In need of repair: to fix the problem of underpriced umbrella policies, casualty underwriters must consider such factors as rising loss costs and antiquated attachment points.

The insurance industry has experienced change like no other time in recent history. Not since the hard market of the mid-1980s have casualty underwriters struggled with such a myriad of issues that include a worsening loss trend in excess casualty layers, greatly reduced investment income and new causes of loss.

These issues are putting pressure on casualty underwriters to return to underwriting basics and deliver a profit, and must be examined to help umbrella underwriters prepare for the upcoming Jan. 1 renewals. In this tumultuous environment, underwriters need all the tools and information they can get to price their products correctly and survive in this new century of rapidly changing risk.

The Major Issues

Loss Trends: The industry has experienced significant loss trends, particularly with regard to the severity of losses in excess layers. The chart, "Increase in Loss Trends," shows the increase as the layer of exposure increases from the ground up. Note that the loss trends exhibit a leveraged effect as limit increases. An analysis of Insurance Services Office data, Jury Verdict Research data and GE ERC results indicates a loss trend in recent years to be between 15% and 22%, for umbrella layers attaching excess of $1 million primary limits. This significant loss trend must be taken into consideration when evaluating the price adequacy of umbrella portfolios.

Attachment Point Erosion: During the early, 1990s, most umbrella programs required a $1 million attachment point--the threshold before the insurer makes a payment--for general liability and automobile policies. This practice became the norm for umbrella policies and can still be found in many programs today. As the loss frequency and severity, in excess of $1 million increased over the past decade, the $1 million attachment lost its value.

Taking into consideration the loss trends that have "affected umbrella liability and medical inflation in particular, the $1 million attachment is no longer holding the frequency of losses at the primary loyal. That explains the significant trend in the frequency as well as the severity in umbrella losses indicated in "Increase in LossTrends."

To meet these increasing losses, umbrella underwriters will not only need to re-evaluate premium adequacy, hut also consider the attachment point. Attachment point erosion has changed the purpose of umbrella coverage--it has made umbrella more of a working excess layer, though it is not priced as such. Increasing the attachment point is one way to re-establish umbrella policies to provide coverage for unexpected shock losses, losses not covered by the underlying insurance and coverage in excess of depleted aggregates.

Inflation has also affected attachment points, as the chart, "Inflation's Effect on Attachment Points," (page 75) shows. Note that the 1990 retention was at $1 million. Using the previous example for attachment point erosion as a reference, if an underwriter wanted to require an equivalent retention in today's dollars, the retention would have to increase to nearly $4.5 million.

The effects of inflation on the retention, coupled with previous umbrella prices decreasing at 5% to 10% per year, has caused insurance underwriters to re-evaluate their commercial-umbrella underwriting approach from an attachment and pricing standpoint. Although umbrella writers have experienced some price adjustments, premium adequacy is always a concern.

Investment income: Investment income is another issue that has to be dealt with because it is at an all-time low. The additional income from investments that many casualty underwriters counted on to bolster performance has diminished. The 3% to 5% returns that are currently available require underwriters to pay more diligence to the pricing of their products. No longer will the industry be able to count on investment returns to supplement underwriting losses. This is most important for long tail liability lines such as umbrella liability--the investment return is a significant driver of profit as in many cases losses would not be fully paid for seven to 10 years.

Pricing: Pricing discipline is fundamental to successful umbrella underwriting. Companies that practice best-in-class methodologies will be able to excel in the excess liability market. Pricing, risk selection and policy conditioning--such as the exclusions attached to a policy eliminating coverage for loss that is not anticipated in the pricing, (terrorism, for example) are all fundamental to underwriting any casualty line of business. There is little guidance in pricing umbrella products, however, because there are no rating agencies that promulgate rates. Companies that develop their umbrella price by using manual underlying premium as a basis for pricing umbrella are ahead of the game. Manual premium is calculated by multiplying a classification rate for a line of insurance coverage by a portion of the insured's payroll. With manual premium as a base, the umbrella price is not influenced by discounts that may be afforded in the primary package programs.

Additionally, with a solid starting point for excess pricing, price monitoring can be applied to a portfolio of umbrella business. With price monitoring in place, companies can make informed decisions with regard to the price fluctuation and formulate a strategy for exiting classes of business, lines of business or geographical territories. Additionally, once pricing factors are in place, they must continually be monitored, re-evaluated and updated to ensure future profitability.

For small commercial umbrellas and high excess layers, minimum premiums are the key pricing issue--it is important to have an annual review of minimum premiums.

Recent data published by the Council of Insurance Agents & Brokers indicates the umbrella line of business has been impacted by recent price adjustments as shown in the chart, "Average Commercial Lines Rate Increases." The price adjustments have improved results, but due to rising loss trend these adjustments must continue in order to maintain profitability.

New causes of loss: Umbrella underwriters are facing several coverage challenges. It is part of an underwriter's responsibility to eliminate exposures that the underlying insurance did not intend to cover. Many casualty underwriters have not only been surprised by the increase in loss trends, but also by the expansion of coverage for such things ms mold, terrorism and cyber-risk. These new causes of loss place a greater burden on the excess underwriter to identify the exposures, determine whether coverage is granted in the primary policy and condition the policies appropriately.

Many companies are moving to more of an excess form to eliminate the endorsements that need to be attached to umbrellas, avoiding mistakes that can be caused ha umbrella conditioning. The new ISO form (CU 0001) has been issued, and companies are analyzing it. Although CU 0001 is not an excess form, there are advantages to using it because it eliminates some of the responsibilities that primary companies have in terms of maintaining forms and endorsements.

Issues such as construction defects, mold, uninsured motorists regulation, cyber-risk and terrorism are examples of evolving exposures that will have an effect on future profitability. These exposures have to be dealt with and treated accordingly by policy conditioning, pricing or both. To be successful, companies will need to develop a game plan for dealing with new causes of loss on a proactive basis.

Best-in-class umbrella underwriting companies are evaluating areas that have caused them excessive losses and they are making changes to their underwriting guidelines to either reduce the frequency of severe losses or adjust pricing for those exposures accordingly. For instance, many companies are requiring higher underlying attachment points for significant automobile exposure. It is not uncommon to see umbrella underwriters requiring trucking risks to have significant attachment points--$2 million to $5 million--to be eligible for umbrella coverage.

Action Plan Items

The changing world of risk is creating the need for commercial umbrella carriers to price their product responsibly. The problem with excess casualty business is that there are no standard rates for pricing. In addition, because of new causes of loss and escalating loss trends, past experience is not necessarily indicative of future results. These changes are exacerbated in excess casualty layers due to the leveraged effect of claims and high loss trends on the percent of casualty premium collected for these lines. Mistakes in pricing and, in some cases, coverage, are often not detected for years in excess casualty, so it is imperative that underwriters consider all factors when selecting and pricing risks.

An action plan that includes periodic reviews of underwriting and pricing plans will give companies a chance to stay ahead of umbrella underwriting trends. The following action items may provide additional help:

* Develop a proactive committee of casualty underwriters that are accountable for maintaining a profitable umbrella book.

* Establish a committee that is responsible for evaluating and adjusting to changing loss exposures. Include members from underwriting and claims teams as well as other stakeholders.

* Develop a price monitoring system that accounts for changes in exposures.

* Use actuarial assistance in the pricing of umbrella products. Take into account changing loss trends, investment income and price monitoring.

* Review umbrella guidelines on a regular basis.

These proactive approaches will give companies a broad perspective when re-evaluating key issues.

Losses in excess of $500,000 are trending at a
greater rate than losses higher than $25,000, which
is important to insurers because the higher the loss,
the more leverage it puts on umbrella policies.

Losses in excess of $25K; annualized trend     9.8%
Losses in excess of $100K; annualized trend   12.2%
Losses in excess of $500K; annualized trend   18.1%

Source: GE ERC, based on Tillinghast analysis of information
published by ISO.

Bob Jones is the global property/casualty umbrella product leader for GE Employers Reinsurance Corp.