Top Coverage and Underwriting Considerations for Franchisors

Remember way back in 1994 when Stella Liebeck spilled a cup of coffee in her lap, suffered third-degree burns and sued McDonald’s for damages?

A jury determined that the franchisor was liable for Liebeck’s injuries because it had dictated to its franchisees how hot the coffee should be when serving it to customers.

The infamous lawsuit is a prime example of vicarious liability, in which a franchisor is held responsible for the actions of one of its franchisees—just one of many legal hurdles a franchisor may face in the course of doing business.

“The typical run-of-the-mill claim we see is when a franchisee fails,” says Peter R. Taffae, managing director of FranchisePerils—an insurance solution dedicated exclusively to the franchise industry which combines D&O, EPLI, E&O, vicarious and fiduciary liability, joint employer and cyber coverages into one single package.

“Maybe they bought in for $50-odd grand, they’ve been paying royalties for a couple years, and then they fail,” Taffae continues. “Their attorneys sue the franchisor and allege fraud, misrepresentation, breach of contract and lack of services provided.”

Franchisee-based suits may also accuse a franchisor of unfair competition, territory encroachment and more. Meanwhile, employee-based suits may allege problems like wrongful termination, discriminatory hiring practices and sexual harassment on the part of both the franchisor and the franchisee—a type of claim that pinpoints a joint employer wrongful act. Overall, franchisors have a laundry list of unique exposures that insurance can help cover.

If a franchisor faces one of these claims, its insurance ideally covers defense costs and settlement. But finding the right coverage for these entities can be tricky. If you’re insuring a business involved in franchising, here are a few common coverage problems to watch out for—and some tips for solving them the right way.

Coverage Concerns

For starters, many policies in the franchise space contain exclusions for suits brought by franchisees—coverage Taffae calls “a total rip-off.”

It’s part of the reason insurers have flitted in and out of the franchise space so inconsistently. “Some of them try to exclude their way out of coverage,” says Jeffrey Wolf, partner at law firm Quarles & Brady. One of Wolf’s current franchisor clients, for example, is being sued by a group of franchisees for failing to make certain disclosures in its federally mandated disclosure document.

“The franchisees are saying they were fraudulently induced into entering the agreement in the first place, which if proven would entitle them to all their investment back—which is hundreds of thousands of dollars, and in some cases, millions of dollars,” Wolf explains. “But the franchisor liability policy isn’t set up to cover that. We’re having a hard time getting the insurer to even participate in a mediation because they’re saying, ‘Well, isn’t everything the franchisees are seeking in damages outside the scope of the policy?’”

Additionally, some coverage requires franchisors to maintain a separate policy for each franchisee. “You can imagine the disaster that could be,” says Sean Jordan, assistant research analyst at the International Risk Management Institute. “I couldn’t tell you the number of insureds that have a major location that they forget to include on a schedule of locations. That’s not only something where the insured is on the hook if they don’t have a location covered, but you could also have an E&O issue for the insurance agent if they should have known about the location and had it covered.”

To avoid these types of issues, you must put a variety of coverage components in place—and read every word of the policy to make sure your franchisor client doesn’t end up with exclusions and restrictions galore.

Securing Solutions

Franchisors require a number of insurance policies, starting with professional liability insurance to cover misrepresentation and failure to support claims by franchisees, explains James Schibuk, vice president at Arch Insurance Group in New York.

“Most franchisors should also consider purchasing directors & officers and employment practices liability insurance,” Schibuk adds. “There is often a gray area where professional liability claims could have elements of a D&O claim, most notably in fraud or misrepresentation claims.”

“We will not sell a policy without D&O and franchisors malpractice,” agrees Taffae, who also encourages agents to place all policies with the same carrier. If you don’t, you could run into serious finger pointing in the event of a claim.

“The claim’s going to come in, it’s going to go right down the middle of these two policies, and then you have to coordinate two separate companies and two claims adjusters,” Taffae says. “Some of the allegations go over there, some of the allegations go over there. And each insurance company is going to pick their own lawyer to defend the case, which drives up the cost.”

On the employment liability side, Jordan also recommends purchasing wage and hour coverage, if possible. But “it’s probably going to be sublimited,” he warns. “You don’t want to just settle for seeing these insuring agreements and say, ‘OK, I’m covered.’ A lot of them come with very, very restrictive sublimits.”

Make sure you track down and offer the highest sublimits possible, because many insuring agreements in this space only apply to specific allegations. “Maybe you’ve got an aggregate of a couple million, which may look great to an insured,” Jordan says. “But then it’s subdivided and sublimited to apply separately to so many different types of lawsuits, that by the time you figure out what’s alleged against you and you flip through the policy, you realize, ‘Oh, there’s only $100,000 in coverage—that’ll go in no time.’”

Franchisors should also consider coverage for the franchise disclosure document, as well as cyber liability. “There have been lots of cyber claims, which is very logical because you have the point-of-sale systems at every store and you have high turnover with your employees,” says Taffae, who notes that eFranchisorSuite from FranchisePerils includes coverage for both first- and third-party cyber claims, liability and notification requirements, as well as prevention services.

“Cybersecurity is something I think more and more insurance companies are writing, whether it’s under the umbrella of a franchisor-specific type of policy or just under a general commercial policy,” Wolf adds. “There have been a lot of franchise companies that have had some large exposure in the data breach space, and there have also been consumer-based claims—lots of franchisors have been hit with large-scale claims involving robo-calls and unwanted marketing calls to customers.”

How to Sell It

Want to make sure you’re getting your franchisor clients the best bang for their buck? The most important step is understanding what underwriters are looking for.

“One of the unique components of rating franchising is that in addition to looking at revenues, underwriters also consider the number of franchisees, since this is the potential claimant pool and the success of franchisees in the system,” Schibuk explains. “In general, happy, successful franchisees don’t bring lawsuits. We look at the growth of franchisees, the turnover rate and any financial metrics provided in the franchise disclosure document.”

FranchisePerils emphasizes training and likes to see franchisors maintaining corporate stores. “We’ll write some franchisors that don’t have any owned locations, but we feel that if they have a location, then they can relate to the problems and challenges that the franchisees have,” Taffae explains.

Jordan suggests diving into the internal controls a franchisor has in place—if they’re too stringent, they could set up your client for a vicarious liability or joint employer wrongful act claim somewhere down the line (more on this next week—keep an eye on IAmagazine.com and upcoming editions of the Markets Pulse e-newsletter).

“A great way to build value is to coach your clients up on recent cases that have shown the focus being placed on employee rights recently,” Jordan says. “These companies are trying to do a good thing by having structured policies in place, but you don’t want them to be too limiting from an employee’s perspective. That’s a big thing an underwriter will be focused on that you can catch on the front end as the agent, before something bad happens.”

Building value on the front end “shouldn’t be anything revolutionary for an agent,” Jordan says—but do everything possible to make sure your franchisor clients don’t have overly restrictive company controls, and ask about procedures like the termination and interview process to make sure managers don’t ask discriminatory questions, for example.

Despite its myriad challenges, the franchise space is a perfect fit for independent agents—as long as you know how to approach it. “I’ve met some amazing, amazing independent agents that I think have the highest integrity and really care about doing the right thing,” Taffae says. “Those are the people we love to work with.”

Jacquelyn Connelly is IA senior editor.