Authored by: Dave Robinson Matson Driscoll & Damico

Dave Robinson Matson Driscoll & Damico
What used to be considered an illicit drug in most countries is now a decriminalized plant with some medicinal potential. Cannabis is in the midst of a global transformation into a major industry with massive investment and growth potential.
Canada was the first G20 nation to fully legalize the cultivation, processing, sale, and possession of Cannabis at the federal level on October 17, 2018. Significant steps towards federal legalization have also taken place in the US, Australia, South Africa, Jamaica, Israel, and many other countries.
We could speak forever just about the cannabis industry and the road to 2021, but as forensic accountants who specialize in economic damage quantification, the subject of this article is around lost profits exposure in the cannabis industry. Specifically, we will discuss the challenges and key considerations when attempting to quantify the lost profits that can arise from either first-party exposure from an insured event or third-party claims.
Being from Canada and exposed mainly to the Canadian market, this article will focus on the Canadian cannabis industry. However, many nations considering legalization are closely monitoring the successes and challenges in Canada.
Background
As with any lost profits calculation, it is essential to understand the background of the industry. Below is a high-level overview of the recent legalization in Canada and the regulatory landscape.Cannabis Legalization Timeline in Canada
Medical use of Cannabis
- On June 7, 2013, the federal government implemented the Marijuana for Medical Purposes Regulations (MMPR) 1.
- On August 24, 2016, the Access to Cannabis for Medical Purposes Regulations (ACMPR) replaced the MMPR 2. The changes made included access to other cannabis products in addition to dried flower.
Recreational use of Cannabis
- October 17, 2018, The Cannabis Act took effect, which legalized Cannabis for recreational use in adults starting October 17, 2018 3.
- This act only included dried Cannabis and specific types of concentrated cannabis/oils.
“Cannabis 2.0”
- On October 17, 2019, the federal government announced new regulations that legalized cannabis edibles, topicals, and extracts.
Regulatory Landscape
Overall Regulation
- Health Canada issues licenses for cultivation, processing, sales, research, testing, etc., to Licensed Producers (“LP” s). These licenses dictate cannabis related activities that each entity can perform (i.e., cultivation, sale, extraction, etc.).
Sales and Distribution
- Provinces manage the recreational aspect, and each one is uniquely organized. Operations range from centralized distribution of all products to decentralized distribution direct to the retailers and/or customers.
- Medicinal: Health Canada continues to regulate the process for the medicinal sale of Cannabis in Canada.
The Results Since Legalization – Is the Hype (or Struggle) Real?
Year 1
Before and during the first year of legalization, there was an almost uncontrollable industry hype about Cannabis’ market potential. Several published analyst projections and outlooks pegged the first year of legal domestic sale of Cannabis to exceed $4B in year 1. Additionally, several Canadian-based public companies peaked during April 2019 with market cap valuations of 22B 4 for Canopy Growth Corporation and 9B 5 for Aurora Cannabis. The actual results of the first-year post-legalization saw massive growth in terms of production, sales, and newly licensed growing space. Some highlights of the first year of legalization (October 2018 to September 2019) include the following:- Monthly retail sales in Canada grew from $42M in October 2018 to $123M in September 2019 (192%).
- Indoor growing space increased from 452K Square Meters in Oct 2018 to 1.5M in September 2019 (226%)
- Total recreational sales fell short of $1B.
- Towards the end of the first year of legalization and into the second year, production capacity growth outpaced sales and led to a massive build-up of inventory, which resulted in downward pressure on price.
- While sales grew by 192%, unpackaged inventory grew by 327%.
- Challenges in provincial distribution networks included no brick-and-mortar stores open for the first six months in the most populated province (Ontario).
- The black market continued to operate and expand alongside legal Cannabis.
- Limited products were available to consumers (edibles, topicals, and other extracts were not yet legalized).
- As a result of these challenges, many public companies experienced massive devaluations and class action lawsuits stemming from disclosure issues, license suspension from unregulated production, and loss of profit claims from breach of contract. Less than one year since peak valuations, Canopy and Aurora dropped to lows of $5.3B (peaked at $22B) and $0.5B (peaked at $9B), respectively.
Year 2
In the second year of legalization, most LPs were hopeful that improved distribution networks and Cannabis 2.0 6 products legalization, which included edibles, vapes, topicals, and other extracts, would provide relief for some of the challenges in the marketplace. Similar to the first year, the growth was impressive:- In October 2019, total retail sales were $130M and increased month over month, resulting in total sales of $297M in December 2020 (growth of 129%), with the biggest growth seen in Ontario.
- Production space increased from 1.4M square meters of growing space in October 2019 to 2M in November 2020 (growth of 53%)
- Delay in capability and regulation meant most Cannabis 2.0 products weren’t available to consumers until January 2020 (despite legalization in October 2019).
- Concerns of illnesses caused by vaping Cannabis delayed the sales of vape pens in certain provinces 7
- Delays continued in opening brick-and-mortar stores in Ontario until it was announced that Ontario would open ten new stores a month beginning in April 2020.
- Unfortunately, in March 2020, the Covid 19 pandemic further delayed the opening of brick-and-mortar stores.
Operations during COVID 19
At least at the time, for the cannabis industry in Canada, a big win was being deemed essential at the onset of the Covid-19 pandemic because it meant that all operations, construction, and sales could continue during restriction periods. From April to June 2020, after the start of the COVID 19 pandemic, consumers spent 74% more money on licensed Cannabis when compared to the same period in 2019 8. During the same period, spending on the black market dropped by approximately 5% 9. Consumers also seemed to change their buying patterns and preferences. Cannabis flower still held as the most common form of consumption but vaping, edibles, and topicals picked up in popularity. The Government of Canada Consumer Survey asked respondents about their methods of consumption. Smoking was the most common method at 79%; however, this statistic represents a decrease from 84% in 2019. While smoking may still be the preferred method, sales of extracts and edibles have increased significantly since the launch of Cannabis 2.0. Despite the significant increase in sales, the industry’s growth did not meet the expectations (or hopes) of many of the LPs as cannabis inventory continued to climb, reaching over 1M KG of unpackaged inventory in November 2020.Today’s Landscape
Today’s landscape in the cannabis industry has been one of consolidation, with significant deals being announced in an e ort to be the first to claim brand loyalty. Sales continue to grow, as does the diversity of products available to consumers. The ability to offer different strains and new products seems to be the recipe for the success of many LPs. But inventory continues to pile up despite companies reducing production and even closing facilities.Insurance
With the landscape described above, major capital investments, huge valuations, large lawsuits, and rapid construction, many insurers have taken a “wait and see” attitude towards the cannabis industry. At least until there is more historical data and the market landscape normalizes (whatever normal is). What some may not have expected, or considered, is the breadth of the industry. The cannabis industry is more than just growing, packaging, and selling. There are numerous supporting industries that, in some way or another, may be exposed to events leading to a lost profits claim from the cannabis industry. These can include:- Construction (delay in start-up)
- Professional services such as engineering, accounting, lab testing (professional liability)
- Suppliers (production supplies, packaging products, growing medium)
- Product recalls and product liability
- Utilities (service interruption)
- Distribution (damage of goods in transit)
Measuring a Cannabis Loss
The subject of this article is lost profits in the cannabis industry, so here’s an attempt to simplify it. Although rarely simple, we have addressed how to quantify lost profits in the cannabis industry and the key considerations in doing so.Methodology
Notwithstanding policy wording, the general methodology for lost profits is the lost sales value less the saved costs it would have taken to bring the products to the customers. If applicable, this includes any additional costs incurred to continue operating or avoid a further loss of sales. This methodology is also applicable when approaching a cannabis loss; however, there are many nuances to this industry.Production
If the triggering event involves a loss of production, often very little historical production data is available or at least relevant historical production data. Although the industry is now a few years old, the only constant in the industry so far is constant change:- New production space, new equipment, new products, new licenses, new regulations, new technology, new methods.
- Not all cannabis plants are the same. Different strains are grown for different purposes under different conditions and can yield very different results.
- A detailed understanding of the context to historical results and forecasted production is required to establish what the expected production would have been but for the triggering event.