Maine Townsman, January 2003)
by J. Alan Johnson, CPCU, ARM, AIS, owner The Johnson Agency, Madisonville, TN
Over the past two years, municipalities and businesses nationwide have seen increases in insurance premiums, decreases in coverage, and a severe tightening of the property and casualty insurance market – all in accordance with predictions made in October of 2001. Because the cost of insurance and risk management programs makes up a significant portion of municipal budgets, it becomes extremely important for public officials responsible for local budgeting to have an understanding of the insurance process and why certain things are occurring.
Before September 11th
During the decade of the 1990s, business operations in the United States enjoyed the longest period of sustained peace time prosperity ever experienced in our history. In this period, our economy moved along with gains each and every quarter at some of the lowest inflation rates since the beginning of the industrial revolution. Manufacturers’ output was so great that almost every market in the U.S. became a buyer’s market due to the overabundance of goods and services offered to the American people.
During this period of prosperity, the insurance industry was no exception. Due to low catastrophe and other unforeseen losses, and coupled with the insurance industry’s ability to invest huge amounts of premium dollars in the skyrocketing investment markets, insurance companies were able to realize substantial investment gains before having to pay out those dollars for losses. Almost every property and casualty insurance company and most life insurance companies changed their corporate philosophy from “Risk Assessment” underwriting (where the company looked at the type and severity of the risk they were insuring and charged a premium according to that risk) to a “Cash Flow” underwriting philosophy (where companies decreased their pricing and increased coverages without consideration of the level of risk in order to increase market share and thus increase premium income, resulting in increased amounts of premium dollars they had to invest). Using Cash Flow underwriting philosophy, companies were able to ignore, up to a level determined by their investment income, the amount of losses they sustained. Therefore, over the past 8 to 10 years, most insurance companies have been able to operate with combined loss ratios of 1.12 or higher. This means that insurance companies were paying $1.12 (or more) for losses and expenses for every $1.00 they collected in premium – but with the return realized on investments, the insurance industry as a whole was still making a profit!
However with the downturn in the general economy which began mid-2000, the bubble started to deflate. With insurance companies unable to cover their underwriting losses with investment income, the bottom lines of almost all insurance companies started to falter. Throughout 2001, the insurance industry witnessed even the giant companies in the business start to lose their A+ financial ratings. This downturn in the insurance cycle was not the result of higher losses, since losses for the most part have maintained their historical level in relation to the amount of insurance written, but simply coincided with the downturn in the general business cycle in the U.S. This particular downturn was the result of the close ties to the profits or losses resulting from financial investments.
In order to shore up the financial strength of insurance companies (which is something we all definitely want to happen since a financially strapped company can’t pay losses when they occur), the general trend in the insurance business, starting with the first quarter of 2001, was to gradually increase rates to cover the actual cost of the insurance being purchased, and to take a closer underwriting look at the degree of risk being insured. In other words, insurance companies were starting to revert back to Risk Assessment underwriting. Thus, the higher the risk, the higher the premium was starting to go.
Both insurance companies and risk management pools specializing in municipal and governmental risk, experienced the same financial pressures that the general insurance market felt. With investment income falling, they too looked to the traditional Risk Assessment Underwriting philosophy to assure their ability to pay claims and expenses. Their re-adoption of this method of determining pricing according to the level of risk resulted in increased inspection, longer applications with more questions and ultimately, in the beginning, slightly higher premiums.
The re-introduction of “risk assessment” underwriting early in 2001, actually was only beginning to affect the larger governmental insurance buyer. For small and medium size cities, municipal insurance was still available and indeed there were several companies actively soliciting business from governmental clients. Premium levels were remaining relatively affordable also with some slight increases beginning to creep into the pricing of insurance policies, but these increases were in general reserved for larger cities and county governments whose operations posed marginally higher risk of loss. Those of us actively working in governmental insurance and risk management felt that for the near future, a slight increase in premium costs would affect most segments of the public insurance market, until prices began to equal the combined cost of losses and expenses – a time predicted to be sometime in 2003 or 2004.
That was before 9/11.
After September 11th
As a result of the terrorist attacks on September 11, 2001 not only was our national consciousness traumatized, but the financial markets, and especially the insurance markets, were also traumatized. Initial reports from “ground zero” started coming out to insurance practitioners by the afternoon of September 12th. Estimates of property damage alone were in the range of $15 to $20 billion – and these reports were being made even before on-site inspections could be made to determine the extent of damage sustained by buildings in the area. To put this into perspective, the largest single loss ever sustained by the insurance industry before September 11th was Hurricane Andrew, which resulted in losses of approximately $17 billion. Hurricane Andrew losses caused an increase in property insurance rates in Florida and other coastal states of 10 to 20 percent, the withdrawal from the market by several small insurance companies and a severe curtailment of coverage writings by most larger companies. Therefore, it became clear that the first estimates of the WTC losses for property alone were going to exceed the largest single loss event in insurance history.
From the time the first airliner loaded with fuel hit the North Tower of the World Trade Center, the insurance industry in the United States and in most of the western world went into a state of shock. A Morgan-Stanley Research Report on the Property-Casualty insurance industry issued on September 17, 2001, only 5 days after the attacks, reported a total loss amount exceeding $40 billion – and then went on to say that the amounts they estimated were unreliable and were more likely to exceed the $65 billion to $70 billion level.
Recent estimates of the final loss figures range from a low of $50 billion to a high of $95 billion (the higher figure attributed to the possibility of high liability settlements). If the higher estimates of loss prove true, there will almost certainly be several insurance company failures before the dust completely settles.
Insurance for Governmental Entities
During this period of instability, the insurance marketplace has become a virtual minefield for all classes of risk, and governmental risk is no exception. As stewards of the public trust, all government officials need to be aware of and prepare for substantial changes in both coverage and pricing of all insurance and risk products. Changes are occurring and have been occurring since the first quarter of 2001, but following the 9/11 event, the extent of change has accelerated.
One of the first changes that municipal and other governmental entities have seen is a tightening of the standard insurance market. This means that municipal property and casualty insurance accounts that are on the margins of being acceptable from an underwriting standpoint, and which before were being solicited by municipal insurance carriers, will now have a very difficult time finding standard insurance coverage. These include risk accounts which have a history of either frequent small losses, or one or more severe large losses, and those accounts who have continued to ignore loss control recommendations made by insurers in order to reduce the chance of loss.
Also included in this wholesale realignment of insurance are superior governmental accounts which have had few or no losses, but possess or control public properties that historically have the potential for loss. These include governmental entities which own or control such properties as large sports stadiums, public utilities (such as electric, natural gas and drinking water production including reservoirs and dams), highly visible public buildings (such as large courthouses or highly visible monuments), and airports (for now obvious reasons). Any governmental entity which has large property concentrations, large personnel concentrations and unsecured public utilities is potentially a terrorist target.
Please don’t misunderstand the above statement and interpret it as saying that the municipal risk and insurance market is going to disappear. In a free market society, that is simply not going to happen. Municipal risks that have been with a company for a number of years, have excellent loss experience and have been cooperative with loss control programs and suggestions will continue to maintain their coverage. But the day of shopping for alternate quotes from numerous insurance companies and risk pools who were clamoring to write your business are essentially over for the near future. And those public entities which possess or control the marginal properties as stated above, may find that the price for insurance coverage is just too high for those properties. In rare cases, it is entirely possible that insurance coverage for the largest risk properties will not be available at any price.
As stated earlier, the commercial insurance market was already starting to experience a slight tightening of underwriting restrictions. Since September 11th, the market has tightened much faster and gotten much tighter than it would have ordinarily.
The second change that municipal insurance is experiencing is increased premiums. When referring to rate and premium increases, I want to be certain that the reader of this report does not misunderstand and think that insurers raise premiums in order to recoup losses already experienced on 9/11. Keep in mind that insurance companies and risk pools are in the business of accepting the financial consequences of risk that are transferred from the governmental entity. If the insurer miscalculated what the cost of risk was – as they most certainly did with regard to the terrorist threat and the Probable Maximum Loss (PML) potential – any losses sustained because of that miscalculation is just their tough luck, so long as the insurer has sufficient surplus to pay the losses sustained. To attempt to recoup an unanticipated loss which has already occurred, with future rate increases is, in my opinion, unethical and should not be allowed.
But you also have to remember how insurance rates are formulated. Rates are determined by predicting the probability of loss for a given class of insurance. These predictions are based on a mathematical principle known as the Law of Large Numbers which states that given a large group of similar loss exposures (for example, brick buildings used for commercial purposes), and taking actual historical losses (for example, the losses to those buildings over the past 20 years), insurance actuaries can predict to an almost exact certainty, how many of those buildings will sustain a loss during a given period of time in the future. Rates are then calculated to cover the cost of the expected future losses plus the expenses of the insurance company, then this figure is spread over the entire group of exposures so that the whole pay for the losses of the few. Therefore, the prediction of future losses will necessarily have to include the losses sustained on 9/11 in the historical data. But because catastrophe losses are capped at a certain level, and the WTC and collateral losses will most assuredly be considered a catastrophe, the entire loss amount will not appear in the calculations – but a portion will certainly be included.
With an understanding of how historical loss information is included in the formulation of rates, it is a certainty that with this inclusion, rates will increase. But, this is not the only reason that rates will increase. Also included in the calculation of rates is the statistical probability of what perils will cause a loss. A peril is defined as the specific event which causes a loss, such as fire, lightning, wind, hail, etc. The 9/11 terrorist action has brought to the attention of underwriters and actuaries that there are perils that have never been anticipated and thus have never been included in the calculation of rates, or if included, only a very slight charge was made. Commercial airplanes full of highly flammable jet fuel being used as missiles is a primary example of this. The insurance industry may have ignored the possibility of these occurrences in the past, but you can bet that they won’t continue to ignore it. Therefore the inclusion of the probability of future terrorist actions and all possible consequences of those actions must be considered in future rates. This inclusion will also serve to increase rates.
Another reason rates will increase is due to the decrease of capacity in the insurance industry. Capacity in insurance is similar to supply in the capitalist marketplace. When supply is sufficient to meet demand, prices tend to stay low, and the same applies to insurer’s capacity. Prior to the September 11th event, most insurance analysts were saying that rates would increase slightly due to the decrease in investment income, but competitive pressures would tend to hold the increases to a minimum because the insurance industry had plenty of capacity. However, following September 11th, capacity suddenly dried up, mainly because of the commitment of the surplus for payment of losses. When capacity is not sufficient to meet demand, premiums go up as a natural function of the market.
Rates are also increasing as a result of persistently lower investment returns. Downturns and corrections are a naturally occurring function of the investment markets, and September 11th was the first in a series of events that made a bad situation worse. And just when our economy began showing signs of pulling out of its slump, the financial markets were hit again with news of inflated profit figures, unethical and downright crooked behavior by CEOs and corporate financial officers that were bankrupting some very large corporations. These occurrences only served to reinforce the low confidence of investors and have prolonged the current downturn.
Insurance companies and risk pools are of course in business to make a profit, either for their stockholders (if a stock company), or their policyholders (if a mutual company), or for the members of the risk pool. As stated earlier, since the third quarter of 2000, insurers have been unable to achieve the level of return on their investments that allowed them to keep their rates at artificially low levels. So if investments are not sufficient to keep them profitable, then rates have to increase to make up for the lower investment profit.
And last, but definitely not least, rates are increasing due to increased re-insurance costs. Remember that the insurance product spreads the risk of loss to a few over a great many, thus reducing the cost of risk to an affordable amount. When insurance companies accept a large risk in an amount that would hurt them financially in the event a total loss should occur, they do the same thing that the everyday insurance buyer does. They insure against the possibility of a large loss, thus spreading the risk of loss further. The companies who insure insurance companies against a large loss are called “re-insurers,” and it is this ability to pass off the risk of a large, financially debilitating loss that allows the insurance industry to function. The primary company will retain some limit of the risk, which acts like the deductible that we see on property and some liability policies. And when primary insurance companies purchase re-insurance, they too pay a premium for the coverage.
When large losses occur, and the loss sustained exceeds the retained limit of the primary insurer, re-insurers are called on to reimburse the primary company for the amount of loss that is over their retained limit. Therefore, in the event of a catastrophe, re-insurers are called on to pay the large losses that result. As a result of the historically large losses resulting from the 9/11 event, re-insurers worldwide have been affected, and they have reacted in the same manner as the primary companies have. Thus far, their reaction has included increasing rates, cutting coverages and looking more carefully at the risks they are (re)insuring, making sure that they charge more premium for the historically higher risk exposures. And when re-insurance costs go up, the premiums for primary insurance will go up.
Finally, when the risk of loss is determined to be too extreme, or too selective, insurers may choose to specifically exclude coverage for some losses. Specifically stated coverage exclusions were one of the first reactions to 9/11. Already specifically excluded in most insurance policies are losses resulting from “Acts of War” and from “nuclear” causes. Terrorism however, was not an exclusion in the majority of insurance policies prior to 9/11, and strict construction of policy language and a close reading of the “War” exclusion does not hold that terrorism is an act of war (no matter whether President Bush calls it that or not). In January 2002, terrorism exclusions were filed for approval with insurance departments across the nation. These exclusions were applicable not only to primary policies, but also applied to coverage in all re-insurance contracts. And without a federal backstop for the risk of terrorism, the insurance purchaser, both private and public, could be faced with the possibility of massive losses for which there is no insurance available anywhere, at any price.
Just as with flood insurance, there has been the possibility of the federal government guaranteeing payment for loss due to terrorism. After months of haggling over the issue, Congress finally passed and President Bush recently signed the “Terrorism Reinsurance Act of 2002.” The Act sets up a reinsurance fund of up to $100 billion over a three-year period to cover 90 percent of future terrorism-related claims. This federal reinsurance fund would be available if terrorism-related losses exceed certain levels of an insurance company’s premiums. This legislation provides a federal backstop to help stabilize coverage throughout the industry for the peril of terrorism.
Predictions that the municipal risk and insurance market will become extremely tight, that premiums for all lines of insurance will increase proportionately with the amount of risk and exposure to loss, and that specific coverages will be reduced, or excluded altogether, have indeed come to pass. And given the continued threat of global terrorism, the length of time that these corrective actions will continue is not known.