A Shift in Policy

An insurance crisis may be the exonomy's unkindest cut into foodservice profits

By Scott Hume, Managing Editor -- Restaurants & Institutions, 6/15/2003

A new insurance agency has opened for business in Applebee’s neighborhood and not a day too soon.

More-cautious consumer spending patterns may be the depressed economy’s most obvious impact on the foodservice industry, but the lingering after-effects of September 11, 2001, the succession of corporate ethics scandals, soaring medical costs and other factors have combined with the slow-growth economy to produce a growing but less-obvious problem: increasingly expensive or even impossible-to-get workers’ compensation and general-liability insurance coverage for operators.

The problem is both severe and widespread enough to have led Applebee’s International Inc.—the Overland Park, Kan.-based operator or franchiser of more than 1,500 Applebee’s Neighborhood Grill & Bar casual-dining restaurants—to form Neighborhood Insurance. The “captive” insurer—so-called because it is owned by Applebee’s and provides services exclusively for itself and its franchisees—was licensed on Nov. 1, 2002. Already nearly two-thirds of its franchised units (plus all 370 company-owned stores) are covered under policies written by Neighborhood Insurance.

“We had been looking at possible benefits of setting up a captive for a few years. When we looked at the insurance renewal market after 9/11, that put us over the edge because we were looking at [rates] that were up 30% to 60%,” says Steve Lumpkin, Applebee’s chief financial officer.

The insurance industry was hit so hard by 9/11 losses that many companies stopped issuing policies for small businesses such as independent restaurants or franchisees. “Others said, ‘Hey, if you can absorb the first $250,000 [loss on a liability claim], we’ll be happy to insure you,” Lumpkin says. “But that’s a pretty big nut for our franchisees to swallow. We stepped in to provide dollar-one insurance [without a deductible] that the market wasn’t able to provide.”

GETTING OUT OF THE POOL
A second reason for creating its own insurance agency, says Lumpkin, was to keep its operators out of the same liability pool with other restaurants or with industries that may not be working as actively as Applebee’s is to improve in-store safety and reduce workers’ comp injuries. “Instead of getting averaged with everyone else, we take advantage of best practices and control our costs.”

The restaurant business is so competitive that continually raising prices to cover rising insurance rates—which he says could jump another 20% to 40% this year—isn’t a viable solution. “You need very healthy same-store sales gains to cover such increases,” he says. “If you don’t, it just eats into your bottom line.”

Accounting scandals at Enron, HealthSouth and others have sent directors-and-officers policy premiums skyrocketing too, but because most franchisees are private, Neighborhood Insurance isn’t providing coverage. But Lumpkin says Applebee’s will consider writing property-insurance policies.

“We want to make sure this vehicle is working as we expect, that we’ve built up [Neighborhood’s] cash reserves” he says. “If it is, we’ll look at what other types of insurance we want to put in.”

CALIFORNIA NIGHTMARE
Orlando, Fla.-based Darden Restaurants reported strong same-store sales increases for its Red Lobster and Olive Garden chains during January, but explained to shareholders and Wall Street that “unanticipated costs related to insurance and workers’ compensation expense have more than offset the earnings benefit we would normally expect to realize from the increased sales.”

According to Mark Kalinowski, restaurant analyst for Smith Barney Citigroup in New York City, insurance averages 2% to 4% of total costs for restaurant chains he follows. That’s enough that a 20% increase in insurance costs can translate into more than a half percent decline in pre-tax profits.

California has become the case study of what happens when business insurance gets totally out of control. State budget deficits coupled with government mismanagement have created a situation described as “unbelievable chaos” by Paula Moore, director of insurance services for the Sacramento-based California Restaurant Association (CRA). A system that a decade ago provided relatively cheap workers’ comp insurance for small businesses has collapsed, forcing state regulators to shut down dozens of insurance providers. The number of private, California-based carriers writing policies has dwindled from 20 to two since 1995, compelling many franchisees and independents to seek insurance coverage from the overloaded State Compensation Insurance Fund, through which CRA offers its members a group insurance program, now covering 30,000 foodservice locations. The state fund was intended to function as the state’s insurer of last resort but it now is an expensive only option for many operators.

A recent “reform” that required applicants to prove they had been turned down by three commercial insurance carriers before applying for state fund coverage was rescinded. However, restaurateurs still must grapple with a requirement to prove “due diligence” in finding other insurance, Moore says.

California had the country’s highest workers’ comp rates before base rates went up 18% in June 2002. Rates rose again in January, and increases of 10% in July and another 9% in January 2004 are expected to be approved by the state department of insurance.

“Every day we hear restaurateurs asking, ‘How am I going to afford this?’” says Moore. “Many are going without [workers’ comp or liability] insurance.” That lack of coverage puts them one serious accident away from bankruptcy.

Doug Kollus, president of the 37-unit Islands Fine Burgers & Drinks chain based in Solana Beach, Calif., calls the state’s insurance problem “a nightmare.” Like many companies, Islands is self-insured, stockpiling capital to pay insurance claims. Five years ago, the chain put $350,000 into its insurance fund; this year it will set aside $1.7 million.

“They’re all afraid of California,” CRA’s Moore says of national chains. The problem is not just securing insurance for a restaurant but also high construction costs. One reason for that: While restaurants pay $6 to $7 per $100 of payroll for workers’ comp, Moore says construction businesses pay as much as $90.