March 1 2002 by Russ Banham
As just about every CEO in America demands departmental cutbacks to survive this recession, the nation’s risk managers, whose job it is to purchase insurance, are handing in bigger budgets-as much as twice that of last year. They are bedeviled by an out-of-control commercial insurance market. Just look at the Meadowlands Sports Complex in East Rutherford, N.J., the stadium in which the New York Giants and Jets football teams play. The complex, which seats close to 70,000, recently reported that its liability premium had tripled to $2.4 million from $700,000.
September 11 and, to a lesser degree, Enron’s bankruptcy have caused premiums in many lines-particularly workers’ compensation, directors’ and officers’ liability, property, fidelity, aviation and surety-to skyrocket. Along with the higher prices is the insurers’ requirement that corporate buyers retain more risk on their balance sheets, with deductibles in many lines now double what they were in 2000. Add it up and companies are paying a much higher premium for a lot less coverage.
These problems pale when compared to the most disturbing news from the commercial market: the industry’s refusal to provide coverage to absorb future terrorist incidents.
“The possibility of financial loss is so huge and so unpredictable that there is no tolerable premium level insurers could charge that could sustain the magnitude of risk,” explains Mike McGavick, chairman and CEO of $7.1 billion SAFECO Insurance Co. in Seattle.
The estimated $40 billion in loss produced by September’s tragic events-which could end up being much more-is a catastrophe that insurers and reinsurers are only beginning to pay out. The disaster caused the industry’s single largest loss, with the second-largest, Hurricane Andrew, an $18 billion loss by comparison. In terms of the property destroyed and the thousands of lives lost, September 11 is also history’s first workers’ compensation catastrophe. According to the Insurance Information Institute, U.S. insured catastrophe losses for 2001 will set a record of $24 billion, compared with $4.3 billion in 2000. Second-highest losses were in 1992, with $22.9 billion.
So companies are handing off the pain. “For insurers to maintain even a modest level of profitability, additional increases of 20 to 30 percent in the premiums were needed in many lines,” explains Joe Plumeri, chairman and CEO of Willis Group Holdings Ltd., a New York-based insurance brokerage with a market capitalization of $3.4 billion. In some cases increases were double or triple what they were. Airlines and firms with aircraft are paying much higher premiums, as are companies with high-profile office buildings, large employee concentrations in one location and operations in big cities.
Prelude to a fall
But even before the attacks ripped a hole in the industry’s capital base, property and casualty insurers were hiking premiums an average of 15 to 30 percent. The culprit was not Osama bin Laden, but the falling stock and bond markets, on which insurers depend to compensate for poor underwriting results. The robust investment returns in the 1990s had permitted insurers to charge less for their products than the losses those products would produce. In 2000, for example, the industry paid out $1.11 in losses for every dollar of premium taken, with the shortfall made up by the substantial investment returns. But when the stock and bond markets faltered in 2001, premiums had to rise.
Companies that renewed their policies on Jan. 1 were the first to get the bad news-that the current environment differs dramatically from the one in the past decade. The 1990s’ fiercely competitive market was one of history’s longest, a consequence of severe overcapitalization. To effectively deploy that capital for shareholders, publicly traded insurers cut prices and deductibles, the latter to zero in some lines like workers’ compensation. As the decade wore on, says McGavick, “it was clear the prices being charged were inadequate to meet claim costs.”
More frequent and severe claims attributed to higher medical costs, and soaring jury awards, coupled with deteriorating investment income, compelled insurers to raise prices in late-2000.
The expensive market is now guiding many companies to forego conventional insurance. Penn Tank Lines Inc., a $55 million Malvern, Pa.-based petroleum transportation company, is buying liability protection through Fleet Solutions Ltd., a Bermuda-based captive insurance association. “We’ve joined with others in our industry that have excellent risk management controls to basically insure each other for general liability, automobile liability and workers’ compensation,” says John A. McSherry, Penn Tank Lines president and CEO. He estimates that his company will save 20 percent this year compared to what he previously paid for traditional coverage.
Some companies are battling higher premiums by retaining more risk internally. Told by its broker that the cost of its commercial automobile insurance would double when the policy renews in February, New York book publisher Scholastic Corp., with $2 billion in revenues, is mulling much larger deductibles, admits Vincent Marzano, vice president and treasurer. By transferring less risk to an insurance company, the cost is reduced, similar to taking a higher deductible on a car insurance policy.
Retaining more risk is cost-effective only if stringent attention is paid to managing it. NOVA Chemicals Corp., for example, quadrupled its property deductible to $70 million for claims from fire, explosions and resultant loss of income in 1994, when its peer companies were more likely to have deductibles in the $1 million range. “We believed that it didn’t make any sense to buy what was expensive insurance given our strong management of risks and effective loss-prevention efforts,” says Brad Silver, risk manager at the $4 billion Pittsburgh-based chemical company. That decision has saved the company roughly $25 million over the intervening years, Silver says. Following a recent merger with Trans-Canada Pipelines and a reorganization in which it spun off its energy business, NOVA has reduced the deductible on its property program to $50 million.
Now, CEOs are especially concerned about the paucity of insurance available to cover terrorism. Within weeks of September 11, the industry filed with state regulators to exclude terrorism as a covered exposure in standard property and casualty policies. Only workers’ compensation policies continue to cover terrorism in full.
The action was fueled by reinsurers-large financial institutions that absorb layers of risk from insurance companies for a premium. “The magnitude of loss now is far greater than anyone ever contemplated and the frequency of loss is completely unknowable. Thus, our policy, at present, is to exclude terrorism coverage,” says Andreas Beerli, CEO of the Americas division of Zurich-based reinsurer Swiss Re Group. Unable to spread terrorism exposures through reinsurance, an insurer would have to bear the risk on its own balance sheet-too dicey for many to consider. “Terrorism for us became an uninsurable risk for the same reason that war is excluded,” says SAFECO’s McGavick.
There is some insurance available, although the amount of coverage is paltry. Companies basically have two options: negotiating a new property policy at renewal that includes a separate “endorsement” covering terrorism or buying a separate terrorism policy altogether.
The first option presents no more than $5 million worth of coverage. The second option-a separate terrorism policy-offers greater coverage, as much as $150 million per terrorist incident, but it’s expensive. “We’ve seen rates ranging from 2 to 10 percent [of the values covered],” says John T. Sinnott, chairman and CEO of New York-based Marsh Inc., the flagship of Marsh & McLennan Cos., the world’s largest insurance brokerage.
Three groups offer the standalone policy: American International Group, Berkshire Hathaway and Lloyd’s of London. But brokers find it difficult to combine the limits of financial protection available in each policy to afford wider protection, common with other insurance lines. “Each facility defines €˜terrorism’ differently and offers different coverage elements,” Sinnott explains. “It’s hard for us as a broker to stack the limits to provide more than $150 million in coverage for clients.”
For a company facing a multi-billion-dollar exposure, such as the owner of a Manhattan skyscraper, $150 million in insurance is a pittance that may not be worth the cost. Many companies, in fact, are passing. “We’re likely to go €˜bare’-without insurance,” says the risk manager of a large utility. “There’s just not enough insurance available to cover the financial severity.”
To entice insurers to provide higher protection limits, the industry wants the federal government to backstop its unlimited liability. In the meantime, there is hope that several new insurance and reinsurance companies formed since September 11 will augment capacity for terrorism risks. “We will consider underwriting terrorism on a case-by-case basis, looking carefully at geographic concentrations to spread our risk the best we can,” says Kenneth LeStrange, chairman and CEO of Endurance Specialty Insurance Ltd., a Bermuda-based property and casualty insurer and reinsurer capitalized at $1.2 billion. As to how much and when, LeStrange would not elaborate. “We’ve just opened our doors,” he notes.
The pricey insurance market is likely to persist for at least the next two to three years. “My advice to CEOs is to work closely with their agents or brokers to make sure they’re getting solid advice about the insurers whose products best match their risks,” says McGavick. CEOs also need to consider the solvency of certain insurers’ being downgraded by rating agencies as the full impact of September 11 becomes apparent.
Marsh’s Sinnott offers optimism that the worst is behind us. “Perhaps September 11 is a random event and not a precursor of more to come. Until that is assured, only a federal backstop will help speed a viable insurance market for terrorism risks, before there is further damage done to the economy.”
The Bucks Stop Here
Federal legislators are expected to look hard at the dearth of insurance to absorb corporate risks from terrorism. While the House of Representatives approved legislation in November creating a co-insurance mechanism to reduce insurers’ aggregate losses, the Senate failed to get its bill off the floor. The bills are different: The House legislation would create a fund to cover 90 percent of terrorism-related losses exceeding $1 billion up to $100 billion; the Senate bill would limit insurers’ aggregate losses from terrorism to $10 billion, above which the government would pay the tab.
Other proposals are also on the table, including one by Warren Buffett, chairman and CEO of Berkshire Hathaway, which would create a mechanism similar to the Federal Deposit Insurance Corp., which protects depositors against the loss of their deposits due to bank insolvency. Another proposal models the safety net on an insurance pool created in the United Kingdom in 1992 after a series of Irish Republican Army bombings. Called Pool Re, the mechanism has paid more than $854 million in terrorism claims to date. “The pool was established for the same reasons that the U.S. Congress is now thinking about a safety net-the U.K. insurance industry indicated it would withdraw its capacity for terrorism exposures due to the uncertain costs of another incident,” says Andrew Hicks, a managing director at London insurance broker Willis Risk Solutions.
Pool Re is structured as a mutual insurer, owned by insurance and reinsurance companies that contribute a percentage of their premium income to the fund. The U.K. government reinsures the pool, picking up the cost of losses from a terrorist act above a certain level. Hicks believes Pool Re would need to sustain a loss above $3.5 billion for the government to foot the bill above that amount.
At this stage, it’s unclear which, if any, course Congress will pursue. The U.S. Treasury objects to the creation of a Pool Re-type mechanism, likening it to a costly government-sponsored enterprise like Fannie Mae. Buffett’s concept has attracted few adherents and the Senate’s bill has received stiff opposition from plaintiff attorney groups. Moreover, a slowly burgeoning insurance market to cover terrorism risks may mute the cry for a federal backstop. “There are anecdotal reports that the coverage limits for terrorism risks are inching up from $150 million,” says Jeffrey Tassey, a partner at Washington law firm Williams & Jensen. “If federal legislators believe a market solution to a crisis is inevitable, it would take the wind out of the sails for a safety net.”