Currently, the United States is suffering through what some say is the most challenging economy since the Great Depression.
Major financial institutions that many thought were "bullet-proof" have gone out of business, been sold or gone into partnership with the government.
Who would ever have thought, for example, that AIG would need nearly $125 billion from the government to stay in business?
At the same time, the insurance industry is well into a "soft" market cycle, and is starting to feel the effects of substantially reduced pricing. Deteriorating underwriting results and lower investment returns are beginning to take their toll.
So what kind of shape is the insurance industry in? In order to understand what might happen in 2009, it helps to understand a little bit about the insurance business.
Insurance Cycles-Where We Are Now
Like many industries, the insurance industry is cyclical. However, the insurance cycle generally runs independently of other business cycles.
Insurance companies make money in one of two ways:
- Underwriting profits
- Investment outcome
An underwriting profit is achieved when losses plus all expenses are less than premiums. When you divide the former by the latter, you come up with what is called the combined ratio. A combined ratio of less than 100 percent means there is an underwriting profit, and a combined ratio of more than 100 percent means there is an underwriting loss.
The industry has generated an underwriting profit in three of the last four years. It remains to be seen if 2008 will generate an underwriting profit. Note that this period of profitability followed substantial underwriting losses in 2002 (107.3 percent) and 2001 (115.6 percent). The underwriting profit in 2006 was the best the industry had posted since the 1940s.
Insurance companies collect premiums and set aside reserves to pay future claims. This represents an insurance company's policyholder surplus. The insurance industry generates investment income from the policyholders' surplus. During periods of substantial investment returns, insurance companies may be willing to underwrite at a loss because they can make up the deficit on the investment side.
Surplus is critical to understanding the economics of the insurance industry. Surplus is set aside to pay future claims, and also determines how much premium an insurance company can safely write. If the ratio of premium to surplus gets too high, the insurance company's credit rating (as quantified by the A. M. Best Company and other rating agencies) could ultimately impair the insurance company's ability to operate.
It is important to understand that the insurance industry is supply-driven. While demand for insurance remains relatively constant, supply fluctuates up and down. If surplus or supply goes down, rates tend to go up. Similarly, if surplus goes up, rates tend to go down. The industry's surplus has increased approximately 85 percent since 2002. This has caused insurance pricing to go down, and in some cases, to go down dramatically.
Finally, it is important to realize that the insurance industry competes with every other industry for capital. In order to attract investment dollars, the insurance industry has to demonstrate an acceptable return on equity. Most investors seek approximately 15 percent. Historically, the insurance industry has underperformed this objective; however, results have improved dramatically in recent years. In fact, 2006 was one of the industry's best years ever, generating a return on equity of approximately 13.9 percent.
The industry's operating results, however, have begun to deteriorate. Net written premiums actually decreased in 2007, and are supposed to decrease further in 2008. This rarely happens in the insurance business.
At the same time, combined ratios are climbing. Although 2007 should be a positive year, 2008 may or may not generate an underwriting profit. Preliminary indications put the overall combined ratio for the first half of 2008 at 102.1 percent. This is a result of continued soft pricing, challenging market conditions, unusually high catastrophic losses and significant underwriting losses. Policyholders' surplus also declined in the first six months of 2008. Recognize that these results were posted prior to the AIG debacle, the impact of which remains to be seen.
Pre-tax operating income has also declined. Net income after taxes for the first six months of 2008 fell more than 50 percent from what was reported in 2007. This is attributable to the deteriorating underwriting results as well as declining investment returns.
Finally, return on equity, after peaking in 2006 at 13.9 percent, dropped to 12.1 percent in 2007, and is estimated to drop to 8.7 percent in 2008.
What Effect Will This Have on Rates?
For the last five years, rates have decreased significantly on almost all lines of coverage, with the exception of coverage for coastal properties on the Gulf Coast and in Florida as well as other catastrophic-type lines of coverage, such as earthquake.
MarketScout.com is an electronic insurance exchange that measures the average change in rates for the property and casualty insurance industry in the United States. Although this is merely an average across the entire country for all lines of coverage, it is still a good barometer of the insurance market.
Workers compensation rates are a major factor in the recent rate decreases. In California, for example, comp rates peaked in the second half of 2003. The average rate per $100 of payroll was $6.46. Rates hit bottom in the second six months of 2007, dropping nearly 62 percent. Rates flattened out during the first six months of 2008, and will probably increase in 2009.
What Can You Expect in 2009?
In general, the insurance industry remains in good shape. The industry remains profitable and industry surplus is near all-time highs.
The trends, however, are not positive. The ultimate impact of what will happen with AIG remains to be seen. If for some reason AIG were to lose its "A" Best's rating, billions of dollars of business would be out on the open market, and this alone could dramatically change the insurance marketplace.
Because of this and other factors, Standard & Poor's Ratings Services (S&P) revised its outlook on the U.S. commercial lines property and casualty insurance sector to negative from stable. S&P was concerned over two issues:
- The ongoing decline in pricing for commercial lines
- Decreases in investment income
Fitch Ratings feels the same way. It believes that the market has crossed a tipping point in the underwriting cycle... knowing that industry returns on capital for current accident year business has slipped to inadequate levels. Fitch anticipates that the marketplace will deteriorate further.
Looking forward, 2009 should still be a positive year for insurance buyers. Although the industry is trending down, strong market capacity and competitive factors are still decreasing pricing in many areas. Following is a line-by-line analysis of what building industry members can expect in 2009:
The Admitted Market-The admitted or standard market is generally comprised of those companies that are writing mainstream or preferred business. The standard market remains competitive, and in general, preferred risks are seeing premium decreases of 5 to 10 percent and in some cases more.
Property-Property insurance costs have dropped dramatically over the past several years. Preferred property risks might continue to see decreases in 2009. Regardless, the recent hurricane activity will impact the property insurance market, especially those properties subject to wind-driven damage. Depending on the desirability of the property risk and previous year rate decreases, we are expecting flat to 10 percent rate decreases in 2009.
Casualty-Casualty-which includes such things as general liability, automobile liability and excess liability-has seen rate decreases consistently since 2004. While these rate decreases have been declining for the right account, there could be further discounts in 2009. Once again, this will depend on the individual risk, its loss history and price decreases in previous years. As the insurance market has improved and competition has heated up, many of the standard carriers have also expanded their appetite into areas that traditionally have been underwritten by excess and surplus lines carriers.
Developers and Contractors General Liability-The construction industry can be divided into residential construction and everything else.
In general, rates for the construction industry have declined just as they have for the balance of the market. It appears, however, that these rates have hit bottom, and we do not anticipate further rate decreases for construction-related risks in 2009.
Underwriting for this class of business has not changed significantly either. Most construction-related policies still have significant exclusions in addition to the standard exclusions found in the ISO Commercial General Liability Policy Form. Almost every policy excludes multi-family housing, and it is not uncommon to see exclusions for prior work or damage, subsidence, mold, silica, restricted contractual liability coverage, electromagnetic fields and a variety of coverage restrictions for construction defects such as exterior installation and finish systems (EIFS). The list of exclusions goes on and on. It is imperative that design and construction professionals review the policy form on any coverage they consider purchasing.
Professional Liability-Rates have trended down significantly for architects, engineers and other professionals over the last five years. We have now reached a point where underwriters are trying to retain their existing rates. In some cases, they are trying to charge more, often with little success.
Despite the soft market, these programs are carefully underwritten. It is imperative that a design firm's annual application for coverage accurately reflects the attributes of that firm and the positive steps they are taking to effectively manage their risk.
Workers Compensation-Every six months, the Workers Compensation Insurance Rating Bureau (WCIRB, a.k.a. "the Bureau") of California publishes and recommends loss costs for each workers compensation classification. Since 2004, each recommendation has been for a rate decrease. Collectively, these rate decreases have totaled over 60 percent. The insurance commissioner has an opportunity to review these "pure premium" rates and come up with his or her own rate recommendations.
Regardless of what the Bureau or commissioner decides, these rates are advisory. Insurance companies have the option of choosing whatever rate they want. Although most companies do not exactly follow the Bureau's recommendations, overall the market tracks pretty closely with them. For many years, the industry was horribly unprofitable. From 1995 through 2002, the best-combined ratio they could produce was 115 percent (for every dollar the industry took in, it spent $1.15). In 1999, the combined ratio was actually 187 percent.
Since 2003, the industry has been very profitable, generating significant underwriting returns in each of the last five years. However, the industry has now reached the point at which underwriting profits might turn into underwriting losses.
Because of increased medical costs and other factors, for the first time in five years the Bureau is recommending a rate increase of 16 percent. Subsequently, the Insurance Commissioner recommended a smaller increase of five percent.
Not every insurance company will take the recommended increase. Regardless, if you look at what's happened to rates in California since 2003, you will note that they have decreased by more than 60 percent. Adding 16 percent on top of the rate decrease still generates a net rate decrease of more than 55 percent.
While not every insurance company will adopt the large rate increase the Bureau recommends, or the modest increase suggested by the commissioner, it is almost certain that workers compensation rates in California will go up. Recognize, however, that net rates (the rate paid after application of all credits and debits) are affected by a number of other factors, including a company's experience modification, and credits or debits the insurance company might apply. Recognize as well that the average rate increase (and/or decrease) is not spread equally among all classifications. Rates vary depending on the experience of each individual classification. Assuming all other things remain equal, however, it is anticipated that workers compensation rates in California will be plus-5 percent to plus-20 percent in 2009.
Insurance costs are only one element of the "total cost of risk." The total cost of risk is what an organization pays to identify risk, figure out ways to manage and transfer the risk (usually to an insurance company). In the long run, the only way to lower the total cost of risk is to lower the underlying losses that drive those costs. Whether or not we are in a hard or a soft market cycle, a well-run company will continue to look for ways to effectively lower the frequency and severity of their loss exposures. When rates are decreasing, it's easy to lose focus on risk management efforts. However, this is not the time to stop investing in risk control programs.
This article, by nature, is a general overview of the insurance industry. Projections are based on assumptions that could change. To more accurately estimate insurance costs in 2009, it is recommended that design and construction professionals discuss their specific situation with their insurance brokers and insurance underwriters.
Construction Business Owner, February 2009
