The insurance industry is now in uncharted territory. A perfect example is American International Group Inc., one of the world’s largest firms. A year ago, it would have been difficult to believe that AIG would require a massive bailout from the federal government. Now U.S. taxpayers own a majority of the New York-based company.
Though most organizations benefited from declining commercial insurance rates during the last few years, this year the landscape will likely change, as many factors are combining to create a unique scenario for insurers.
What is driving the change? How will the change affect premiums? What can be done to minimize insurance costs?
Looking ahead and having a clear strategy will pay financial executives dividends on their 2009 insurance renewals.
What’s Changing
Investment income is down dramatically for nearly all insurance companies, while at the same time, claims activity is up significantly. For example, many insurers had invest- ments in Fannie Mae and Freddie Mac, the mortgage giants seized by the federal government.
In an ideal world, insurance carriers garner a positive return on investments and collect more in overall premiums than they pay out for claims. This generates policyholder surplus, which represents the positive difference between their assets and the legal obligations to pay on potential claims.
As policyholder surplus erodes, carriers are under pressure to increase rates and premiums. Many carriers reported disappointing third and fourth quarters last year, driving down their yearend financial results. Adding to the situation is the realization that chances for an economic recovery this year appear slim, at best, as the United States recession has worldwide implications, making strong investment returns unlikely anytime soon.
Insurance buyers have benefited from competitive pressures among carriers in recent years. But the flip side of the equation is weakening financial performance. Recent catastrophic losses in the U.S. have added to the woes of the industry. Due to last year’s sharp upturn in hurricane activity, property losses were significantly higher than in 2007.
This year will be a challenging one in the insurance world due to a weakened economy, Wall Street woes, the subprime fallout and faltering profitability due to competitive pricing and claim losses.
The competitiveness of insurance markets has masked the necessity of stringent risk management. Many insurance buyers have come to expect rate and premium reductions, without significant regard to how risk is being addressed and managed in their day-to-day businesses.
Identifying and quantifying risks will increasingly be viewed as the best way to control costs in insurance programs. By mitigating potential for loss, there is a stronger case for savings in the risk-transfer process of purchasing insurance.
Will Policies Cost More?
One potential casualty of insurance program renewals in 2009 could be the curtailment of automatic rate cuts. Though it is unlikely there will be a large spike in insurance costs, it is likely many insureds will experience a bottoming-out of rates this year. Underwriters are increasingly attentive to coastal areas, where the threat of wind-related claims activity is greatest, especially since the losses for Hurricanes Ike and Gustav are exceeding $30 billion, by some estimates.
As a result, the potential for hurricane-related losses has again moved to the forefront in the minds of underwriters. If there is sizable exposure to wind-related damage to property, carriers may actively pursue single-digit rate increases in 2009. Upgrading buildings to be more wind resistant and documenting those changes can pay significant dividends in the reduction of losses and premiums.
The financial and real-estate sectors should expect to see increased pressure for rate increases due to subprime and other credit-related issues. This will mainly center around directors and officers liability as well as professional liability policies, with potential for one or more of the following changes: higher premiums; more restrictive terms and conditions; higher deductibles; or lower limits of offered coverage.
Directors and officers liability premiums could also be impacted if the economy continues to worsen and forces more companies into bankruptcy. Increased equity market volatility usually precedes amplified securities class-action litigation, triggering D&O claims.
Employment Law Trends
This will also be an interesting year when it comes to employment-practices liability coverage. The U.S. Supreme Court recently issued several key decisions that appear to broaden employees’ rights, with emphasis on age discrimination and retaliation by employers against employees. In addition, the Genetic Information Nondiscrimination Act, of 2008 prohibits discrimination in employment - including compensation, hiring practices, firing and demotion - on the basis of genetic information.
Some underwriters are attempting to limit or delete coverage for third-party claims for financialservices insureds. That’s because they want to avoid claims alleging predatory lending practices, where discrimination is claimed by plaintiffs. With the expected continuation of layoffs in the retail, manufacturing and financial-services sectors, underwriters will pay close attention to the handling of reductions in force of their insureds.
Of particular interest will be judicious use of employment law legal counsel and severance packages to reduce the likelihood of claims. A balancing factor is the continued capacity of the industry to provide coverage and competitive pricing. Given the slow nature of the U.S. legal system, it will likely take some time for changes in the law - if they occur - to create any downward pressure on rates and premiums.
Some businesses will see an increased need for trade-credit insurance. Given the global credit crunch, collection of receivables has become an increasing concern to businesses in general. Many companies see the availability of this coverage as a financial backstop for unexpected losses where credit has been extended.
Demand for trade-credit insurance rose significantly last year, due to the turbulent U.S. economy and that trend is likely to strongly continue in 2009. A word of caution: Don’t wait until issues with receivables have gone out of control. At that point, the risk may have become uninsurable for all practical purposes.
Another likely trend will be an increase in mergers and acquisitions in the insurance industry as companies struggle to grow organically. During the last two years, there has also been an increase in the number of foreign insurers making plays for their American counterparts.
Accelerating that trend was the decline in the U.S. dollar relative to other world currencies, making American companies more attractive. With the recent sharp increase in the dollar to the euro /yen, it will be interesting to see if that trend continues. Uncertainty as to the eventual outcome of AIG adds to the possibility of further industry consolidation.
Industry Focus
Insurance carriers will be likely be extremely focused on adequacy of rates and premiums, maintaining underwriting discipline, policyholder surplus and their exposure to catastrophic losses. Protecting balance sheets will take on increased importance as carriers recognize no firm is immune to dramatic reversals.
One way insurers may hedge their positions this year is through increased use of reinsurance. Reinsurance carriers share risks taken on by primary carriers. The insurance carrier issuing the policy takes a portion of the premium received and buys an insurance policy for itself. In case of a large claim, the primary carrier has spread the loss between itself and the reinsurer, minimizing the effect of a large loss on policyholder surplus of the primary carrier.
If the major carriers decelerate rate cuts or stabilize rates, it is probable that much of the industry will follow suit. More emphasis will be placed on prudent and thorough underwriting procedures as opposed to “cash-flow” underwriting, where the main objective is to create profits through lucrative gains on investments made by the insurance companies.
Underwriters are increasingly intent on accepting risks only after a proper evaluation from a micro and macro perspective. The micro evaluation focuses on the individual risk itself. From a macro sense, aggregation of all losses that could occur from single event are being viewed more seriously due to the multiplying effect many related claims could have on a carrier’s bottom line.
In addition, the financial strength (or lack thereof) of insureds will play more prominently in overall underwriting. With many insurance companies, financiáis will have to be approved before the traditional underwriting process even begins. Due to tightened credit markets, insurers are becoming somewhat more conservative where collateral (such as a letter of credit) is required to support the insurance program.
More Federal Control?
Is the federal government going to radically increase its role in the insurance industry in the future?
Significant discussion has recently revolved around the current system of state regulation of insurance companies. Proponents for a new regulatory regime have advocated for a federal charter of the insurance industry. The AIG bailout package made it inevitable that greater congressional scrutiny was a part of the deal.
To wit: the House Oversight and Government Reform Committee has already conducted hearings on AIG’s bailout. Further-reaching regulation of the insurance industry will likely be a hot topic this year and beyond. There are signs of what to expect by looking at changes already proposed.
For example, last March, Treasury Secretary Henry Paulson released the “Department of the Treasury Blueprint for a Modernized Financial Regulatory Structure.” The blueprint consists of a series of recommendations for regulatory reform of financial entities, including insurance companies. It would also seek to provide improved market stability, enhance protection for insureds and increase efficiencies in the overall insurance marketplace.
Of particular interest is a recommendation to implement an optional federal charter (OFC) that would be charged with oversight of insurance companies and reinsurance companies, as well as federal licensing of insurance agents and brokers.
This blueprint would also permit insurers to be federally licensed under an OFC and be regulated by a newly created Office of National Insurance federal regulator. Since participation is optional, the proposed system would resemble the current dual-chartering system used by banks. (State regulatory agencies would continue to provide oversight for insurance companies not licensed on the federal level.)
Additionally, all insurers would still be subject to state tax laws and laws requiring compulsory workers’ compensation or personal automobile insurance, along with requirements related to state guaranty funds.
The effects of a federal oversight system would be far-reaching. It would have broad powers to regulate and supervise the insurance industry, along with enforcement of those regulations. In addition to the Treasury Department, the Federal Reserve would have new powers as a market stability regulator to evaluate capital, liquidity and general business practices of the industry.
Given the direction of increased governmental intervention by the new president and Congress, increased industry regulation is a strong possibility.