By Robert Menninger
Research and development in the medical, biological and pharmaceutical fields has been and continues to be a critical component of a company's ability to do business, to remain in business and to grow one's business. It is also a critical component in the quality of life of the human race.
In this industry, it has historically been known as "R&D" but now goes by a number of names such as biotechnology (bio-techs), biological engineering, life sciences, medical technology and others. The terms indicate that this industry has emerged as a major factor in the drug and medical hardware business and that it is more than a simple laboratory. A closer look will show an infrastructure that is more intricate than most of us ever imagined. Yet, it is not an industry full of mystery. From a risk management and insurance perspective, the exposures and coverage needs are very discernible and treatable.
Organizationally, bio-techs exist in the following venues:
* Divisions of global companies fully funded by the parent.
* Small and medium-sized manufacturers, who transition their research to their own manufacturing facilities or who license the approved technology to others.
* Firms who begin as R&D and then move to full-scale manufacturing as their products are approved for sale to the public.
* Firms, who are R&D only, also known as contract research organizations (CROs).
* Service companies that organize and manage clinical investigations at one study or several study sites. These are also known as site management organizations (SMOs).
Financially, bio-techs are heavily expensed because of scientific and other professional staff, testing costs, laboratory materials, and overhead. The output is not a performing asset until it has been approved. Some firms do generate royalties from earlier efforts, which will offset, in whole or in part, the costs of current research. Other firms augment revenues through funding from IPOs, private offerings, grants in aid or contracts with a manufacturer, who has exclusive rights to the output. Developmental costs can easily run into the millions of dollars. Funds assembled from the various sources are earmarked for these expenses but will generate investment income in the interim.
From an investment perspective these are highly speculative ventures because many research efforts fail to reach FDA approval. For those that do reach approval, the rewards can produce returns high enough to more than justify the initial investment. Considerable sums of money are invested in these ventures with a success rate of one out of every five or six projects. The Biotechnology Industry Organization reports that R&D expense in 1999 was $9.9 billion, up from $4.9 billion in 1993.
The Liposome Company, now a division of Elan, reported in its 10K that competition in this industry is intense, as several companies could be working on similar products at the same time or working on alternative products that treat the same medical condition. For these reasons great emphasis is placed on performance, safety, patient compliance, ease of use, price, physician acceptance, marketing, distribution and adaptability to various modes of administration. Other factors that contribute to the competitive intensity are the availability of patent protection, ability to commercialize their technology, ability to obtain government approval for testing, manufacturing and distribution of the approved output. Time is also a consideration, and development can sometimes turn into a race for first approval.
The development process
R&D in the drug and medical products field is regulated by the federal government. The prescribed procedure is (1) pre-clinical trials, (2) application to the FDA for an investigational new drug (IND), (3) human testing, known as Phases I, II, III and IV, and (4) FDA approval for manufacture and sale. Depending on the substance involved, this process can take anywhere from a few years to 15 years to complete. This is because there are no universal formulae for curative or therapeutic substances. Numerous human system variations must be factored into the final product. They may look good on paper and in the laboratory, but most break down when introduced into human beings.
According to CenterWatch, a clinical trials listing service, about 70% of the drugs in Phase I graduate to Phase II, about 33% of the drugs in Phase II graduate to Phase III and about 70% to 90% of the drugs in Phase III receive FDA approval. Therefore, for every 100 INDs initiated only 16 to 21 will become marketable products. Phases I, II, III and IV are as follows:
Phase I: toxicity testing on a small sampling of human subjects
Phase II: continued toxicity testing on a larger sampling plus initial research into efficacy of the product
Phase III: efficacy testing on a very large sampling (as many as several thousand human subjects)
Phase IV: integration of the new drug into standard treatment for patients.
Most drugs receive approval after Phase III, and this could either be unconditional or qualified, meaning either further testing or limited to specific applications or specific illnesses.
The entire process emphasizes safety; and procedures are designed to protect the human subject, while assuring that the ultimate product is, indeed, effective and safe. However, it is not a foolproof process, as was evidenced by the withdrawal of some high profile drugs in recent years. For that reason, additional steps are required, such as protocols that spell out the method of testing and objectives, informed consents that must be signed by each test subject, and institutional review boards (IRBs) that review the trials as they progress and assure the rights and welfare of the test subjects.
Risk management considerations
The exposures are a blend of physical properties and professional activities. Some present serious hazards and others are remote. To determine the degree of risk, Commercial Insurance Research developed the CIR Hazard Level Benchmark for each area of activity. It is intended to measure the risk that is typically found in a given class of business, and it is a benchmark only. From it, other measures can be applied to recognize individual conditions and specific loss reduction measures, which both increase or decrease the benchmark. Ultimately, the underwriter will know how a specific R&D operation measures up to the industry standard. The CIR Hazard Level Benchmarks (1 low and 10 high) for biotechnology companies are as follows:
Property 5.45
Business Interruption 6.50
Workers Compensation 6.42
General Liability 3.86
Automobile 1.25
Directors & Officers 8.00
Valuable Papers 8.00
Crime 4.00
Environmental Liability 4.50
Inland Marine 3.00
These are average benchmarks. Each line is evaluated by risk component. The range of hazard scores can run from very low to very high.
Products liability is not a consideration in research and development operations. For those firms that do manufacture, their hazard levels will be comparable to those of a pharmaceutical or medical hardware company.
From a property perspective this is a laboratory operation with solvents, pathogenic substances, radioactive isotopes, highly damageable and combustible contents and a floor plan layout prone to clutter. Normally, physical values are not substantial because the real value is in the intellectual property.
From a business interruption perspective it is either an income or an extra expense and exposure, depending on the venue of the bio-tech. For CROs and SMOs, benchmark payment agreements, grants or endowments may be suspended or canceled and this is a loss of income. For the manufacturer or developer receiving public or private funding there are two scenarios. Where funding is comparable to that of a CRO or SMO, it is a loss of income. Where funding is provided through public and private offerings and the bio-tech has custody of all funds, there is no actual loss of income sustained, and it becomes an extra expense and key employee exposure. In this instance the real concern is future income if a loss occurs during this period. The dilemma is fixing a value on a project's future income, when its chances of FDA approval are uncertain given the success rate that currently exists in this industry.
From a workers compensation perspective, it is an operation with a high caliber of employee functioning in an environment that is not labor intensive but has the presence of chemicals, animals, isotopes and pathogenic substances. The controlling factors are the employee and the environment. If they break down, the hazard level increases significantly. From a premises/operations perspective, laboratories are normally restricted access, which keeps the exposure low. From an automobile perspective, vehicle use is normally incidental to the operation and consists of private passenger and perhaps a van for errands and other support service.
Directors & officers liability is considered a high hazard due to the nature of the industry. As was noted earlier, the low success rate combined with the substantial sums invested in research creates an atmosphere of high or unrealistic expectations and high speculation. These conditions do not lend themselves to patience or tolerance and lawsuits are, in many instances, the only recourse for an unsatisfied investor. The exposure is not limited to public companies. Privately funded ventures, CROs and SMOs are also at risk. If the failure of an IND to advance through the phases is tied in any way to a management decision or testing procedure or any other corporate act, then a potential for a D&O claim exists. In addition, the highly competitive atmosphere can generate lawsuits from other companies citing unfair competition.
The bio-tech industry is unique; its principal asset is intellectual property. Information is stored in a hard copy and/or electronic medium. The very nature of the medium's contents makes it a concentration of risk and, therefore, a high-hazard level. The controlling factors are storage, duplication and reconstruction procedures, should the information be lost or destroyed. Crime exposures overall are low; however, there is concern over industrial espionage. As was noted earlier, competition is intense and given the amount of dollars invested in this industry, the opportunity for theft of proprietary research does exist. From a pollution perspective, waste generation is a normal activity. The type of waste is a concern because it will include biological, radioactive or viral materials. Bio-tech labs must have EPA licenses, meaning they are subject to regulation and must follow prescribed handling, storage and removal procedures.
Other areas of risk that have not been measured are patent infringement, design errors and omissions and clinical trials errors and omissions. As was noted earlier, it is not unusual for more than one company to be developing similar products at the same time or to be developing different products to treat the same condition. Much of the research will likely involve similar techniques and the end products may have many similarities. Whether intended or unintended, competing companies may sue each other if they determine that their positions have been compromised in any way.
Design errors and omissions would apply to researchers, as products liability applies to manufacturers. In the event the IND causes injury to a test subject that is the result of faulty design or preparation, there would be grounds for liability. Clinical trials liability would apply to a CRO or SMO if there is injury through improper conduct of the tests or through supervision or support of clinical investigators or medical institutions conducting trials.
Insurance considerations
The risks of loss are treatable and insurable. Two national carriers have programs for life science and biotechnology firms. The areas covered are:
* Property to cover buildings, contents and inventory, including animals, cultures, documentation, contamination, pollutant cleanup and removal. One carrier states that it has limits up to $600 million per structure.
* Business interruption to cover loss of income. One carrier states that it provides key employee replacement expense. The other carrier singles out endowments, grants and benchmark payments as insurable items.
* General liability and liability for human clinical trials. One carrier states that it has limits up to $25 million.
* Crime to cover dishonesty, burglary, robbery and theft.
* Employment practices liability
* Equipment breakdown
* Commercial automobile
* Products liability for manufactured goods. One carrier offers products withdrawal expenses.
* Workers compensation
Neither carrier states whether it offers special treatment for the valuable papers exposure or if it is included in their basic contract form.
For directors and officers liability, many carriers will consider a submission but may not have the intimate knowledge of the business to offer competitive terms or pricing. There is one wholesaler who does state that it is a market for biotechnology companies. There are also five MGA/wholesalers who state they are markets for health care but do not state if that includes bio-techs.
A number of carriers offer patent infringement coverage. However, one specifically states that it is a market for biotechs. No one carrier states that it is a market for design errors and omissions for the bio-tech industry.
Bio-techs as clients
As a class of business, I can speak from experience. This is a fascinating industry to service. The risk management aspects are challenging, the caliber of client is refreshing and the premiums are significant. IMR (Insurance Market Research), in a 1998 study, projected that the average premiums per risk were $84,000, excluding some of the esoteric lines that were not purchased but should have been. Financial resources sometimes impeded their ability to purchase all coverages, but eventually they recognized the importance of protecting the substantial investment.
As a market for targeting, Biotechnology Industry Organization reports that there are close to 1,300 companies, employing 153,000 people as of 1999. Two-thirds of the companies had fewer than 135 employees each. It is not a labor intensive industry. Instead it is capital intensive, which is what drives the premium levels.
The foregoing is part of a broader in-depth study of the biotechnology industry. To obtain a copy of this study, contact Commercial Insurance Research, LLC; P.O. Box 172; Fanwood, NJ 07023; e-mail bobmenn@bellatlantic.net or call (908) 490-1327. *