Do not be surprised to see a day in the not too distant future when patents become valuable insurance tools

Every noble acquisition is attended with its risks; he who fears to encounter the one must not expect to obtain the other. Metastasio

Chicago, Illinois, 18th March 2004: One of the most oft-quoted truisms of business is: "No surprises." Make your estimates, plan your strategy, take your profits. If only corporate life were this simple. But standing athwart our goals is that little matter of risk. The risk that the future will not happen as we plan it; that our competitive advantage will be swept aside by new innovations; that acts of God will occur, that what we hold valuable falls out of fashion; and so on and so forth. Which brings us to risk management, the art of quantifying the cost of bad things that might happen to good businesses. Which is why we have insurance. However, risk management is also about the good things that sometimes happen to businesses but don't necessarily end up on the balance sheet. And, if you manage IP, you quite likely are in the good risk management business. Matching the value of good risk against the cost of bad risk is one of the best ways to avoid surprises. In this column we will address two ways to hedge against surprises in corporate earnings: intellectual property and commercial insurance.

Astute investors intuitively grasp that earnings are nothing more than probabilities. Risk stalks corporate earnings through time and space. Cash booked, counted, and long since spent can be retroactively claimed by the plaintiff's bar for a failure to comply with non-existent product standards. Taxes paid in Europe can be re-billed in North America with no prospect of recoupment. Environmental liabilities, transferred by contract, can be reinstituted by insolvency or judicial fiat. The balance sheet, by itself, is defenseless against such predation. It is not enough for a publicly traded company to make money in the course of its business. The well-managed company must make cash appear when and where it is needed most.

In this situation, consider how a high-quality intellectual property portfolio complements an intelligently designed corporate insurance programme. By excluding or licensing erstwhile competitors, intellectual property enhances borrowing power because it protects future profits. This is helpful, especially in the face of liability crises that might otherwise threaten credit quality. Such enhanced borrowing power of IP can be locked in by insurance or securitization. Intellectual property can do this because it operates like a series of cash options that exist independently of corporate credit. Patents confer the right to exclude competitors from desirable products and markets. These rights may be asserted or leased (licensed) even if creditors padlock the office and factory doors. And patents, like options, may hedge risks to market position in the ordinary course of business by charging rents to competitors coming within the scope of strong patent claims. In other words, good patents make it less likely that competitors will erode market share and more likely that the company will be able to access cash in the event of a catastrophe. So it now comes as a pleasant surprise that intellectual property looks more and more like one of the most valuable tools in the risk management tool kit.

Insurance policies are another form of off balance sheet assets. By purchasing casualty or product liability coverage, commercial insurance enables the company to access cash in a crisis, without impairment to corporate credit or operations. Our insurance assets resemble our patent assets in at least one other way: complexity.

Insurance policies and patent claims are not light summer reading, and we may be surprised by the way in which lawyers, courts and counter-parties read these instruments. That's why the complete risk management programme of the 21st century must make deft use of both of these off-balance sheet assets. Insurance policies and patents are the mirror image of each other in another interesting respect. Underwriters prefer underwriting profit, meaning that over time the dollars sunk into premiums should exceed the dollars paid back in claims by at least a small amount. In the same way, technology companies expect profits from R&D, meaning that each dollar spent in patent development should yield a surplus in the form of future patent value. The insurance buyer trades yield for timing; the patent holder trades timing for yield. The insurer converts periodic premiums into lump sum claim payments, while the patent holder may amortize the cost of R&D by charging (or saving) periodic royalties.

Risk management also benefits from sound tax planning. Insurance, like R&D, is an expense of doing business and both are deductions prior to the tax on profits. The commercial policyholder delivers the insurer's underwriting profit a bit less grudgingly because the tax code likes premiums. An insured party that deducts 40% of the cost of premiums may account itself ahead if it receives 80% of premiums back, over time, in the form of untaxed claim payments. An insurer is perfectly happy with an 80% payout on claims if it obtains favorable timing for the retained 20% of premiums.

Companies that become sufficiently large and successful can become a source of self-insurance. This is particularly appropriate when corporations possess significant off balance sheet assets, such as patents. Companies in times of catastrophe can then monetize these off-balance sheet assets to cover unplanned costs. By monetize we mean the selling off of an asset while retaining its use through lease or license. Sales licenceback technique confers some of the same benefits to the patent holder monetizing patent values, whether in a crisis or otherwise. The patent-creator sells patents at a price that recognizes (in effect insuring) the economic benefit of patent-protected future profits. By taking a back-license to the patents and paying fully deductible royalties, the patent creator can offer a reasonable return to the patent investor at a lower net cost of capital. And insurance underwriters are now beginning to look at patents as just that sort of counter-party transaction.

Patents as insurance policies? This just might be a surprise we can live with.

Douglas Elliott is the Chief Technical Officer for Ocean Tomo SLB Partners LLC. Robert Block is the Managing Director of the Risk Management Division of Ocean Tomo. The views expressed herein are those of the authors and do not necessarily reflect those of Ocean Tomo, LLC or its affiliates.

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