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Insurance company professional liability.


One exposure where the risk manager should be inherently involved is in the area of insurance company professional liability. Insurance company professional liability covers the risk of a policyholder suing the company for improper denial of coverage or lack of timely claim payments. In a few jurisdictions, the insurance carrier's liability for first-party claims is strictly confined to the scope of the insurance contract; in these jurisdictions, bad faith severity is not variable since the insurance contract limits the size of payment. However, in most jurisdictions, the tort of the breach of the duty of good faith and fair dealing in evaluating claims made under a contract of insurance will permit an insured to recover consequential and, on occasion, punitive damages.

While consequential damages may awards for thousands of dollars due to loss of wages or pain and suffering, the worst severity cases, with multimillion dollar awards, are attributable to punitive damages. Like most instances of professional liability, this constitutes a true catastrophic risk. A number of publicized punitive damage bad faith awards have exceeded $50 million at the trial court level.


Due to the catastrophic nature of a professional liability exposure, the company must create a sound professional liability plan. For the risk manager, the first step in this process is to develop an intercompany communications program that stresses the need for adequate catastrophic coverage and the formation of an intercompany team that can work cooperatively to create a credible liability program.

Specifically, this step entails relating the professional liability risk to the managers of both the operations and financial departments. This step is important because the two departments may see the same issue differently; for example, in the event of a catastrophic loss, operations managers may have strong reservations about a $1 million vs. a $5 million self-insured loss that affects their quarterly financial statement; a financial manager, on the other hand, would be willing to self-insure higher levels. These propensities need to be balanced with professional liability premium savings derived from selecting higher self-insured retentions. To accomplish this, insurance brokerage specialists can be called in to assist with peer group comparisons to illustrate the range of self-insured retentions that other companies have adopted. Furthermore, in the event that the company is considering a very large self-insured retention, the risk manager must involve the company accounting department if a self-insured loss could be deemed "material" and possibly require a footnote to future financial statements.

The risk manager should also employ intercompany communications to determine if a professional liability exposure or risk is already being managed in whole or in part by another company department in the form of indemnity agreements, hold harmless agreements or side letters of understanding. In addition, it is vital that the risk manager maintain accurate communications with the company's reinsurance department. Through this process, the risk manager must determine whether reinsurance treaties contain an extra contractual obligation (ECO) provision, which, in the case of a bad faith lawsuit, could protect an insurer if compensatory or punitive damages exceed the original policy limits.

ECO coverage may be present in the excess of loss reinsurance treaties of most property/casualty companies; essentially, reinsurers obligate themselves to follow the underwriting fortunes of the policy issuing company. This step is important because if an ECO provision is present in the reinsurance treaty, the reinsurers may end up in the same position as a policy issuing company that is sued for bad faith claim handling and suffers consequential and punitive damages.

Typically, property/casualty treaties contain ECO provisions, whereas life and surety treaties may not have them, Furthermore, the coverage terms of the ECO provisions in each treaty must be reviewed to determine the limits of the ECO coverage and whether it constitutes an 80 percent or 100 percent limit of coverage. The scope of the ECO provision protection causes tremendous confusion among risk managers and reinsurance departments. As a result, the extent of available ECO coverage should be documented by the reinsurance department or by their reinsurance broker. After the ECO reinsurance analysis is completed, the risk manager should take note of any of the company's unprotected insurance product lines or services.

Because a catastrophic professional liability loss could put a small insurance company out of business or seriously impair a medium-to-large-sized one, risk managers must assume leadership in raising company-wide awareness of the need for service quality standards, loss prevention strategies and an effective professional liability program.


The second step in the creation of a liability plan is to analyze the company's professional liability exposures and risks. To do this, the risk manager should utilize the traditional techniques for identifying risks. These techniques will include determining the company's professional liability exposures, measuring losses, reviewing the changing legal environment, raising company-wide awareness of professional liability loss prevention techniques and developing a self-insured and/or risk transfer program.

In addition to this approach, the risk manager should also utilize an interdisciplinary strategy that includes financial, accounting, and frequency and severity analyses. These interdisciplinary analyses constitute one of the value-added features that an insurance brokerage specialist can provide to a risk manager.

In order to determine an appropriate working layer or risk retention level, a company must perform various types of financial analyses. The ability to assume loss, which stems from a variety of risk retention measures, is applied for the purposes of illustration to a hypothetical insurance company called ABC Life.

The company's financial profile reveals that it has a good ability to produce income, a better-than-average ability to fund losses out of this future income and enjoys a strong overall liquidity. In addition, the company's uncommitted cash position is strong, is free of an excessive fluctuation in cash flow, and does not suffer from significant long-term debt. Finally, ABC's revenue growth in recent years has been better than average, shows strong stability in after-tax profit, and demonstrates a below-average interest in risk assumption.

Based upon commonly utilized risk retention measures, these financial characteristics demonstrate that ABC Life displays a fairly strong capacity to bear risk. However, since ABC Life is a mutual, the current conservatism of mutuals' corporate cultures and their consequent tendency to retain low levels of risk indicates that the company will be adverse to significant risk assumption. If ABC Life decides not to utilize professional liability protection, it could leave itself open to a catastrophic loss of material proportions.

Because there is no formal Financial Accounting Standards Board statement of what constitutes a material loss, earnings per share could be considered to be an appropriate measure for material loss for a stock organization; because ABC Life is a mutual company, a "pre-tax excess of income over deductions" will be utilized.

Guidelines of 0.5 percent to 2.5 percent of pre-tax income are most frequently used. The 0.5 percent measure is usually associated with low yield, non-volatile operations, such as consumer retail operations. Based upon the 1990 "pre-tax excess of income over deductions" of $1.532 billion, potential materiality thresholds would be "$7.6 million at 0.5 percent of pre-tax income and $38.3 million at 2.5 percent of pre-tax income." Another self-insured retention level materiality test that ABC Life might consider is a percentage of the 1990 net working surplus of $2.4 billion. Based upon ABC Life's 1990 financials, potential materiality thresholds would be $6 million at 0.25 percent of net working surplus and $24 million at 1.00 percent of net working surplus.

An average of the above two methods of materiality testing would yield the minimum test level to reach materiality at $6.8 million and maximum test level to reach materiality at $31.2 million. This is not to suggest that an insurance company's management will be comfortable with self-insurance up to a material loss level. Risk transfer with insurance company professional liability insurance is usually available with deductibles far below a material loss level.

However, besides protecting itself against a material loss, the company must also take into account the possibility of large losses or the potential cumulative effect of multiple retentions in a single year within the level of retentions being evaluated. By dividing the layer of limit of liability being evaluated by the premium quotation, a time frame break-even for premium cost vs. a catastrophe loss can be achieved. For example, if the quotation of $35 million excess of $15 million of insurance company blanket bond coverage was $350,000, this known premium cost would be equivalent to one full limit catastrophe loss for every 100 years. The company can then contemplate the likelihood of such a loss on a more frequent (buy) or less frequent (self-assume) basis.

Another factor influencing the level of working layer risk assumption is the term of loss payouts. For example, property losses are generally detected and proven quickly, which results in an immediate impact on the organization's income stream. However, in the case of workers' compensation, once losses are detected and proven, benefits payments may continue over many years of a worker's rehabilitation or over a lifetime of permanent impairment. Considering these typical payout patterns, lower retention levels should be applied to property exposures, whereas high levels of retention may be applied to workers' compensation. In 98 percent of professional liability claim handling for insurance companies, losses may be settled within several months. However, in some cases adverse circumstances may result in litigation that may not reach final adjudication or settlement for anywhere from four to seven years.

A final factor influencing working layer risk assumption is the effect of loss frequency and loss potential. In general, the less frequent the loss, the greater the retention that can be assumed. However, while low frequency coupled with low severity suggests the need for a high risk retention, low frequency coupled with high severity constitutes catastrophic loss potential wherein a moderate risk retention should be coupled with higher limits to protect quarterly income and net working surplus.

To measure frequency and severity of loss, the following general guidelines can be applied: Low frequency, once every 10 years or more; high frequency, at least 10 times per year; low severity, $25,000 or less; high severity, $750,000 or more.

Each year most insurance companies experience some degree of bad faith threats or litigation. Generally, though, these threats can be dealt with very effectively at the operating level so that they never reach the stage of serious litigation; 98 percent of the time, the combination of well-trained claim adjusters, effective claim handling procedures and vigilant inhouse counsel results in manageable, non-material bad faith incidents.

However, many companies tend to discount the 2 percent of cases that may result in a catastrophic, material loss. While most insurance companies could not conceive of an insurance program without umbrella liability coverage, a surprisingly high percentage of insurance companies themselves do not have professional liability programs that contain adequate limits or coverage.


After communicating the need for a professional liability program and subjecting the company to a rigorous financial analysis aimed at determining its liability situation, the next step is to create the liability program itself.

In order to ensure the formation of a successful program, the risk manager should team up with a knowledgeable insurance broker to assist in the process.

The creation and design of the program begins with identifying and measuring the company's record for handling bad faith/ECO cases. When identifying the historical record, the risk manager must determine if a bad faith litigation data base has been established. If no bad faith data base exists, the risk manager should seek senior management support to create one; then, to initiate the data base, the risk manager can design a claim survey form and send it to each insurance subsidiary operating manager who is responsible for bad faith loss cost.

To measure the effectiveness of existing guidelines to handle bad faith/ECO cases, the risk manager must conduct a review and evaluation of company procedures. Specifically, this evaluation should ascertain whether bad faith/ECO cases are handled by the claims or legal departments. The risk manager should then obtain a copy of current procedures for handling bad faith/ECO cases. If no written procedures exist, then current company procedures should be committed to print. Equally important is to determine which company department develops reserves for bad faith/ECO cases and how often these reserves are reviewed; the risk manager is also responsible for discovering which loss prevention techniques the company utilizes to avoid bad faith/ECO cases.

It is important to realize that risk identification and measurement will vary depending upon an insurance company's product line mix. For example, casualty, health and professional liability insurers may have a higher frequency and severity of bad faith/ECO losses, whereas life, property and marine insurers generally experience both a lower frequency and severity of these losses; however, there is no indication that these lower rates of bad faith/ECO losses will continue in the future.

To optimize quality of coverage, each insurance company must analyze its operations and review the full extent of ECO protection available under current reinsurance treaties; most companies choose to protect their reinsurance treaties with insurance company professional liability acting as the primary coverage. Occasionally, a company elects to consider ECO coverage present in their treaties as primary, but due to ECO coverage limitations purchase insurance company professional liability as excess over any ECO provisions to further protect earnings as well as capital and surplus.

For example, life insurance companies that display conservatism in most areas of management often rely on the relative lack of bad faith litigation, and therefore self-insure their professional liability exposure. However, while this rationale may work for pure life companies, life companies that have entered the disability and health insurance fields have significantly altered their professional liability exposure because these coverages experience a higher frequency and severity of bad faith losses arising from denials of coverage or timeliness of claim payments.

Life companies that have diversified should review whether their bad faith exposure to loss is still all working layer or if the exposure has changed with their business mix. If the risk becomes material, then professional liability insurance becomes a prudent means to protect the financial statement.

As noted previously, risk management leadership in intercompany communications is absolutely vital. Managing professional liability must become a total company concern through increasing service quality. In this regard, interdisciplinary analysis needs to be employed to determine self-insurance vs. risk transfer attachment.

In addition, each company must match its limits of protection to its financial strength and its business mix. For example, the limits of coverage necessary to protect a small insurance company will vary significantly from the coverage needed to protect a medium-sized company from material loss or to safeguard a large company from catastrophic loss. Ultimately, the limit of protection necessary for a catastrophic bad faith award is a combination of the working layer, which may be secured with an internal funding program, the insurance company professional liability program available to mitigate a "material" loss, and the ECO protection available in reinsurance treaties as a top-level excess program.

The design of an effective professional liability program requires both leadership in company-wide communications as well as an interdisciplinary approach to risk management. The rewards gained from the implementation of such a program can have a number of positive effects on the entire company, including an increase in service quality, an enhanced business reputation, and an increase in the growth and protection of company assets and profitability.
COPYRIGHT 1992 Risk Management Society Publishing, Inc.
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1992 Gale, Cengage Learning. All rights reserved.

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Author:Moore, James E.
Publication:Risk Management
Date:Dec 1, 1992
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