Carving Out Risks

Carve-outs let companies protect the bottom line by isolating specific risks.

As the insurance market continues to harden, competitive pricing and readily available coverage are rapidly becoming things of the past. Higher premiums and stricter underwriting requirements have combined to create an environment in which certain risks are difficult to insure and problematic to the bottom line.

To secure an appropriate level of coverage for these exposures, CFOs are turning to a powerful risk transfer technique -- carve-out programs. In simple terms, carve-outs manage specific risks by isolating them from the broader risk management program and insuring them separately.

The increasingly widespread adoption of enterprisewide risk management has given many CFOs and risk managers a clearer idea of which risks they want to retain and which they want to transfer. Carve-outs let companies leverage those insights. "Although common risks can be transferred through traditional hedging or insurance programs, highly unique risks can require alternative risk transfer techniques, such as carve-out programs," says James Lam, president of James Lam & Associates, a risk management consulting firm in Boston.

Why Carve Out?

Carve-outs are appropriate in many situations. "You can carve out a coverage, a peril or a location," says Jill Dalton, managing director of Marsh Inc., a risk and insurance services firm headquartered in New York City. "A carve-out is a way to obtain different terms and conditions for a particular peril or to obtain coverage that the company might not get otherwise." Companies can use carve-outs to obtain higher limits, lower deductibles, broader coverage, and better terms and conditions for a specific risk. Carve-outs also let self-insured organizations obtain fixed-cost coverage for volatile and expensive categories of risk such as catastrophic health-care claims.

Corporations can use carve-outs to manage the exposures arising from exclusions of specific causes of loss, locations or product lines. For example, a manufacturer can depend on a general liability policy to cover the use of its products in most situations. However, if those products will sometimes be used in high-risk situations -- in nuclear power plants or aircraft, for example -- the company may decide to carve out those risks into a separate policy. "Every policy has a collection of standard exclusions that serve to reduce coverage," says John Schaefer, vice president of enterprise risk management with ABD Insurance and Financial Services in Redwood City, Calif. "In a softer insurance market, these exclusions are sometimes added back for the entire company, but that may not be possible in today's hard market."

Over the past 15 years, insurance companies have introduced exclusions for environmental risks, employment practices liability and network liability, among others. Within a few years of creating a gap, insurers often fill it by offering policies specifically designed for the exposure. Some observers believe that this process is currently under way in the directors and officers (D&O) liability insurance market, but others note that specialized policies are not yet available to fill every coverage gap: "Insurance companies are taking away certain D&O coverage, but they are not developing new policies to pick up that exposure," says John Bugalla, managing director of insurance broker and consultancy Aon Corp. in Chicago. "Companies have to take on this additional risk themselves."