July 2008

The views expressed in this article are not intended to represent the views of Matson, Driscoll & Damico or any of Matson, Driscoll & Damico’s clients.

The recent - and continuing - turmoil in the global credit markets is, in some large part, related to “mark to market” requirements imposed upon financial institutions.  When a bank marks down the value of certain securities, others who hold like paper are forced to take similar write-downs, notwithstanding the fact that the assets could ultimately be worth a great deal more to that particular bank in the future.  Their instant pricing at current mass liquidation value causes dramatic reductions in their capital base.

While sub-prime mortgages, collateralized debt obligations and the ratings of their tranches are a world away from the nitty-gritty of property loss adjustment, there is, in this writer’s mind, some small similarity that sets the stage for this discussion.

Not long ago, we were called to the scene of a devastating flood loss at the service center of a major metals company.  Some ten thousand tons of coiled and sheeted steel and aluminum were stored within the plant, awaiting processing to customer specifications (sheeting, slitting or blanking), and roughly one-third of the stock had been either completely or partially submerged in silt-laden water.  High air temperatures at the time of and subsequent to the flooding had created a saturated environment, and day-night temperature cycles produced heavy condensation on the “above the water-line” materials, with attendant osmosis promoting the movement of water into the laps of the coils and between the sheets of processed material.

At the outset, there was consideration given to our liquidating all product in the facility into the salvage market.  The dollar figure of the sales would have been impressive, and our long experience informed us that the recovery, as a percentage of current market value, would have been greater than 50%.  Importantly, we were also cognizant of the fact that, had there been no flooding at all, the liquidation value of the stock in pristine condition would be no more than 70-75%.  This implies that the impairment to value resultant from the flooding is only 20-25% Why is that so?

The insured purchases material for processing to customer specifications, and buys little or none on a speculative basis.  In other words, almost their entire inventory has a future home - a specific customer who requires specific product for their manufacturing applications.  The liquidation of this stock, even if undamaged, into the general marketplace, with the attendant costs of loading, shipping and integrating into another center’s inventory for processing and sale would force a significant discounting.

With this in mind, it made sense to slow things down a bit and consider alternatives to the total liquidation of all material.  Certain customers had sourcing problems, and their end-use allowed less than pristine surfaces (e.g. heavy plate), such that the product could be, literally, hosed off prior to shipment.  Another customer used aluminum sheets whose imperfect finish was acceptable for their applications, and a cooperative competing service center was willing to do the work on the insured’s coils and fill the customer’s requirements with material that was above the water line.  Likewise, much of the structural steel was able to go to its intended customers after washing down.

Ultimately, we did liquidate, in a measured and orderly fashion, about half of the product, recovering some 50% of its original value, while the added expense and discounting of the other half cost only around 10% of its value.  In sum, the loss to the stock, in its entirety, came to only 30%, not much different from what would have resulted from the liquidation of a mirror-image undamaged stock.

The instant case brings us to the broader point of this article:  From time to time, an adjuster will find him or herself dealing with an insured who has a stock - whether finished goods for sale, raw materials, in-process or bulk commodity - that has been damaged to some degree.

A particularly well-informed (or well advised!) insured may make a “reasonable” proposal:  That being to offer the stock, in its entirety, for sale into the general salvage market, whether by sealed-bid, open outcry or web-based auction.  Further, they may wish to participate in that process as a bidder or - even better for them - enjoy the right of first refusal on the high bid.  Their loss will then be computed as the difference between the original value of the stock, and that price for which it is “sold” (back to them).

This is somewhat analogous to a building loss which calls for $10,000 worth of roofing and siding repair to a $200,000 structure.  Would it be an attractive proposition to auction the property (with the insured “buying” it back at a dollar over the high bid), and the insurance company paying the difference between its insured value and the liquidation price?

The proper adjustment of a stock loss must include consideration of the many alternatives to liquidation of the property into the salvage markets, including but not limited to: separation of stock not actually degraded by the event; restoration; re-work or re-processing and/or discounting for sale into existing markets. 

Howard Stoner is the president of Stoner & Company, Inc., a nationwide commercial salvage and appraisal company.  Its headquarters is in Sudbury, Massachusetts.