Consumers have a reasonable expectation that they will not be harmed by their purchases, and if they are, they’ll likely seek recourse. Manufacturers, distributors, suppliers, and retailers are held liable for any injury or damage caused by their products. Many of us can easily recall a few infamous cases like McDonald’s too-hot coffee spilling on the lap of an elderly woman or the recent "unintended acceleration" of certain Toyota car models as prominent examples of product liability.
Multiple government agencies are focused on consumer safety and can influence product liability.1 In the past few years, two product regulation agencies in particular, the Consumer Product Safety Commission (CPSC) and the Food and Drug Administration (FDA), have notably publicized their increased authority.
In 2008, the CPSC updated its authority with the Consumer Product Safety Improvement Act after the CPSC recalled a record-breaking 473 products in 2007.2 The Act focuses on children’s toys and the dangerous substances in them, especially phthalates and lead.
The FDA’s new Food Safety Modernization Act, which went into effect in January 2011, further shifts the administration’s focus onto more preemptive methods of preventing food contamination rather than just responding after an outbreak. The most important pieces of the Act as it affects product-based liability may be FDA’s new mandatory recall authority (upgraded from its prior recall requests) and the new requirement that food importers verify the safety of food from their foreign suppliers. Both of these increase food producers’ exposure to product liability and recall liability.
Not only do a company’s products come under review, but its reserves are scrutinized as well. The auditors who sign off on the company’s practices are, in turn, monitored by the Public Company Accounting Oversight Board (PCAOB). In February 2012, Ernst & Young was fined $2 million by the PCAOB when its client, pharmaceutical company Medicis, which produces cosmeceuticals such as Restylane, had not been conforming to GAAP in reserving its product-based liabilities.3 This case highlights how product liability’s reserving practices are more complex than those for other traditional self-insured lines of commercial insurance such as workers’ compensation, auto liability, and medical malpractice.
The FDA and the CPSC are concerned with the effects of harmful products on the safety of the public. Insurance brokers, actuaries, and auditors are concerned with the effects of product liability on financial statements. Insurance brokers, actuaries, and auditors can all play key roles in helping companies manage the effects of potential product liability. Insurance brokers can help with the purchase of appropriate product liability insurance. Actuaries can help determine reasonable insurance prices and compare the financial impact of buying insurance to self-insuring. Actuaries also estimate the reserves to be held for any retained product liability exposure. The auditors make sure the reserves are properly reflected in the financial statements.
Where do product liability losses come from?
Legally, product liability is established when a defective product causes injury or damage and that product is deemed to have been defective before the consumer took control of it.4 There are three broad categories of defect: manufacturing defect, design defect, and inadequate warning.
Manufacturing defect covers any portion of the manufacturing process, including materials used, that can make a product more dangerous than if it had been manufactured properly. For example, if a children’s nightlight starts fires because of cheap materials, exposed batteries, exposed electrical wires, or a part being incorrectly made, that would be a manufacturing defect. Other manufacturing defects, especially using hazardous paint or chemicals, and products with unnecessarily sharp corners, are common complaints for children’s toys. Contaminated food is also considered a manufacturing defect.
If the manufacturing went according to plan, but the plan itself was based on faulty concepts or poor execution, the product is subject to design defect. The Ford Pinto is a popular law-school textbook example of design defect. Even though the car was properly manufactured, rear-end collisions caused the gas tanks to rupture and often burst into flames. Ford engineers determined that two defective design elements caused the gas tank ruptures and subsequent deadly fires. The largest lawsuit against Ford resulted in approximately $3 million in compensatory damages and $3.5 million in punitive damages.5
Inadequate warnings can also give rise to product liability claims. Familiar notices seen on an almost daily basis include, “WARNING: Choking Hazard – Small parts. Not suitable for children under 3 years” and plastic bags bearing the warning, “This bag is not a toy.” These warnings caution against any dangers that may not be clearly apparent to consumers. Another common warning seen on takeaway coffee cups declaring that “the beverage you are about to enjoy is extremely hot” is more meaningful knowing that McDonald’s was facing $2.7 million in punitive damages at one point after 79-year-old Stella Liebeck spilled her 49-cent coffee in her lap.6
Who might be liable?
A safe product, free of any defects and used as intended by consumers, should be the highest ambition of any manufacturer. Without a defective product, there can be no liability; no one gets hurt, no property is damaged, and no claims are filed. However, even with good risk management, losses do happen. And manufacturers, distributors, suppliers, and retailers must be cognizant of their potential exposure.
Consumers bring lawsuits against companies for defective products, seeking compensation for any property damage suffered that is due to the product in addition to any medical bills, additional pain and suffering caused by, and any lost wages resulting from the injury. Punitive damages against the defendant may also be awarded.
One legal website has an entire section devoted to product liability claims with the telling title, "Defective Product Liability Claims: Who to Sue?" It encourages potential plaintiffs to “take the time to dig up all potential defendants because this will increase your chances of getting full recovery for your injuries.” Potential defendants listed include all parties in the chain of distribution—parts manufacturer, supplier, assembling manufacturer, wholesaler, retailer, and any other possible middlemen—because “the more defendants the merrier.”7
Plaintiffs are not the only ones looking as far back along the supply chain as they can—producers and manufacturers will also do their best to blame the defect on their suppliers and wholesalers to avoid claims altogether or to look for subrogation opportunities. Retailers and distributors, less likely targets for both consumers and manufacturers, should be aware that if they outlast an out-of-business manufacturer, they may be the last remaining deep pocket for a lawsuit to target. Juries, looking to compensate injured parties, may also see these retailers as the only chance for a recovery despite their level of involvement.
How are product liability reserves different?
Product liability reserves are unique in that they have two components: loss reserves and unearned reserves. Other lines of insurance only need the loss reserve component. Loss reserves are established for claims that have already occurred (regardless of whether or not they have been reported). Unearned reserves are for claims that have not yet occurred on products that have already been made.
If a factory shuts down on December 31, 2011, it is responsible for all workers’ compensation injuries incurred on or before December 31, 2011. The company knows it will not have any more workers’ compensation claims occurring after December 31, 2011. Similarly, the products made in that factory have loss reserves for claims occurring on or before December 31, 2011. But even after the factory shuts down, the products are still in use. These products have the potential to generate claims after December 31, 2011, and need unearned reserves set aside to cover those losses.
The loss reserve component
Estimating the loss reserve component for product liability uses some of the techniques seen in other lines of insurance but, because of the unpredictable nature of product liability claims, additional estimation methods are needed.
Loss development triangles show claim dollars’ growth over time. For lines of insurance with robust data, development methods can be heavily relied on to estimate future increases in claim dollars. Incurred dollar development typically produces a better estimate of loss reserves than paid dollar development because incurred amounts include estimated case reserves for future payments on known claims. However, case reserves are not as easy to estimate for product liability claims as they are for other lines of insurance.
For standard lines of insurance, companies may have a dedicated claims manager or hire a third-party administrator to establish case reserves. Product liability claims are less frequent and often dependent on uncertain lawsuit outcomes; this leads to inconsistent case reserving practices. Case reserves are often set by the company’s lawyers, who may set reserves at an estimated settlement amount. These reserves could be best-case or worst-case estimates—but they may not reflect the probability of such a settlement. If a potential verdict is $1 million but there is only a 10% chance of losing the lawsuit, is it more appropriate to reserve $1 million or $100,000?
It is also notable that product liability claims, especially those that develop into large lawsuits, will take many years, if not decades, to resolve. Product liability’s extremely long-tailed development adds to the complexity of estimating reserves.
Examining historical claim frequency and severity is often an appropriate method for estimating future claim payments. Frequency trends can be examined to estimate if the number of claims is rising or falling. A falling trend in frequency may show that an older product version or model is being discarded in favor of a newer version or model. Publicity could cause a spike in claim reporting. If the product is mentioned by one of the overseeing government agencies or if an individual’s bad experience or successful litigation becomes well known via the Internet, claims may rise dramatically. (In addition to increasing the product liability, it can have lasting effects on the company’s reputation.)
Another estimation technique not commonly used on other lines of insurance looks at the payment decay ratios by production or sale date and applies these patterns to estimate future payments.
Estimating the correct exposure base may be as challenging as estimating adequate case reserves. The correct number of products needs to be matched to the losses they specifically generated. Product counts must be known by not only annual production rates but also how by many products are currently in use. The useful lifespan of a product depends on many factors: has it been replaced by a new model (upgraded cell phone) or replaced by competing product (DVD versus VHS) or have consumers been warned against buying certain products (CPSC warnings about children’s toys made in China)?
The unearned reserve
The loss reserve component for product liability (and any other line of insurance) establishes reserves for any claims that have already occurred. The unearned reserve component establishes reserves for products that have been made but for which no claims have yet occurred.
The lag between the product’s manufacture and a claim occurrence can be significant. Because the unearned reserve is not a balance sheet item for ongoing companies, this very real (and possibly very costly) liability is often overlooked when companies begin run-off proceedings or become targets for mergers and acquisitions. These unearned reserves must be factored into any run-off, merger, or acquisition considerations in order to accurately estimate the economic cost—especially because they are not reflected on the target company’s balance sheet.
Product liability poses a unique risk to product manufacturers because it is unpredictable and can involve large dollar amounts. While product liability often begins with a defect—itself an unpredictable trigger—the flames can be fanned by the media, the government, or the public in general, especially with social media giving every consumer a podium from which to broadcast discontent. The unique nature of this risk can leave manufacturers struggling with how to cope. But manufacturers can plan for the unexpected, in particular by managing both the loss reserves and (for some companies) the unearned reserves. Some companies have failed to recognize the need to manage their unearned reserves, in effect creating a defect in their risk management that can exacerbate the original product defect. Any company that manufactures products should recognize its risks and structure its reserves with eyes wide open to the possibilities.