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Every time a defective product is recalled, the company responsible must follow a long, meticulous and costly process of expiation. By James Stanbury
The alleged defects in Toyota cars have dominated the headlines in recent months, and according to recent reports have already led to the recall of 8.5 million vehicles.
Whenever a faulty product is recalled (there were more than 80 instances of product recall in 2009) the company has a series of legal and insurance issues to untangle to establish cause, determine any contravention of regulations and laws and assess who and/or what was to blame. As well as liability it is also crucial that the company begins to establish the actual cost of the recall.
Total recall cost
When quantifying the cost of a product recall the first stage to consider is the physical recall itself. Depending on recall efficacy and the effect on long-term profit, this can be the most significant cost area. It will include transportation and logistics, disposal, destruction, warehousing and storage. When claiming for these costs the insured will have to prove they were a direct result of the recall.
For example, in the case of fast-moving consumer goods such as drink products, the recall costs of products that were either past their sell-by date at the incident date or would not have been sold due to overproduction and/or lack of market should be excluded.
The next step is evaluating the cost of damage control. These costs typically relate to advising customers of the recall and providing reassurance that all necessary steps have been taken to ensure that a safe product is on the market again. Such costs may include advertising, mail shots or broadcasts to the public. Notwithstanding compliance with legal obligations to advise the public, proportionality is important in assessing such costs - a balance needs to be struck between the cost of restoring the product in the shortest time and the loss of sales that could arise if such costs are not incurred.
Once a product is out of circulation, there may be - and indeed needs to be - a period when there is no product to sell. Lost sales and increased costs could arise while production is reorganised and restarted.
However, if the company is a well-known brand that offers a range of products, then it may not be so straightforward to evaluate loss of sales. Such products may be ’complementary’ to those recalled and customers may switch to them, helping the company to mitigate its sales loss. If there is no ’make-up’ resulting from product substitution, there may still be reason to credit the claim, whereby customers wait until the product is available for sale again and then make the purchase. This is more likely with high-value products where brand loyalty has generated and retained a customer base.
However, the risk for any company experiencing a recall is that the consumer switches not to other products of its own, but to a competitor’s - hence the need to balance the damage control costs. A case in point is Toyota where, by January this year, its competitors were promoting incentive schemes (General Motors) and elevating their ’quality’ marque (Ford). Interestingly, fellow Japanese manufacturers, at least presently, have shown restraint in such promotion.
After the recall
The final stage to be considered is the relaunch of the product in question. In some cases it is inevitable that the reputational damage caused by the recall has an adverse impact on sales long after it is reintroduced. Any loss evaluation will require an analysis of pre-recall trading levels. A company may record markedly lower sales in the years after a recall, but the two might not be linked - it may be that market conditions are to blame. For example, it could be argued that Toyota, like many of its competitors in the automotive industry, would have seen a decline in sales this year without the product recall.
From an insurance perspective, the policy terms will dictate the period of loss. In general it should end when the product returns to pre-recall levels, but this is not always the case. There may be other factors unrelated to the loss that could extend the time it takes to recover market share - for example, a company may decide to use the opportunity to redesign its product, the packaging or production process. This is perhaps especially so in the automotive industry, which is currently having to respond to green technology issues.
For the insured company, of course, losses may extend beyond the insurance cover period. The impact on brand and longer-term sales cannot always be assessed with certainty and should not be underestimated. In a recession, when companies are perhaps struggling in any event from the global economic downturn, the need to recall faulty products is no doubt one of the last things they would want to have to respond to - with or without the cover of an insurance policy.
James Stanbury is a partner at RGL Forensics