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Companies must now expect coverage providers to share risk, not absorb it.
Russ Banham, CFO Magazine
November 1, 2001
Much has been made of the losses insurers are taking in the wake of September's terrorist attacks. According to some estimates, the industry could lose almost $60 billion, making them the most costly disasters ever. The previous record of $20 billion was set by Hurricane Andrew. In turn, insurers have been quite clear that Corporate America will share in their pain. Says Carl Roth, managing director at insurance broker Willis Risk Solutions in New York, "For many classes of insurance, there will be a sharp increase in rates of such significance that people have not seen before. This will be the classic hard market magnified several times."
But sharing in the pain won't mean just paying higher premiums — companies have already seen double-digit increases in those this year. For some, it may mean seeing restricted coverage, and for most, it will mean taking on more financial risk.
Although for much of the past decade insurers have provided 100 percent risk-transfer financing in such lines of insurance as workers' compensation in order to gain business, that strategy has been greatly curtailed. And the idea of offsetting higher premiums with higher deductibles (called self-insured retentions, or SIRs) may no longer be a corporate choice.
That latter trend, in fact, was in motion before the terrorist attacks. According to Chris Treanor, head of global brokering at New York-based insurance broker Marsh, deductibles had been doubling and more across the board this year. "Even prior to September 11, if a company had a $10,000 SIR at its last annual [policy] renewal, chances are it would be $25,000 this renewal," says Treanor. "If it was $1 million, it was likely to be $2 million, and so on. And if there was no SIR or deductible last time around, there would likely be one this time around." And there's no doubt, says Stephen Lowe, managing principal of product development at Tillinghast-Towers Perrin, that next year "there will be pressure for those deductibles to move up further."
Reversal of Fortune
Vinnie Marzano felt the pressure early on. The vice president and treasurer of New York-based Scholastic Corp. recalls that in the 1990s, the children's publishing and media company was the beneficiary of giveaway insurance prices. Its workers' compensation insurer was so eager to retain the company's business that it waived the usual $200,000-per-claim deductible and even lowered the premium by 35 percent. "We had a great deal," recalls Marzano.
This past February, however, Marzano had to tell CFO Kevin McEnery that "the good days," as he terms them, were over. Although Scholastic's losses from workers' compensation had not changed as a percentage of payroll, the insurer, New York-based Atlantic Mutual, insisted on a deductible of $250,000 per claim. It also hiked the price of the policy by 60 percent to 76 percent, depending on a formula assessing Scholastic's loss experience.
Marzano shopped around for a better deal — to no avail. "To get the same 'no-deductible' policy would have cost an additional $800,000 a year, quite a bit more than I was willing to spend," he says. "Either we took on more risk through the deductible or we'd pay through the nose."
Marzano's dilemma is symptomatic of the return of the hard insurance environment. During the bull stock market, insurers competed by pricing their products lower while simultaneously absorbing more risk, figuring their investment income would pick up the shortfall. Robert Hartwig, chief economist at the New York-based Insurance Information Institute, contends insurers went too far, pricing their policies well below expected losses. When the market became a bear market, the investment income to pay losses dissolved. "Record catastrophe losses didn't help, either," he says.
Meanwhile, the losses that came in had much higher dollar values than was anticipated. Claim settlement costs for directors' and officers' liability insurance, for example, is up from an average $7.5 million four years ago to $14 million today, according to Steven Anderson, managing director of Marsh's FINPRO unit. Other tallies include a doubling of general business negligence claim costs from $759,000 in 1993 to $1.7 million in 1999, an increase in premises liability (so-called slip-and-fall cases) claim costs from $324,000 in 1993 to $457,000 in 1999, and a fivefold increase in product liability claim costs from $1.4 million to $7.4 million during the same period.
After the events of September 11, those losses are only going to increase. And what's different about the new claims, says Lowe, is that they cut across multiple lines of insurance, from property and casualty to workers' compensation to life insurance. Moreover, their catastrophic nature will cause first reinsurers and then primary insurers to further evaluate "the limits of insurance they offer" as well as the financial risk they will assume. The result, says Lowe, could be an insurance environment in which "buyers don't have much ability to negotiate."
To Sir, With Love
In the soft market, buyers often used their negotiating power to secure higher SIRs, reasoning that it made more sense to pay low-value risks out of cash flow than to pay an insurer. Several large companies accepted even higher risks.
Take Pittsburgh-based Nova Chemicals. When other chemical commodities companies reduced or dissolved their SIRs as insurance prices bottomed out in the mid-1990s, $3.9 billion Nova did the opposite, quadrupling its property insurance SIR to $70 million for claims from fire, explosions, and the resultant loss of income. Nova's peer companies were more likely to have SIRs in the $1 million range. "We felt then and continue to feel that it makes no sense to spend all this money on insurance when we could be spending it instead on loss prevention," says Nova risk manager Brad Silver, who notes that the company hasn't submitted a claim to its insurer for the past decade. "It was a radical decision," he says, "but it has paid off for us over time."
Following a recent merger with Trans-Canada Pipelines and a subsequent reorganization that spun off its energy business, Nova reduced the SIR on its property insurance program to $50 million, still very high compared with its peers. However, that deductible, says Silver, will have to be reevaluated during the next renewal cycle, in June 2002, in light of current economic and insurance conditions. SIRs, he says, "are influenced by the financial position of the company, which can change from year to year."
Accepting higher deductibles — whether by choice or not — comes with a downside. "Obviously, you subject your corporation to more earnings instability when you take on more risk," explains Hartwig. "If you take a $50 million SIR instead of a $25 million SIR and there's a loss, that will wind up in your quarterly earnings, not an insurer's. If there's no loss, then you've won the gamble."
Some companies have been unwilling to take that gamble. Epix Holdings, for example, a Tampa-based professional employer organization with $1.3 billion in annual revenues, balked at absorbing a high SIR. Prior to September 2000, the company had a no-deductible workers' compensation insurance program, similar to the one at Scholastic. That fall, however, Epix president and CEO Thomas Taylor found the market had changed — considerably. The company's insurer no longer would write workers' compensation without an SIR, an outcome that did not sit well with Taylor. "I wanted the same attributes I had with my former program — earnings stability, cash flow, tax deductibility, and so on," he explains.
So Taylor turned to his broker for help. "Marsh put together a program with two insurers: The Hartford, which would provide the coverage above the $250,000-per-claim SIR, and Scandinavian Re, which would absorb the SIR in full," he says. "The upshot is we now have full coverage, as before, although it is through two insurers and the cost is 50 percent more than what we paid for our previous single policy."
Costco Wholesale's response to its higher SIR was to take matters into its own hands. Instead of transferring the SIR to a commercial insurance company — as Epix did — the wholesale-retail company set up its own corporate-owned captive insurance company to insure it. "We wanted to be in charge of our own destiny," says Janice Chamberlain, risk manager at the Issaquah, Washington-based company with $34.1 billion in 2001 revenues. Adds Chamberlain: "We're very glad we did what we did, when we did."
Costco's $1 million SIR for general liability, $500,000 SIR for workers' compensation, and $250,000 SIR for auto liability are insured by its brand-new Bermuda-based captive, which provides similar tax treatment accorded to premiums paid to a conventional insurance company. The difference is that Costco gets to keep the investment income drawn on the premium paid to the captive, rather than the insurer having it. Above the SIR, Costco buys insurance from Kemper Insurance in Chicago.
"This is a much better, lower-cost way to insure ourselves," says Costco executive vice president and CFO Richard Galanti. "We don't get hit with the overhead and profit charged by the insurer to take these low-value risks," he adds. "We're also not subject to the vagaries of the [insurance] marketplace, we get far more financial predictability on an annual basis, and hopefully we can garner significant investment income on the premiums paid the captive."
Other companies are pursuing the same course. According to executives in Marsh's Bermuda office, the number of new captives is up in all domiciles, from Guernsey to Vermont. "The hard market is driving corporations to increase their SIRs, which is encouraging them to put that risk in a captive," says Andrew Carr, a managing director in Marsh's captive management practice. Carr notes that as of August 31, 64 Bermuda captives have been set up this year; Marsh has formed 14 of them, and expects to form a total of 30 by the end of the year. Carr adds that several companies that were undecided about the approach have been prodded into action by the disasters. "After all, it is the best defensive action one can take," he says.
Lowe of Tillinghast-Towers Perrin estimates that it will take six months to a year before the insurance industry has a firm handle on the business-interruption costs stemming from the September 11 incidents, and several more years for total liability claims to be known. But in the meantime, many companies are reevaluating just how high an SIR they can handle without jeopardizing earnings stability.
Some businesses, such as Praxair Inc., a Danbury, Connecticut-based industrial gases company with $5.1 billion in annual revenues, are turning to their brokers for guidance. "We hired Willis Risk Solutions to help us do an analytical assessment of the SIR that would be appropriate given our size, range of exposures, and appetite for risk," says Richard Inserra, Praxair assistant treasurer and risk manager. Willis is creating an algorithm to model the cost of Praxair's risk at various risk-retention levels. Similarly, for Costco, which is expecting higher retention rates when its policies come up for renewal, broker Sandy Dillmann of Marsh is using financial modeling to determine what loss levels would have a direct impact on earnings per share.
Scholastic is taking its SIR on the chin, at least for the time being. "We're just going to pay the $250,000-per-claim SIR out of cash flow," says Marzano, a strategy that he too says will be reevaluated at the next renewal cycle. Not all is doom and gloom, though. "We get to pay losses now as we go, as opposed to paying the insurer one big chunk of money up front," he says. "If there are no losses, we'll at least get some [investment] float on the money."
A Shared Liability
Another area where insurers are insisting that companies share risk is directors' and officers' insurance. Stung by the increased costs of securities litigation, D&O carriers are demanding larger co-payments over and above any deductible paid.
The strategy is an about-face for the industry. In the mid-1990s, most carriers actually waived the co-insurance element requiring corporations to absorb a percentage of per-claim costs for what was then a nominal additional premium charge. Before long, they waived that additional charge as well. "Basically, D&O insurers were taking on greater exposure to loss and not charging for it," says Steven Anderson, managing director of Marsh's FINPRO unit.
The strategy failed. By not requiring companies to pay a percentage of losses, insurers say, there was little incentive to curtail litigation settlement costs. "Companies no longer had a financial stake in what the settlement amount would be," explains Anderson. "Since they had no skin in the game, it became immaterial if the settlement was $20 million or $50 million, provided it was within their overall D&O limits."
Insurers argue that the increasing number of earnings restatements will only fuel shareholders' resolve to sue, and they are reinstating the co-insurance element. Such carriers as AIG and Chubb have already announced that they are requiring it, and the rest of the market is expected to follow suit by the end of the year. "The only question is the amount of co-insurance demanded," says Anderson. At a minimum, companies will have to fork over 20 percent of per-claim losses above the SIR. Meanwhile, the cost of new policies will be at least 30 percent higher than what companies paid two years ago for full coverage.
Sidebar: Where the Losses Are
U.S. insurance losses from the terrorist attacks will be second only to the long-term costs of asbestos liability.
Source: Tillinghast-Towers Perrin