By KEY COLEMAN, CFA, CPA, CPCU, ARe, managing director of SMART Business Advisory and Consulting
Following the market meltdown of 2008, one might have expected to see a more cataclysmic impact on property/casualty insurance rates. After all, many of the infamous hard markets have been driven by a sudden reduction in the industry's aggregate policyholder surplus.
Typically a property catastrophe produces underwriting losses that soak up any excess surplus and lead to higher rates the following year. While there has, in fact, been a significant surplus reduction in the marketplace, this time it was not brought on by underwriting losses. Instead, massive investment losses from the financial crisis have delivered a blow to surplus that rivals many of the large hurricanes.
Yet in spite of this setback, by year-end 2009, overall property/casualty rates had actually dropped as much as 4 percent, year over year. Professional liability insurance, which may ultimately suffer claims related to the construction boom and bust, has experienced rate decreases in the range of 2 percent. And directors' and officers' (D&O) insurance, which will ultimately suffer the fury heaped on financial institutions, has, on average, experienced flat rates in 2009, according to MarketScout.
All this leaves the risk manager somewhat quizzical as to what to expect in the coming year. Before plotting a course for the future, it makes sense to gain a more thorough understanding of certain drivers underlying the market dynamics. Armed with this knowledge, critical decisions will become all the more clear.
To say that D&O rates were "flat" in 2009 is a gross oversimplification. Because D&O loss experience has been bifurcated, renewal rates have followed suit. Financial Institutions (FI) have generated most of the D&O losses, and have, in turn, been met with a punishing renewal season.
In the second quarter of 2009, FI rate increases were reported as high as 79 percent, while non-FI rates saw decreases of up to 56 percent. Jack Hughes, vice president of the Chicago brokerage firm Thompson Flanagan, said many of his FI clients did, in fact, experience a significant increase, but not at the high end of this range. According to Hughes, "in 2009, we saw increases in our nondistressed FI book of business average from 5 percent to 30 percent."
Hughes added that with regard to professional liability, "we are continuing to see rate decreases of 5 percent to 10 percent. In isolated instances rates are 'flat' or higher if they have exposure to real estate (commercial and residential), securities, or M&A advice."
WHAT IS KEEPING RATES LOW?
One estimate indicates that the total impact of the financial crisis on D&O and professional liability lines of business will be roughly $6 billion and $4 billion respectively, according to a presentation made by CNA Financial at a RIMS/CPCU joint conference in Chicago on Jan. 19. This begs the question, why rates for these two lines of business have not reacted more severely.
Some of the explanation lies in the financial statements of the insurers themselves. Premium and loss statistics for both D&O and professional liability insurance appear under the Annual Statement category known as "other liability." The category is dominated by 10 carriers that collectively write more than 75 percent of the business, according to NAIC's annual statement database.
As a subset of "other liability," D&O writings are actually more concentrated among only five carriers. In fact, in 2007, AIG and Chubb alone wrote roughly half the D&O by premium volume, according to Towers Watson.
Many of these insurers continue to make an overall profit, much of which is generated outside of these lines. The absence of a major insured property catastrophe has only added to their overall profitability and undermined any attempt at wholesale rate increases.
As a result, in 2008, in spite of the financial crisis, the industry was able to deliver a 4.2 percent return on equity; in fact, through the second quarter of 2009, the combined ratio for the property/casualty industry as a whole stood at 99.5 percent, both figures excluding mortgage and financial guarantee insurers, according to the New York-based Insurance Information Institute.
At the same time, the financial crisis has raised questions of financial stability at companies with a large market share, including AIG, Hartford and XL. As other companies attempt to take advantage of this situation, rate competition, according to some in the industry at least, has increased.
OUTLOOK FOR 2011
All of these developments have combined to keep overall rates on an even-to-downward slope. However, at least three other factors indicate the potential for market hardening over the next two years:
1. Industry surplus has decreased significantly since 2007, from $521 billion to $463 billion.
2. The release of over-reserving from prior years has served to buffer current year results. In 2008 and 2009, prior-year reserve reductions actually helped the industry's combined ratio by more than 4 percent according to the Institute. Once this effect plays itself out, there will be no buffer in future years.
3. There will be a renewed effort to underwrite at a profit due to low investment returns. Insurers are just now beginning to comprehend the difficulty of underwriting in a low interest rate environment. For the coming decade, insurers will need to target a more substantial underwriting profit in each line of business, as interest rates will add very little to the bottom line.
Each of these factors would seem to indicate that higher insurance rates are just around the corner.
So just what is a risk manager to do? D&O and professional liability represent a large chunk of the risk management budget. Simply doing nothing while the potential for wholesale rate increases exists is not advisable.
Instead, this is a good year to get the house in order from a risk management standpoint. A market hardening may come in the form of a tightening of underwriting standards, so it will be important to provide underwriters with accurate information that will help distinguish a superior risk.
For D&O, this would include:
1. Making certain the application is accurate. Errors found in the underwriting process can erode confidence; those found at the time of a claim can actually be grounds for rescission.
2. Enumerating loss control measures taken. From Sarbanes-Oxley compliance to an enhanced control environment, underwriters will be interested in how a company has not only met but gone beyond the minimum requirements of corporate compliance.
For professional liability, according to Noah Bearden of NHB Group, it will be important to demonstrate:
1. Use of appropriate contracts:
a. Make certain a contract is in place before starting work.
b. Properly define each party's role and responsibilities.
2. An understanding of your own professional limitations. Have controls in place to demonstrate you do not accept work you cannot perform.
3. Client communication is taken seriously. Using frequent and documented means of managing client expectations.
4. The American Institute of Architects in its professional liability insurance survey advises that the client selection process be rigorous. The decrease in revenue for professional firms stemming from the financial crisis may tempt professional services firms to replace the revenue without fully vetting new clients. This can be a mistake for attorneys, architects, engineers and other professionals who are used to dealing with only the most reputable of clientele.
Market dynamics, from declining surplus to low interest rates, have combined to create a delicate relationship between insurers and policyholders. Without investment income to save the day, underwriters will be justifiably concerned about underwriting profits. While rates have not taken a decided step upward, a poor hurricane season on the property side or adverse reserve development on the liability side could be the trigger that sends rates to higher levels within the next 2 years. Risk managers who understand these underlying market dynamics and prepare their organizations accordingly will be best positioned to withstand abrupt market fluctuations.
March 1, 2010
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