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Assumptions in insurance claims and quantifying losses: An Expert's view

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Quantification of losses in insurance claims often rely upon assumptions instructed or adopted by an expert. In many cases the losses can substantially change depending on the assumptions, be that growth forecasts, age of retirement, career progression, cost structures the list goes on.
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Example

In a recent matter the age of retirement had a material impact on the assessment of loss. 

This matter involved a personal injury claim involving a motorised scooter and a pedestrian (the Plaintiff) who was stuck by the scooter. The Plaintiff was allegedly injured and unable to return to work.  Prior to the incident, the Plaintiff was a home handyman conducting a business in a personal capacity. The Plaintiff’s forensic expert assumed a retirement date of 70 years in the assessment of loss.  

Our experts were able to demonstrate based on sound industry data that the probability of this individual retiring at an age of 70 years was less than 2% and a more reasonable retirement age was closer to 60 years.  The impact on the loss claim was significant in the order of $600,000. 

The ABS data confirms a significant difference between retirement ages of blue collar and white-collar workers.

Assumptions such as age of retirement, underpin and are often material to the expert opinions, provided the critical element is to ensure that these assumptions are reasonable and supported by other anecdotal evidence. 

In another recent matter a key assumption used in the analysis of stock movements had a significant impact on the analysis conclusions. 

Example

This matter involved the loss arising from a fire and the damage to the stock of a high-end men’s retail fashion business from smoke.

An issue in the matter was the ultimate profits realised from the damaged stock.

It was a difficult matter to determine as the business’ records did not match sales to a specific individual item of stock on hand, and it was not possible to determine from the records whether the sale was of damaged or undamaged stock. 

The Plaintiff’s expert embarked on an exercise to match sales to specific individual items of stock, a task that ran to hundreds of pages of an excel document and the foundation assumption of the analysis was that the damaged stock was sold first and the newer undamaged stock purchased after the fire was sold last. 

A one line statement in the business’ financial accounts supported the concept that the business applied the first in, first out inventory method.

However, the method referred to in the financial accounts, is itself an assumption, used by the business’ accountants to assign a value to stock sold and on hand. It does not necessarily mean that this is how the business deals with stock in practice. 

Our Experts undertook a thorough review of the other Expert’s analysis and were able to demonstrate that this assumption was inappropriate and did not reflect the operations of the business in practice. Plaintiff’s Counsel stated they would no longer rely on the report after the cross examination of their Expert. 

Application of discount in quantification of losses

In many cases where a loss is being calculated, some portion of the loss relates to a future period. 
It is also often the case, whether the loss relates to a past or future period, that there is some uncertainty (often significant uncertainty) as to how the amount of the loss has been determined and whether it would have actually been achieved.  

The traditional approach of the expert, when considering such circumstances, would have them determine and apply a discount reflecting the time period of money and the risk relating to the business’ ability to generate the earnings calculated.

More frequently we are seeing the issue of an appropriate discount not being considered when quantifying loss and in some circumstances the expert is being specifically instructed not to consider a discount. 

This approach is often justified with the statement that it is a matter for the Court as to the appropriate discount. While certainly the ultimate decision is a matter for the Court (as is the overall loss suffered) it remains a matter on which an appropriately qualified expert can assist. 
In my view an expert can assist significantly in this area as an undiscounted loss can set an expectation on the amount of the loss that is not reasonable. 

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Example

This matter involved the loss arising from a defect in a building product that could give rise to rectification work required on nearly 1500 structures. The period that the rectification work was expected to unfold was 2021 to 2044 with the average rectification cost estimate to be approximately $25,000 per structure. 
The Plaintiff’s Expert did not discount the estimated rectification costs, as this is notwithstanding:

  • The costs to rectify were expected to be incurred over an extended period of time.
  • If paid the amount of their claim they would have the money to meet the rectification period long in advance of needing it.
  • Historical failure rates suggested that not all structures were failing as a result of the defect or that customers were requiring rectification works.
  • Historical average rectification works per structure up to the date of the report had been declining.

Our Experts undertook an exercise of considering the appropriate discount, the basis for such a discount and the manner in which it should be applied. While not large, the discount has a significant impact on the calculation of loss given the expected timing of the rectification work and the overall period of the loss. 

The difference highlighted the impact that timing had on the calculation of the loss and the benefits that would accrue to the Plaintiff if the claim was paid with such a long lead time until the rectification costs would be incurred. 

Another instance requiring an expert opinion in quantifying losses is where a business has been purchased by another business, only to discover potential wage underpayments, which would legally require back payment. 

Most people are now familiar with wage underpayments issues affecting many organisations. In fact announcements of back payments barely make headlines anymore.
But what happens if you’ve purchased a business and have identified historical underpayments? Has this caused you to pay more than the value of the business?

Example

This matter involved the acquisition of a business where the purchaser discovered an ongoing issue of wage underpayments in business, resulting in three main issues:

  • A potential liability for back-payments
  • Costs to resolve the issue
  • The ongoing business was not as profitable as the Purchaser thought

The Purchaser had Warranty and Indemnity Insurance in relation to the acquisition and we were engaged by the Insurer to assess their claim.

Back payments

If an underpayment is discovered, the lookback period is typically six years from the date the issue is known. This meant that the Purchaser of the business was potentially liable to make historical payments to the employees from the time before they owned the business.
In this instance, the structure of the transaction was important, as it was actually a sale of the business assets rather than the legal entity. Consequently, the historical issue remained a liability of the previous owners as they were still the shareholders of the legal entity that had underpaid employees.

Costs to resolve the issue

Underpayment issues are inherently expensive to resolve. There is a great deal of work to be performed, which requires a combination of analytical skills and legal advice. Issues that need to be analysed are:

  • Which Award(s) may have applied
  • Whether all the requirements of the relevant Award(s) were applied
  • Recalculation of a sample of employees and then a full recalculation if necessary
  • Contacting former employees concerning the underpayment
  • Dealing with the Fair Work Ombudsman

Profitability of the ongoing business

In this matter, the issue was that the Purchaser claimed that the underpayments were approximately $400,000 per year. As the Purchaser had paid a multiple of 10 times the earnings, the claim was for $4 million.

We were engaged to consider whether:

a)    The $400,000 was reasonable;
b)    The effect flowed to the value of the entity; and 
c)    The claim should be for $4 million.

The first phase of work identified that significant work had been performed to quantify the $400,000 and we were able to agree with the Purchaser’s analysis.

The second phase of work related to the value of the entity. The approach to the difference in value depends on the circumstances and legal precedents. In this instance we were instructed that the relevant measure of loss is the difference between the price paid by the Purchaser (being the ‘Insured’) and the fair value of the assets acquired. 

At a high level, our analysis found that the total difference between the price paid and the fair value of the assets acquired was less than the $4 million. This was due to the price paid including some items that were not valued at fair value in the transaction. Ultimately the Insured party was able to reach agreement with the Insurer as to the amount claimed.