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Insurers' woes are mounting -- and your company's coverage may be at risk.
David M. Katz, CFO Magazine
April 1, 2003
The scary thing about the demise of Reliance Insurance Co. was the sheer speed of it. As recently as December 1998, the property/casualty company was reporting a $1.7 billion statutory surplus, the biggest in its 181-year history. That same year, Reliance also boosted its profit to $585 million, a huge increase from the $62 million in earnings it recorded the year before.
But then, out of nowhere, Reliance fell into a tailspin. By the end of 1999, an onerous debt load and heavy workers'-compensation reinsurance losses had pushed the insurer toward the brink of insolvency. In its 1999 annual statement, Reliance management acknowledged that the company had lost $500 million of its surplus, on the heels of a $177 million loss in net income. That was followed by another net income loss of $198 million in 2000. A resultant salvage attempt by state insurance regulators failed, and in October 2001, M. Diane Koken, Pennsylvania's insurance commissioner, ordered the liquidation of the venerable company.
In the end, Reliance's liabilities outstripped its assets by $1.2 billion, making it the largest insurer liquidation in U.S. history, according to the Insurance Information Institute (III). But the size of the failure wasn't the only thing that disturbed commercial insurance buyers; many wondered why Reliance's financial woes had slipped under the radar of some top rating agencies for as long as a year. In fact, up until June 2000, A.M. Best Co. rated Reliance's financial strength as an A- (excellent), while Standard & Poor's assigned the insurer an A- (strong), according to Schiff's Insurance Observer.
Wayne Salen, then director of risk management for New Millennium Care, a nursing-home operator and customer of Reliance, recalls watching anxiously as the insurer's Best rating plunged first to a "secure" B++ (very good), then to a "vulnerable" B (fair) in little more than a month. And, although Salen was able to secure coverage with a new carrier, he worries that the Reliance debacle may not have been a one-off event. "It was shocking how fast it happened," he recalls. "It makes it incumbent on us to check the ratings quarterly — or even monthly."
Watch the Watchers
Salen is not alone in worrying about the health of the insurance industry. To a fair number of seasoned buyers, the reliability of corporate insurance policies has not been this shaky since the mid-1980s.
That's saying something. During that previous period, key liability coverages became practically unavailable, and 100 percent premium boosts were not uncommon. In addition, massive failures, such as those of Transit Casualty, Mission Insurance, and Integrity, had Congress threatening a federal takeover of the state-run insurance regulatory system.
Nothing like that surge of insolvency has happened this time — at least not yet. In fact, according to Weiss Ratings, the number of property/casualty insurer failures dropped from 39 in 2001 to 20 in 2002. The reason? Even though investment income was way off for most insurers last year, indemnifiers raised premiums high enough to assure their survival, says Stephanie Eakins, a Weiss financial analyst.
What insurers haven't been able to curb, however, is the number of property/casualty rating downgrades. Best, for instance, issued 151 ratings downgrades for insurers last year, up from 77 in 2000. And it's this perilous decline that should have CFOs poring over the analytical reports issued by insurance-industry rating agencies. Why? Despite missing some red flags in the past, the ratings that agencies such as Best, S&P, Moody's, Fitch, and Weiss bestow on insurers remain the best first step in assessing their financial strength.
At Peabody, Massachusetts-based athletic footwear and apparel supplier Saucony, for example, CFO and COO Michael Umana relies heavily on credit ratings in sussing out the reliability of insurers. Two of Saucony's main insurers, AIG and Chubb, get an A++ rating from Best, and Umana says he "puts a lot of value in that rating." Conversely, he is not as pleased about the financial health of Lloyd's of London, Saucony's business-interruption carrier, which is currently rated A- by Best. But, says Umana, "Lloyd's insures risks that many others won't touch."
Some insurers, however, claim CFOs should look beyond credit ratings to gauge the true financial health of a carrier. Arch Capital Group Ltd., for example, currently holds an A- rating from Best. But the carrier was formed only in 1995, and executive vice president and CFO John Vollaro says the Hamilton, Bermuda-based property/casualty insurer and reinsurer's relative youth is a mixed blessing. While Arch's rating has inevitably been discounted because of the company's short history, the businesses it has underwritten aren't saddled with the burdensome liabilities more-seasoned companies face, Vollaro contends. He argues that the period during which an insurer experiences premium growth is just as important as the magnitude of that growth, and should be taken into consideration in the rating. Moreover, he insists that measuring the staying power of any insurer should be a process that also includes examining how much exposure there is to adverse reserve development and to reinsurance receivables. "Don't blindly follow ratings," he warns.
Still Lurking About
If the advice seems somewhat self-serving, it's also spot-on. The truth is, it's hard to encapsulate the complex financials of a large insurance company in a single letter rating.
As industry watchers note, big insurers — those that typically write a variety of policy types — face sizable problems these days in setting up adequate loss reserves. The numbers tell the tale. All in, the loss reserves of property/casualty commercial-lines insurers were deficient by $36 billion in 2001, according to a recent study by financial services firm Conning Research and Consulting. That's a 17 percent shortfall. Says Carol Fox, director of risk management for Convergys Corp., which lists ailing Kemper Insurance among its carriers, "This is the worst I've seen it, and I've been in risk management since the mid-1980s."
Some of the gap undoubtedly stems from the inherent unpredictability of many commercial insurance risks. During the soft market of the 1990s, for example, insurers began offering riskier products — including directors' and officers' coverage and medical malpractice insurance — and then failed to get adequate premiums for those high-risk policies. In their defense, says Pat Gallagher, president and chief executive officer of Arthur J. Gallagher & Co., a large commercial insurance brokerage, it's almost impossible for a property-casualty carrier to predict the future cost of their policies. "You don't know anything about the cost at the time you sell your product."
The unprecedented nature of the September 11 attacks, of course, only heightened concerns that insurers are groping with new — and unforeseeable — perils. Besides the human and financial toll (the III puts the total insured loss figure at $40 billion), the events of 9/11 produced catastrophic losses in lines that had never taken such hits before, particularly workers' compensation.
Then there's the mounting terrorism-related claims, which led to the industry's push for a government bailout. Last November it got it, along with the ability to cap liabilities and price the risk of terrorism into policies. But the law expires in three years, and many insurers say they're still not sure how they'll price the exposure once government backing goes away.
n addition, industry watchers say carriers are currently grappling with a new round of asbestos claims — this time from people with little or no disability. And perhaps as damaging as the asbestos claims themselves are revelations that some insurers massively miscalculated their asbestos-related risks. In January, three of the biggest property/casualty carriers (Travelers, ACE, and Chubb) announced hefty fourth-quarter charges against earnings to bolster their asbestos reserves. The Travelers charge was particularly unsettling, with the insurance giant taking a huge, $1.3 billion aftertax hit.
This One Goes to Chapter 11
This welter of problems currently dogging sellers of commercial insurance might not get better for some time. And that is definitely bad news for buyers. While struggling carriers can resort to layoffs or mergers to get healthy, the result is often poor loss-control services and a slowdown in claims payments.
Right now, it can't get much slower. Michael Weinstein, director of research at Conning, says the loss-adjustment expense (the cost to both the industry and its clients of settling claims) has risen 11 percent and 16 percent in the past two years. The percentage, which often indicates the involvement of lawyers to help settle disputes, is expected to bump up another 13 percent this year.
It's pretty easy to figure out why the loss-adjustment numbers are rising. With the insurance industry in its worst funk in 15 years, Weinstein says, carriers "are fighting claims harder." What's more, if a carrier does wind up in liquidation, big corporate customers will find few avenues of recourse. While state insurance-guaranty funds are designed to protect corporations from insurers gone bad, about 30 of those funds exclude large companies from protection. Worse, about half of those state-run funds can go after a policyholder for payment of a claim — if the company's net worth is greater than $50 million.
Moreover, practically all state funds cap the amount a policyholder can recoup per claim: the caps range from about $100,000 to $1 million. And Salen, now director of risk management for Niagara County, New York, says that even if a policyholder is entitled to the money, extracting it from a regulatory body is more time-consuming than getting a claim paid by a private carrier.
Not unexpectedly, the threat of insurer insolvency has moved some corporate executives to consider alternatives to conventional coverage. After more than a year of closely watching the downgrades, layoffs, and other troubles at Kemper, Convergys's Fox learned early this year that the insurer would be selling off high-risk accounts — including, apparently, Convergys's policy. Since the company's coverage with Kemper is set to expire October 1, the risk manager will probably find a new insurer or form a captive to cover the company's own risks — a possibility Convergys's management is seriously considering.
Fox thinks CFOs faced with teetering insurers would do well to discuss even-more-radical risk-financing scenarios with their risk managers. "A wonderful conversation for a company to have internally," she says, "is, 'What would we do if our insurers are no longer there?' "
For some, that may turn out to be more than just a theoretical discussion.
David M. Katz is assistant managing editor of CFO.com.
How Healthy Is Your Insurer?
Comprehensive assessments of insurers can be hard to come by. And while many state insurance regulators require carriers to report risk-based capital ratios and pass an IRIS (Insurance Regulatory Information System) test to assure financial stability, such gauges are only "a quick triage to measure a company's health," says Steve Dreyer, a managing director of Standard & Poor's insurance ratings. "They don't provide a comprehensive assessment."
So how better to determine if a carrier could be headed for trouble? Beyond monitoring basic financial metrics and credit ratings, experts say finance chiefs should be on the lookout for the following signs of trouble:
1. Poor Spread of Risk. Writing too much business in a troubled line — medical malpractice liability, for example — can tie up an insurer's reserves and affect earnings. The St. Paul Cos., for instance, had inked so many medical malpractice policies that staying in that business reportedly threatened the company's solvency. When the big carrier announced it was exiting the line in late 2001, says David Parker, director of risk management for Pima County, Arizona, it created "the world's biggest sucking sound" among its many insureds. Other high-risk policies: workers' compensation and directors' and officers' liability.
2. Lots of Reinsurance Recoverables. The fate of reinsurers has long been a leading indicator of insurer financials. Pounded by 9/11 losses and their own loose pricing, reinsurers have reportedly been questioning payments more aggressively. "You're seeing a deterioration of the credit quality of those recoverables," says Marc Serafin, an analyst with Moody's Investors Service. While the quality of a carrier's reinsurance protection might be tough to gauge, experts say the management discussion and analysis section of a carrier's 10-K is a good place to start.
3. Excessive Growth. Signing on scores of new policyholders might be too much of a good thing — if the sales expose a carrier to excessive risk. The keys are pricing and timing. A big surge in customers right now (when carriers are charging high premiums) might be no problem, says Matt Mosher, vice president of property/casualty ratings for A.M. Best. But growth of 50 percent or more should trigger questions. One rule of thumb: if an indemnifier rakes in three times as much in premiums as it holds in surplus (called the premium-to-surplus ratio), be wary. Most of the industry is below the 2-to-1 ratio, says Mosher.
4. Earnings Charges. By all accounts, posting adequate loss reserves is a key measure of an insurer's financial strength. In the fourth quarter of 2002, for example, Travelers, Ace, and Chubb all took big hits to cover asbestos liabilities. Some observers applauded the write-downs, noting that insurers should be conservative in their accounting. Others said the companies had blundered in putting those risks on their books in the first place. Both were right. But make no mistake, when an insurer slashes earnings to boost loss reserves, the carrier's management is admitting to a loss exposure it hadn't counted on.
5. Low Net Income or Losses. A drop in profit might signal that an insurer isn't doing its job well. At the very least, buyers should make sure carriers aren't overcharging to make up for income shortfalls, advises Stephanie Eakins, a financial analyst with Weiss Ratings. "If they're losing money," she warns, "that's going to eat into their capital." Damian Testa, president of New York-based broker Kaye Insurance Associates, says losses become a double whammy if they're out of step with the industry as a whole.
6. High Assets to Liabilities, Low Cash Flow. By law, carriers must run a cash surplus to back their underwriting business. Cash-rich insurers routinely show assets outstripping debt. But experts say a healthy debt-to-equity ratio won't fix a negative cash flow. Even balance sheets flush with cash may not be as healthy as they seem, warns Testa. Why? Because the insurers "can't get at the cash."
7. Earnings Volatility. If forced to pick the single most-reliable indicator of an insurer's stability, S&P's Dreyer would choose earnings volatility. Big shifts in earnings, either up or down, are a harbinger of trouble. "Even if the swing can be explained," he notes, "you are probably well served to avoid those companies." —D.K. and Marie Leone
What's My Line?
Whether shopping for or renewing their coverage this year, companies will find several factors affecting cost in different lines of insurance.
General Liability. Most buyers will see moderate premium increases from 2002 rates. But insurers are also primed to palm off more risk on companies in the form of higher deductibles to counter inflation of medical costs and jury awards. For those finishing up three-year contracts, or in risky business areas (firearms, toys, medical products), expect carriers to make up for lost ground by raising premiums above the industry average.
Property. Lower increases is the good news here, but buyers will have to make a compelling case. Insurers, which likely overcharged clients with 100 percent to 300 percent premium increases, were compensating for one-time catastrophic disasters — like Hurricane George, the Millennium Bug, and the $40 billion in insurance losses caused by the September 11 attacks. But they are ready to listen. This is the year to renegotiate premiums and underwriting risk.
Worker's Compensation. Rising medical costs guarantee a 10 percent to 30 percent premium rise for most companies, but if you're coming off a three-year contract, brace yourself: a 100 percent increase could be possible. Some carriers may offer higher deductibles in place of dizzying premium increases, though. Meanwhile, if you operate in a state that bases benefits on demographic profiles, be prepared to furnish underwriters with all sorts of fine-tuned employee data.
Directors' and Officers'. Double and triple rate rises are predicted for companies that can't convince underwriters that their risk profiles haven't worsened since the Enron debacle. Pundits of this long-tail business blame rising premiums on a swell of shareholder lawsuits and several bankrupt D&O carriers. No one expects the effects of either to subside anytime soon. Deductible limits will increase to between $5 million and $10 million, and it won't be unusual for the Fortune 100 to see deductibles of $25 million.
Employment Practices Liability. Large employers will bear the brunt of the 35 percent to 100 percent premium hikes, while smaller companies will wrangle with 10 percent to 25 percent increases. Mass-claims ploys — lawsuits that target famous brands and push for a settlement before airing the icon's dirty laundry in the press — are the modus operandi here, and they're working. Buyer beware: if your aim is to protect a brand, deductibles could reach $1 million. —M.L.