety of approaches that range from putting the risk though a captive, using alternative risk transfer or "taking it on the balance sheet," one observer said. The effort could use actuarial estimates or be as simple as "paying a check and writing it out of cash flow."

For some pharmaceutical risk managers, taking the self-insured route is seen as a positive choice rather than a reaction to the failure of the insurance market.

"For many companies, insurance provides a sound solution as a hedge against large losses that could negatively impact the financial picture of an organization," said Gary Nelson, vp, risk management and legal administrative services for Medtronic Inc., based in Minneapolis.

"In theory, insurance provides a key source of critical cash to an organization when it needs it the most. However, insurance may not be the best solution for a company when trying to hedge against mega-catastrophic losses, when insurance coverage is limited or significantly restrictive, or when insurance premiums are significantly higher than the expected losses of the entity," he said.

"Companies which analyze their insurance needs by reviewing their profit and loss, balance and cash flow along with their expected losses and premium costs may be surprised to find out that they could easily afford to take on more self-insurance as a part of their risk management program," Mr. Nelson said.

Retaining more risk often goes hand-in-hand with a greater focus on risk management, and in the product liability arena this is tied in with the research and development phase.

It also ties in with a robust legal defense, as pharmaceutical companies and their directors are major targets of plaintiffs' lawyers, especially for class actions in the United States.

Business interruption

Business interruption is the other major insurable risk that pharmaceutical companies face, industry experts say.

Alex Hindson, former risk services manager at AstraZeneca P.L.C. and now Weybridge, England-based associate director of the enterprise risk management unit of IRMG, the integrated risk consulting practice of Aon Captive Services Group, says pharmaceutical companies face a huge potential business interruption risk.

"A typical pharmaceutical company's property exposure is 80%-90% business interruption, with the remainder related to actual physical damage. The focus in this industry needs to move from physical protection towards effective supply chain management and the establishment of business continuity strategies across sites," Mr. Hindson said.

Business continuity planning is essential, but the industry needs to go much further than simply having one's own plan. The industry is moving toward more complex business models with significant outsourcing, joint ventures, strategic alliances and partnerships--often with much smaller biotechnology companies. This has important consequences for issues such as assumption of liability, but also, more importantly, business continuity.

"A lot of pharmaceutical and biotech companies rely heavily on sole suppliers," Marsh's Mr. Belzak said.

"We tell them they need to go to key suppliers and ask them what they would do if they were unable to supply the key ingredient that we need in a particular drug," he said.

"It is important that pharmaceutical companies have their business continuity plans, but it is also important that the people that they are dealing with have their business continuity plans as well," Mr. Belzak said.