Insuring cannabis businesses: Risk and opportunity in an emerging market

The recent trend toward cannabis legalization in many U.S. states has propelled the U.S. legal cannabis industry to $27 billion in retail sales in 2021 and growing rapidly. Market estimates expect U.S. cannabis sales to hit $53 billion by 2026.¹ As of August 2022, 38 states had legal cannabis programs; cannabis has been legalized in 19 states for recreational use and in 38 states for medical use (some states have overlapping medical and recreational programs).² The cannabis ecosystem encompasses a diverse range of businesses including cultivators, processors, product manufacturers, wholesalers, testing laboratories, and medical and recreational dispensaries. Businesses range in size from small craft growers and retailers to large vertically integrated “multi-state operators (MSOs)”—companies that own and control the full “seed-to-sale” process, including the cultivation, extraction, manufacturing, and retail, at a national scale, some with annual revenues exceeding $1 billion. Different states have vastly different rules surrounding the stages of the value chain in which license holders can participate, with some states, such as Florida, requiring vertical integration, and other states, such as California, offering license holders the opportunity to participate in only one part of the value chain.

Cannabis remains illegal at the federal level, though, and this creates complications for the industry, particularly in the realm of financial services such as banking, due to uncertainty surrounding the applicability and enforcement of money laundering statutes and other federal laws. Much of this uncertainty stems from a series of communications from the U.S. Department of Justice (DOJ) and the U.S. Department of the Treasury over the last decade, partly in response to rapid growth of state-legal businesses that rely, ultimately, on federal decision makers to opine on commerce. The Cole Memorandum, issued by the DOJ in 2013, outlined a clear set of criteria that state-legal cannabis businesses must follow to avoid potential scrutiny by federal executive branch agencies. It included high-level guidelines reminding operators that interstate commerce was prohibited, and other guidelines resembling safety measures such as restrictions on marketing to minors. A counterpart set of guidance was needed from Treasury to guide depository institutions on the legality of accepting deposits derived from cannabis revenue receipts. In 2014, the Financial Crimes Enforcement Network (FinCEN) issued a memorandum explaining certain compliance steps depository institutions would need to take to service plant-touching cannabis clients.³

Most U.S. cannabis operators relied on the coexistence of these two memorandums, combined with annual federal appropriations bills that prohibited DOJ funds from being used to prosecute state-legal cannabis businesses, to operate in good faith in the absence of clearer, more sweeping federal reform. This reliance was somewhat clouded in 2018 when the Cole Memorandum was rescinded by the DOJ. This left many operators confused, because the FinCEN guidance, still in effect, references the Cole Memorandum—but the Cole Memorandum itself was no longer in effect. However, Senate testimony from Treasury officials between 2018 and 2020 stated that the FinCEN memo was still alive and well, easing concerns of many operators and their financial institutions.

"Insurers entering the cannabis space should be aware of its unique risks and ensure they are reflected in their pricing and underwriting."

Still, the unsteady signals sent by federal agencies, uncertainty about what future administrations may bring, and extensive reporting required by the FinCEN guidance leaves most banks unwilling to work with cannabis businesses. Support on Capitol Hill is currently building behind the need for financial institutions to properly serve the cannabis industry. However, two major bills introduced to address this—the Cannabis Administration and Opportunity Act (CAOA), which calls for, in essence, legalization of cannabis at the federal level, and the Secure and Fair Enforcement (SAFE) Banking Act, which aims to resolve the more immediate need for protection of the banking industry—compete for political support, and thus it may well be some time before either measure passes Congress. In the meantime, many cannabis businesses are left with no option but to conduct all business in cash—leading to high theft risk.⁴

Theft is one of many unique risks faced by this nascent industry, on top of the same liability and other risks faced by similar “traditional” businesses. Thus, cannabis businesses have a clear need for insurance, but insurers are deterred from covering them amid similar uncertainty regarding federal laws. However, a few insurers have stepped in the game—and bipartisan support is building in Congress for the passage of the Clarifying Law Around Insurance of Marijuana (CLAIM) Act, a bill that would allow insurers to cover cannabis with no threat of federal prosecution, which would bring more capacity into the cannabis insurance market.⁵

Insurers entering the cannabis space should be aware of its unique risks and ensure they are reflected in their pricing and underwriting. This article looks at some of the risks faced when covering cannabis under several major lines of business.

Product liability

Cannabis products can potentially be dangerous or defective if production standards are not carefully upheld at every stage of the seed-to-sale process. In cultivation, cannabis plants can be contaminated if unsafe nutrient mixes or pest-control products are used. Manufacturers need to ensure the safety and potency of all ingredients—both “active” (THC-containing) substances as well as non-cannabis food ingredients that may be used in edible products—and must also ensure the proper functioning of devices such as vape pens, which carry heavy metal leeching risks due to their heating and burning functions combined with an inhalation method of administration. Retailers need to vet their products to ensure they have been rigorously tested and come from well-reputed manufacturers. Failure in these areas can expose cannabis businesses to product liability lawsuits.

While much of the cannabis product liability suits to date have focused on contaminants and pesticides, there remains potential for cannabis operators to be held liable even for products with no known defects. Firstly, cannabis businesses may be found responsible in cases where intoxicated customers cause harm to themselves or others while under the influence of cannabis products—much like the liability risk faced by businesses that serve alcohol. This liability potential remains uncertain, though, as there have been few such cases to date and case law has yet to evolve. One important lawsuit that made national headlines—a wrongful death case against a medical marijuana bakery that sold cannabis-infused edibles to a man who later murdered his wife after having consumed them—remains pending.⁶ In addition, cannabis producers may be held liable where an inexperienced user ingests too much of their product and experiences severe adverse health effects or even death, as alleged in one pending lawsuit against a cannabis edibles manufacturer brought by the family of a woman who died after consuming their product.⁷

Aside from these risks, however, a broader liability potential lurks due to emerging research linking cannabis use to various adverse health effects, such as increased risk of stroke or cardiovascular complications. This may give rise to expert-driven legal action by plaintiff attorneys representing sufferers of these health issues against manufacturers of any cannabis-containing products they may have used.⁸ These risks may be mitigated through consumer education, careful labeling, and other risk management measures.

Management liability/D&O

Executives of cannabis companies face an array of risks as they start up and grow their businesses, leaving them with a need for directors and officers (D&O) insurance—a line of business that few insurers are currently willing to provide to the cannabis market.

As with any rapidly emerging market, much of the cannabis industry is in the position of needing to raise capital in the private equity and venture capital markets. This can leave executives exposed to lawsuits that arise when disagreements among management and investors or shareholders turn into legal action, which can be costly to management—even if they win. In one case, a cannabis startup’s failure to complete an initial public offering (IPO) after having raised $30 million in financing led to a derivative lawsuit filed against the company and several of its executives.⁹

Furthermore, cannabis businesses at all stages of their development find themselves in new and rapidly evolving regulatory environments. As states legalize cannabis for medical and recreational use they must formulate the necessary regulation, licensing, and enforcement procedures that govern its manufacture and sale. This will be a lot for businesses to keep up with and can expose them to regulatory investigation and action if their compliance falls short.

"For insurers willing to accept the legal risks that come with the federal illegality, the cannabis industry presents an opportunity to get into a market with little insurer penetration to date and high growth potential."

Customer and employee complaints can also lead to D&O claims—for example, if a company’s products fall short of their target potency or fail to yield the desired psychoactive effects. In addition, many cannabis companies have made pledges regarding environmental, social, and corporate governance (ESG) concerns, exposing them to litigation if their ESG outcomes fall short of expectation or cause them to fail to deliver on key promises in other areas.

Moreover, the federal illegality of cannabis results in cannabis businesses not being eligible for federal bankruptcy protection, leaving them with limited restructuring options in the event of financial distress, amplifying the downside risks for managers and investors.¹⁰

Employment Practices Liability (EPL)

The legal cannabis industry in the U.S. currently employs around 430,000 people, in both “plant-touching” jobs such as cultivation and retail sales as well as ancillary jobs such as accounting, construction, regulatory compliance, and human resources, with 107,000 new jobs having been added over the past year.¹¹ With that expanding workforce comes the growing need for Employment Practices Liability insurance.

The EPL market in general faces challenges with increased frequency and severity of lawsuits related to social inflation (i.e., public sentiment favoring plaintiffs over corporations, leading to larger verdicts and settlements). The cannabis market may hold greater exposure to EPL lawsuits due to its unusually high turnover rate—in the U.S., around 50% of cannabis employees hired during 2021 left the job the same year.¹² Many employees may be lured by the glamour of the cannabis industry only to quickly experience burnout and dissatisfaction with the reality of the job. This, combined with a pace of hiring that may exceed the rate at which employers are able to properly onboard and train new employees, can lead to increased risk of employment-related lawsuits.

Sexual harassment and discrimination are risks to be wary of as well. While many cannabis businesses strive to maintain diverse and inclusive workforces and provide their employees with safe and friendly work environments, bad actors remain. A 2020 study found sexual harassment and discrimination to “plague” the legal cannabis industry, noting that it may be a legacy of the industry’s past illicit nature.¹³ Discrimination lawsuits are also on the rise, including a recent suit filed by two female employees of a cannabis operator alleging repeated discrimination because of their gender, including being barred from growing operations and being warned they would be terminated if they were to become pregnant.¹⁴ Cannabis businesses and their insurers should ensure that qualified human resources staff, employee handbooks, and discrimination/harassment training are in place to ensure all employees are treated fairly.

Professional liability/errors and omissions (E&O)

Skilled workers at all stages of cannabis production need professional liability coverage, as the failure of products to perform as expected can subject them to liability. Growing cannabis is a tricky business, made increasingly complicated by ever-rising demand for newer, more potent, and more exotic strains. Successfully cultivating and manufacturing the desired products involves a range of professionals with expertise in choosing the right seeds, soil, nutrients, and equipment, ensuring optimal growing conditions, testing the plants, and so on. Extraction and processing of oils, CBD, and other compounds, as well as the manufacture of various products, similarly require experts in fields subject to a constantly evolving state of the art.

Cyber

Cyber coverage may not seem like an obvious need for cannabis businesses, but it can be vital. Many states require cannabis operators to use “seed-to-sale tracking,” a rigorous electronic inventory monitoring system that tracks each plant from its cultivation through the various stages of processing and manufacturing, up to the point of sale. A cyber incident that interferes with this process can subject a cannabis business to a host of problems including lost sales, legal costs, and regulatory fines and penalties. Furthermore, medical marijuana facilities may need to collect protected health information (PHI) on their clients, raising the risks in the event of a data breach.

Property

As noted earlier, cannabis businesses operate mainly on cash, due to their limited access to banking. It is not uncommon for dispensaries and other cannabis operations to have $100,000 or more in cash on premises on any given day. That, along with their cannabis stock—a valuable commodity that is easy to sell on the street—makes cannabis businesses attractive targets for thieves, increasing the crime risk on their property coverage. Theft prevention is crucial for this industry, and cannabis businesses often employ security guards and many state-of-the-art security measures. Furthermore, cannabis production and processing often require specialized buildings (such as greenhouses) and expensive equipment, creating unique property risks. In addition, cannabis crops, both those grown outdoors and indoors, can be exposed to an array of hazards, including fire and smoke damage—a particular concern in California, the number one state for legal cannabis production, where wildfire risk continues to escalate.

Underwriting and pricing considerations

For insurers willing to accept the legal risks that come with the federal illegality, the cannabis industry presents an opportunity to get into a market with little insurer penetration to date and high growth potential—but they should carefully manage their exposure through underwriting, policy language, and loss control, and ensure their pricing is adequate. Insurers would also be wise to learn from the lessons of the recent hardening of the market and control their risk through minimum premiums, strict maximum limits, and minimum deductibles or self-insured retentions.

While very limited data exists to assess the expected loss for policies for cannabis businesses, analysis of related classes of business in similar industries, such as pharmaceuticals, tobacco, alcohol, and food products, can be helpful. For financial lines coverages, it can also be instructive to analyze prior emerging markets that have faced similar challenges, such as biopharmaceuticals, life sciences, and tech startups.

Due to its unique nature, cannabis is currently insured mostly in the excess and surplus lines markets, but a few insurers have made inroads into the admitted markets in some states. Many state regulators are actively encouraging insurers to write admitted programs, recognizing the need for easy access to insurance faced by their burgeoning cannabis industries, which they view as sources of much-needed tax revenue. Thus, the cannabis market remains a broad, diverse, and (dare we say) intoxicating new landscape for insurers to explore—but tread carefully.

Mark Goldburd, FCAS, MAAA, is a consulting actuary with Milliman. He can be reached at [email protected] or (646) 473-3405.

James Whitcomb, MBA, is the former CEO of Parallel, a multistate cannabis operator, and the current CEO of Frontier Risk Group. He can be reached at [email protected] or (203) 984-0560.

¹ MJBizDaily (June 2022). U.S. Cannabis Retail Sales Estimates: 2015-26. Retrieved September 7, 2022, from https://mjbizdaily.com/us-cannabis-sales-estimates.

² Avery, D. (August 29, 2022). Marijuana Laws by State: More People Smoke Pot Than Cigarettes. CNET. Retrieved September 7, 2022, from https://cnet.com/news/politics/marijuana-laws-in-every-state.

³ FinCEN (February 14, 2014). BSA Expectations Regarding Marijuana-Related Businesses. Retrieved September 7, 2022, from https://www.fincen.gov/resources/statutes-regulations/guidance/bsa-expectations-regarding-marijuana-related-businesses.

⁴ Khan, S. (May 23, 2021). U.S. pot sellers stash cash as banks leave them high and dry. Reuters. Retrieved September 7, 2022, from https://www.reuters.com/world/us/us-pot-sellers-stash-cash-banks-leave-them-high-dry-2021-05-24/.

⁵ Lerner, M. (March 30, 2021). Optimism high for passage of federal cannabis insurance bill. Business Insurance. Retrieved September 7, 2022, from https://www.businessinsurance.com/article/20210330/NEWS06/912340777/Optimism-high-for-passage-of-federal-cannabis-insurance-bill.

⁶ Kirk v. Nutritional Elements, Inc., Case No. 2016-cv-31310 (Denver County Court).

⁷ Leon Steele et al. v. Passion Care, LLC et al., Case No. 37-2020-00038013-CU-PO-CTL (San Diego County Court).

⁸ Stewart, I.A. (February 2, 2021). Evolution of the Cannabis Product Liability Lawsuit. Wilson Elser. Retrieved September 7, 2022, from https://www.wilsonelser.com/news_and_insights/insights/4092-evolution_of_the_cannabis_product_liability.

⁹ 2567423 Ontario Inc. et al v. MXY Holdings LLC et al. (LA County Court).

¹⁰ Byrd Jr., T. & Urness, H. (June 8, 2022). Cannabis Companies Lacking Bankruptcy Protections Can Explore State Options. JD Supra. Retrieved September 7, 2022, from https://www.jdsupra.com/legalnews/cannabis-companies-lacking-bankruptcy-8224422/.

¹¹ Barcott, B. & Whitney, B. et al. Leafly Jobs Report 2022. Retrieved September 7, 2022, from https://leafly-cms-production.imgix.net/wp-content/uploads/2022/02/18122113/Leafly-JobsReport-2022-12.pdf.

¹² Headset (July 13, 2022). An analysis of employee turnover in cannabis retail. Retrieved September 7, 2022, from https://www.headset.io/industry-reports/an-analysis-of-employee-turnover-in-cannabis-retail.

¹³ Smith, A.N. & Privateau, G.T. (2020). Prospects and Pitfalls: Confronting Sexual Harassment in the Legal Cannabis Industry. American University Journal of Gender, Social Policy & the Law. Retrieved September 7, 2022, from https://digitalcommons.wcl.american.edu/cgi/viewcontent.cgi?article=1823&context=jgspl.

¹⁴ Donna Rivadeneyra et al. v. Toluca Lake Collective, Inc., et al. (Los Angeles Superior Court Case No. 22STCV14074).