Nick Goyal, ASA
Associate Director, Aon Risk Solutions
In each of the past several years, the number of mergers and acquisitions (M&A) involving businesses within the U.S. and those worldwide has continued to grow at a rapid pace, setting new records both for transactional volume and value. In 2019, the level of M&A activity has remained at all-time highs.
Meanwhile, the speed with which new deals are conceptualized and consummated today may be testament to several trends. One is the heightened levels of financial transparency of public companies. Another is the widespread use of technology to capture, store, and analyze tremendous amounts of financial and performance data critical for decision-making and establishing the terms of a transaction.
In this context, the due diligence process typically includes a thorough examination of potential liability risks, such as those arising from existing and pending lawsuits, pension obligations, and retiree and current employee healthcare benefits. However, there isn’t always a corresponding disciplined focus on obtaining fully accurate and up-to-date property valuations.
Besides their potential implications with respect to the ultimate purchase price, property valuations also can affect insurance costs for the combined enterprise when the transaction is completed.
Notably, although an acquisition or merger can help a company meet its short- and long-term goals for expansion, either scenario can introduce potentially significant exposures associated with uninsured or underinsured assets of the target company.
Thus, in evaluating a target company’s property portfolio, financial executives should consider the following factors.
Will the target or merged company have multiple properties in high-hazard zones for natural catastrophes, social unrest, crime, or terrorism? If so, are they in areas with modern infrastructures and ready access to robust emergency response services? Are all assets adequately protected against natural hazards, including fire, flood, windstorm, and earthquake? Given the recent spate of natural catastrophes and incidents of domestic and international terrorism, insurance companies have paid close attention to concentrations of risk in their own portfolios as well as of individual insured businesses. Depending on the combined values of all the properties, special coverage arrangements – potentially involving multiple insurers – may be needed to procure appropriate levels of insurance to adequately address potential exposures.
Are they fully operational and well-maintained or in need of significant repairs and retrofits? Are any repairs or upgrades required by law? Outdated valuations may not reflect the status of assets in disrepair, which may make them overvalued, potentially inflating the cost of the transaction. Should there be legal requirements to have any structures meet standards, the seller may need to establish an escrow for necessary repairs.
In these situations, the acquiring company should seek to determine if the target company has a significant portfolio of properties in countries with high rates of inflation and/or high-hazard exposures, including natural disaster risks or political risk/terrorism. In some emerging countries, there may be limited access or availability to first responders or critical resources, such as adequate water supplies for firefighting, to prevent a total loss of the property. Thus, an accurate valuation is necessary to make sure the asset is properly insured so the company will be in position to recover from a potential loss.
A company should try to quantify the elements of the target firm’s value chain. This is true whether the company is: making a strategic acquisition to achieve vertical integration of its existing product line; purchasing a direct competitor to grow market share; or seeking the financial and sustainability benefits of product diversification by buying a non-competitor with a different product mix. Consider the target firm’s inventory system. Is it just-in-time or does it stockpile large inventories of finished goods in a central warehouse or multiple warehouse facilities within specific geographic markets? Has demand for product been stable, or are there potential pricing fluctuations that might make inventory over- or undervalued?
The current global political and economic realities are placing new stresses on international supply chains. These realities also may have implications for the availability and pricing of components and raw materials from individual countries or regions. Acquisition targets should be examined in terms of how components and raw materials are sourced and whether alternatives have been identified should trade relationships be compromised. The target company’s political risk, trade disruption, and business interruption insurance coverages should be carefully examined along with its business continuity and supply chain resiliency plans and related risk management measures. Significant and unanticipated supply chain disruptions could have dramatic effects on a company’s cost of goods. Consequential changes in pricing may result in a decrease in sales (and, conceivably, related valuation of the enterprise).
The target company’s recent (within the last two years) and historic losses typically have an impact on insurance premium costs. If the company has had significant insurance claims for property damage, business interruption, trade disruption, product recall, or other issues, it is likely to have experienced related premium increases. Alternatively, in order to manage insurance costs to compensate for higher premium rates, the company may have restructured its insurance program to assume more risk. In this case, though its insurance costs may be stable, it now has a potentially significant uninsured exposure.
Depending on the type of businesses involved in the transaction and the scope of their operations, these issues and the existence or availability of relevant insurance coverage may require careful assessment. Notably, substantial uninsured, uninsurable, or underinsured exposures ultimately may affect the value and terms of a potential transaction.
In addition to their importance for estimating financial forecasts and calculating debt/equity ratios, balance sheets, and other financial statements, accurate asset values are critical for the creation of an effective property insurance and risk management program.
For insurance procurement, accurate valuations are needed to ascertain adequate levels of insurance to protect or replace the asset should it be damaged or destroyed as a result of a covered event. Accurate values are also needed to establish priorities for investing in building retrofits that provide added protection against windstorm, earthquake, floods, and other catastrophe-related exposures.
On the other hand, incorrect or outdated valuations can lead to serious uninsured exposures or premium overpayment. Specifically, overly high valuations could result in premium overpayment, and under-reported values could result in co-insurance, under-insurance, and non-renewal of policies.
For planning purposes, it is difficult to budget what property insurance premiums will be if the business being acquired does not have accurate values. More significantly, in the event of significant damage to an asset or a total loss, a complete insurance claim will have to include a statement of values. If values are outdated or inaccurate, they may compromise recoveries or lead to prolonged disputes with any insurance companies involved in the loss.
In addition to providing credibility in the procurement of insurance and adjustment of any related claim, independent insurable appraisals are the most reliable source for determining an asset’s true value.
A commercial property insurance underwriter relies on the estimated value of an asset or group of assets when assessing risk and ultimately determining the policy premium. Depending on various circumstances, a company may attempt to estimate the insurable value of its property, plant, and equipment (PP&E) without hiring an independent valuation professional. That stated, an independent valuation professional who has no ties to a specific company or insurance provider generally can conduct a thorough and well-informed appraisal that yields an accurate and supportable value while eliminating the risk of value bias.
The most reputable valuation professionals are bound by strict valuation guidelines enforced by the Uniform Standards of Professional Appraisal Practice (USPAP), American Society of Appraisers (ASA), and the Appraisal Institute. Working with firms whose professionals meet these standards helps ensure accurate and supportable insurable value estimates. These professionals are well-versed in the various issues and resources that must be considered when reaching insurable value conclusions, such as:
A standard practice in the U.S. commercial property/casualty insurance industry is to conduct an independent insurable value appraisal every five to eight years, relying on an indexing method between years as necessary. Of course, situations may arise where an updated appraisal of the property is necessary to assess significant changes in market or commodity pricing, or asset composition due to divesture or acquisition.
Unfortunately, without a recent appraisal, it is often difficult to determine whether values are accurate, which can lead to the serious potential issues with insurance recoveries as noted. Furthermore, it is important to note that insurable values are based on CRN (cost of replacement new), rather than PPA (purchase price allocation), the latter of which may be based on fair value.
Business acquisitions require specific financial reporting procedures. Companies with financial statements based on generally accepted accounting principles (GAAP) must comply with the guidance set forth in FASB Accounting Standards Codification 805 (commonly referred to as “ASC 805,” “purchase price allocation,” or “PPA”): Business Combinations. Part of this guidance requires the appraisal of PP&E at fair value. The valuation of the PP&E for PPA presents a leveraging opportunity to obtain insurable value estimates at a significantly reduced professional fee.
Frequently, the Cost Approach is used (among other approaches) to value PP&E during the PPA exercise. Often, certain replacement cost estimates have already been developed as a first step in the Cost Approach. In most cases, if replacement cost estimates were already developed within the PPA valuation work, then the groundwork for insurable value estimates has already been done, and a limited amount of additional work (and related professional fee) is required.
However, in every PPA appraisal there may be an opportunity for fee economies. Each of the following scenarios increases the potential for significant professional fee economies when leveraging a PPA appraisal to obtain insurable values.
Fee economies may or may not exist, depending on a number of variables, including the company’s data and insurance policy as well as the appraiser’s valuation approach. However, much of this information is known or determined during the scoping process of the PPA. In some instances, accounting and insurance valuation firms collaborate to help a company obtain accurate and timely valuations and appropriate insurance solutions through the completion of an acquisition.
As businesses throughout the U.S. and around the world move with greater speed to consummate or pursue mergers and acquisitions to achieve their strategic objectives and short- and long-term growth goals, they should invest the time to obtain accurate and timely property valuations of their potential targets or partners. These measures may be critical both for determining the terms of the transaction and in assessing significant pre- and post-transaction property exposures and related insurance protection.