Franchise risk management

A new trend is developing as some of the world’s largest franchisors take a fresh look at including (or expanding) the use of a captive insurance facility in their overall risk strategy.
For some, this includes establishing a ‘franchisee insurance programme’ and using a captive to reinsure it. In doing so, it is possible to eliminate the expenses traditionally associated with tracking each franchisee’s compliance with the insurance requirements established in the applicable franchise agreement.

With the same amount of effort and resources used to track insurance certificates, franchisors can establish their own insurance programmes, and thereby replace a cost centre with a profit centre. At the same time, franchisees (particularly smaller franchisees) often find these programmes provide a more efficient way to secure required (and/or enhanced) coverages that would otherwise be cost-prohibitive or unavailable to the smaller buyer.

Cyber and pollution are good examples of coverages that may not be available to the ‘mom-and pop’ franchisee. In our experience, given the opportunity, an overwhelming majority of franchisees will elect to participate in a franchisor-sponsored risk programme.

Franchisee insurance is the first line of defence when a problem arises in the franchise operation. For this reason, franchisors require specific types and amounts of insurance as a foundational element of their risk mitigation plans. The objective of the franchisor is to ensure franchisees maintain insurance that adequately protects both the franchisee and the franchisor from claims that can significantly impact their respective businesses.

Franchisee insurance requirements should be established with the help of a licensed insurance professional and specifically documented in the applicable franchise agreement.

Examples of the types of insurance typically required by franchisors include:
• Property;
• Business interruption/loss of income;
• Comprehensive general liability;
• Automobile liability;
• Workers’ compensation; and
• Umbrella liability.

Of course, franchisors may require other available insurance coverages (eg, cyber, pollution or transportation coverage) to properly protect themselves and their franchisees’ investments.

Often (but not always) it is the intent of the franchisor to hold the franchisee responsible for indemnifying and defending the franchisor against claims that originate out of the franchisee’s operations. In this case, the franchisor should include provisions in the franchise documents that properly align franchisee insurance coverage with the desired indemnification and defence requirement.

For example, provisions should require that (i) the franchisor is named as an ‘additional named insured’ on liability policies; and
(ii) the franchisee’s insurance be ‘primary’ and ‘non-contributory’ with the franchisor’s own insurance coverage.
Even if a waiver of subrogation is not included in the franchisees’ policies, as an additional named insured, the franchisor will be protected from claims of subrogation by the insurer.

Another way

Under traditionally required insurance programmes described above, the franchisor should maintain an insurance certificate tracking system to verify that franchisees comply with established requirements.

Depending on the size of the franchise operation, this can be costly. As an alternative, franchisors should consider establishing a franchisee insurance programme, including the use of a captive, to insure the risks of franchisees.

The concept is less complicated than one might expect. Essentially, the franchisor is offering the franchisee an optional ‘check the box’ option for satisfying insurance requirements. The franchisor establishes a licensed insurance producer entity, thereby allowing the franchisor to earn a ‘front-end’ profit (ie, commission) on the sale of insurance within its franchise system.

This licensed entity partners with an experienced broker to offer individual policies (naming the franchisee as the insured) to each franchisee. Once the programme is in place, the need for compliance tracking is essentially eliminated.

In summary, the steps to establishing a franchisee insurance programme including the use of a captive are as follows:
• Approach insurance brokers to discuss potential programme structure, coverages, and insurance carriers;
• Revise franchise agreement to: (i) allow franchisees the option of participating in a ‘franchisee protection plan’ to satisfy insurance requirements (and perhaps offer other ‘risk management services’); and (ii) include appropriate disclosures regarding the optional insurance plan;
• Identify fronting insurer(s) to issue required coverages to franchisees;
• Establish a licensed insurance producer entity within the franchisor’s corporate structure to earn commissions from the sale of required insurance to participating franchisees; and
• Execute reinsurance agreement(s) between the franchisor’s captive and fronting insurer(s).
The potential benefits of establishing such a programme include:
• Ensuring uniform coverage with appropriate insurance carriers throughout the franchise system;
• Eliminating costs associated with tracking certificates of insurance;
• Making available other ‘optional’ coverages that may be difficult for franchisees (particularly smaller franchisees) to obtain;
• Profiting from the sale of insurance in the form of commission earned by the insurance producer entity; and
• The franchisor may be allowed to earn both front-end and/or back-end profit (earning underwriting profit on insurance issued to the franchisor and its franchisees by the [optional] use of a captive to reinsure fronting carrier(s) on the insurance programme).

A number of key legal issues relate to the potential implementation of a franchisee insurance programme. For example, it is vital that revisions to the applicable franchise agreement are made in such a way as to disclose that: (i) participation in the programme is entirely optional even though obtaining the required coverage is not; and
(ii) the franchisor may profit from the programme.

There must also be a separate/discernible charge for the insurance. There may be a need to include a licensed producer entity within the franchise system. Furthermore, any reinsurance agreements executed between the fronting insurer(s) and the captive should be drafted to include a cut-through provision to ensure that the franchisees will continue to receive claims payments in the event of the insolvency of the fronting insurer(s).

The captive may also be used to insure/reinsure other insurance, such as warranty and service contract offerings made to retail customers of the franchisees. In such case, additional agreements may be needed to insure these risks in the captive.

Although some time and expense is required to add a captive insurer to the traditional franchisee insurance programme, in the right circumstances this investment makes sense. A well planned and executed franchisee insurance programme with a captive can reduce operational expenses, ensure uniform compliant coverage among franchisees and potentially create an additional profit centre.

Corinne Carr is a partner at Dentons in Chicago. She can be contacted at: corinne.carr@dentons.com

Dan Brown is a partner at Dentons in San Francisco. He can be contacted at: dan.brown@dentons.com

Dan Marino is a managing associate at Dentons in Chicago. He can be contacted at: daniel.marino@dentons.com