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Putting risk managers on the solvency alert.

Chaos is the best way to describe today's insurance market. Between 1984 and 1989, about 140 property/casualty and life/health insurers went belly-up and insurance commissioners had to intervene in 175 insolvency cases, according to the National Association of Insurance Commissioners. California reacted by passing Proposition 103, which said, in effect, that insurers are making too much money Yet shortly thereafter the consumer group Public Citizen concluded that these same companies are running out of funds.

Turmoil is also evident among the insurance companies themselves. For example, the Travelers Corp. took a $650 million charge against 1990 earnings for losses on real estate investments, and Equitable Life Assurance Society of the United States followed with a statement outlining its intention to convert from a mutual company to a stock company. To top things off, the federal government is investigating the insurance industry. Mindful of the political backlash of the liability crisis in the mid-1980s, Congress is concerned about insurer solvency and the comparisons that are being made between insurers and the $500 billion savings and loan industry bailout.

Yet despite the recent turn of events, in a sense it is business as usual in this boom and bust industry. The market is in the soft end of the cycle, awaiting the predictable correction when capacity declines and premiums increase. However, this time the cycle is heading into uncharted waters. New realities have emerged for insurers competing with inadequate capital. Consequently, risk managers are advised to be on the solvency alert.

The industry's underwriting losses, which, according to Conning & Co., a consulting and investment banking firm in Hartford, CT, are 10 cents on every premium dollar, are steadily increasing. Indeed, insurers have recently been hit with several large claims, including catastrophic property losses. According to Merrett Syndicates Ltd., a Lloyd's syndicate, the Piper Alpha disaster cost insurers $1.4 billion; the Exxon Valdez oil spill, $1 billion; the U.S. winter freeze, $1 billion; French storms, $1.2 billion; and Colorado hail storms, $1 billion.

These enormous underwriting losses came at a time of declining short-term interest rates and economic recession. Worse, there is a belief that the industry is severely underreserved and that reinsurance recoveries on the books of many primary insurers are significantly overstated. As if this were not enough, many insurance companies carry junk bonds and real estate investments at cost rather than current market value. According to the Washington, DC-based American Council of Life Insurance, life insurers carried $40 billion in junk bonds and $40 billion in real estate on their books in 1989, along with another $254 billion in mortgages. And in December Fortune magazine reported that the revenue enhancement bill Congress passed last year will cost life insurers some $8 billion in additional taxes over the next five years.

No Easy Solution

The insurance industry is governed strictly by the law of supply and demand. Since demand for the product is relatively constant, it is the supply of capital invested in the industry, or capacity, that determines price. It is easy to invest in this industry and only slightly more difficult, because of long-tail liability, for capital to exist. Furthermore, there are no economic stabilizers, such as margin requirements in securities transactions, built into the system to smooth out market cycles.

The industry is also highly fragmented, with as many as 6,300 companies selling largely undifferentiated products through approximately 1 million licensed agents and brokers, according to the Insurance Information Institute in New York. Understandably, it does not pose a monopolistic threat, a feeling shared by Congress in the 1940s when it passed the McCarranFerguson Act, which exempts insurers from many anti-trust laws and requires states to regulate the industry. Fifty years later, the system has been called into question, as the House Subcommittee on Oversight and Investigation, chaired by Rep. John Dingell, D-MI, looks into the industry from the standpoint of solvency and fraud and considers changes in insurance regulation.

However, changes in regulatory authority-whether it be from state to federal, from federal to state or even from self-regulation-will not be quickly accomplished. In any event, there is doubt that changes will even reduce the number of insolvencies. The Dingell subcommittee and, more recently, the Senate's Judiciary Committee have voiced concern about the industry and are likely to consider a mixture of legislative and regulatory reform to prevent a savings and loan-type fiasco.

It is easy to see why insurance has in many states become an effective political platform for candidates. The industry has few supporters outside its rank and file, and to a large extent, the public is uninformed about insurance and its premiums/claims relationship. For some, insurers are simply deep pockets to be picked. Indeed, many consumers liken homeowners' and automobile insurance to a tax that carrys with it an entitlement to a defined benefit to be collected at a later date.

Despite its problems, the industry will survive. The rationale behind this optimism is that the insurance transaction-the spreading of risk among the many to pay for the losses of a few-is still essential to the investment in and development of the U.S. economy. Without risk spreading, investors are less willing to invest and consumers less willing to buy.

Steps to Take

Although risk management covers a wide range of strategies, products and services, insurance is central to its function. Therefore, the topic of insurer solvency and what others do to protect their companies is a natural concern for risk managers. The following are precautions designed to reduce the risks of using an unhealthy insurer.

It is the risk manager's responsibility to monitor carriers. He or she, along with the broker, should insist on meeting periodically in person with underwriters and executives to discuss the insurer's financial condition and operating strategy. The risk manager should request in the policy that the carrier provide financial statements with the same frequency required of the insured. This combination of intuitive sense of a carrier's future prospects based on personal discussion and hard facts will keep the risk manager well-informed.

The risk manager should also monitor the broker. Brokers and agents are expected to use care and sound judgment when recommending carriers to their clients. The risk manager must make sure that the broker bases his or her recommendations on reliable financial and ratings standards. They should also check review procedures, internal controls and management commitment. Although the agent represents the carrier and the broker represents the client, they both have a partnership interest in monitoring solvency reports.

A regular review with the broker of the overall market and the financial conditions of specific carriers is a productive way for the broker to gain a new client or win a renewal. This procedure is often referred to as a stewardship meeting or report. It also enables the broker to demonstrate the account team's capabilities and commitment to providing quality financial analysis and service.

In the past, carrier selection was based on the lowest price. While price is still a critical factor, others are equally important, including service capability, loss control engineering and safety programs and the ability of the carrier to pay claims. Carrier selection should therefore be based in part on balance-sheet strength. Further, the risk manager should be able to justify why a higher premium is paid for financial strength and the relative likelihood that the carrier will remain solvent.

With the availability/affordability issues of the mid-1980s still fresh in everyones' minds, it is propitious to discuss with management the insurance issues likely to emerge in the near and distant future. Prepare management for the probable upturn in market rates and inform them of the solvency risks involved. This will set the stage for a carrier selection process that, possibly for the first time, is based partly on comparable financial condition and the ratings assigned by independent services.

The risk manager should formulate a solvency-related action plan with the agent or broker. If the insurer becomes involved in regulatory intervention such as Chapter 11, rehabilitation or insolvency, the risk manager should know about it. The plan should be in place with the broker to assure mutual communication and that immediate action will be taken when significant developments occur concerning the financial health of the insurer.

A company may occasionally have to use a carrier that is not approved by the broker or agent. In these instances, the broker usually requests that the insured sign a disclaimer letter holding the broker harmless from any liability in connection with the solvency of that carrier. Before requesting the letter, however, brokers are expected to survey the marketplace for alternative carriers. Likewise, before signing a disclaimer, insureds should determine for themselves that no reasonable alternatives exist. Clearly, the letter is an accepted practice, but only once the issue of alternative choices is made clear to both parties.

In addition to monitoring the solvency of property, casualty and life insurers, risk managers must keep abreast of the financial condition of the health maintenance and preferred provider organizations delivering health care services to their company. Particular attention should be paid to multiemployer trusts that are inadequately capitalized.

Risk managers should also stay politically active through trade groups and associations. After all, they can assert tremendous influence on the legislative agenda, perhaps even more than carriers, agents and brokers.

Finally, corporate risk managers should make monitoring the financial condition of carriers and brokers a main component of their job. No one should know insurance accounting and the financial status of insurers better than risk managers, since they are the ones who will be held accountable for subjecting their companies to unnecessary risk. When an insurer Can't Cover Your Catastrophic Claim America's insurers are doomed to a decade of insolvencies, for all the obvious reasons. Theirs is an overcrowded and competitive business in which most players are taking more risks and less familiar ones. -The Economist, Oct. 27,1990 The epidemic of savings and loan and other bank failures has raised concerns that insurers may next fall victim to financial difficulties. indeed, the failure of an insurer could be far worse for the policyholder than the failure of a bank for a depositor, because the insured loses not only premium dollars but the reimbursement for catastrophic loss as well. However, there are avenues that risk managers can explore when faced with a catastrophic claim and an insolvent insurer, including the following.

File a claim with a state guaranty association, if available, and demand that the association defend the claim. Keep in mind, however, that state-mandated insurance guaranty associations only provide limited protection. In Pennsylvania, for instance, the limit for property/casualty insurers is $300,000. Moreover, if a broker places the insurance with an unlicensed company, such as a surplus lines insurer that does not belong to the state's guaranty association, the insured will have no claim against the security fund.

File the claim with the insolvent insurer's receiver or liquidator. Most of these companies pay a percentage of claims, but the right to this payment may be lost if the insured misses the filing deadline.

If the insolvent insurer provides a lawyer to defend the insured, the insured should direct its own attorney to monitor the case to guard against direct exposure to an adverse judgment.

Consider parties who may be responsible for the insured's predicament. A prime suspect is the insured's broker, who may have breached a duty of care by inadequately investigating the insurer's financial strength at the outset, not advising or misadvising the insured about the risks of insolvency, or not recognizing warning signs of the insurer's financial distress. In the 1986 case Goldstein v. Milton Brokerage Associates, a Pennsylvania federal court held that a broker's failure to follow statutory requirements in placing insurance with a surplus lines insurer constituted negligence.

Review with counsel excess policies, which could provide benefits when the underlying insurer becomes insolvent. A prompt declaratory judgment against an excess insurer may alleviate the time gap between a possible adverse judgment against the insured and a determination of the excess insurer's responsibility. The Courts' interpretations

In today's litigious society, it is necessary that insureds familiarize themselves with cases involving insurance contracts. The following decisions provide a framework for understanding how the courts are interpreting insurance policies.

A case decided last year by the Pennsylvania Superior Court illustrates how courts have interpreted excess policies in favor of insureds. In Luko v. Lloyd's London the underlying insurer, Midland, provided a $1 million liability limit. Lloyd's policy agreed to pay the amount of loss in excess of underlying insurance limits based on an attached schedule or "where no underlying insurance" in excess of $100,000 per occurrence to a limit of $10 million. The court held that Midland's insolvency resulted in no underlying insurance, and thus the Lloyd's policy afforded coverage beginning at $100,000, not $1 million as Lloyd's had argued.

Under most legal jurisdictions, where the contract is one of insurance, any ambiguity in the language of the document is to be read in a light most strongly supporting the insured." This principle, taken from the 1974 Pennsylvania case Mohn v. American Casualty Co. of Reading, stems from the perceived superior bargaining position of insurers and a desire to protect the reasonable expectations of insurance purchasers. Various courts have held excess insurers liable for additional coverage when an underlying insurer became insolvent, and when the excess policy provided benefits if underlying insurance was "exhausted," "uncollectible," "unrecoverable" or words to that effect. For example, in the 1985 Illinois case Donald B. MacNeal, Inc. v. Interstate Fire and Casualty Co., the excess insurer's policy limited its liability to an amount in excess of the "amount recoverable" under underlying insurance. The ruling stated, "We hold that the language of the excess insurance contract requires defendant to assume the risk of the primary insurer's insolvency." in the 1987 case Massachusetts Insurer Insolvency Fund v. Continental Casualty Co., the court held that the insolvency of the underlying insurer caused the underlying limit of liability to be "reduced" as provided in the excess policy, causing the excess insurer to step into the void.

Conversely, in the cases of Kelly v. Weil (1990, Louisiana) and United States Fire insurance Co., Inc. v. Capital Ford Sales Inc. (1987, Georgia), the excess policy clearly provided that the liability limit of the underlying policy was a fixed numerical level below which the excess policy will never provide benefits, despite the underlying insurer's insolvency. The New Jersey Supreme Court has been more neutral, permitting the insured to offer evidence of its reasonable expectations when the excess policy was not ambiguous enough to afford the insured relief based solely on the face of the policy.

Regarding reinsurance, the courts have consistently held that unless the reinsurance contract expressly states that it benefits the insured-a so-called cut-through clause-the insured has no right of action directly against the reinsurer. If the direct insurer becomes insolvent, the courts have held that without a cut-through clause, a reinsurance contract remains a general asset of the insurer. Additionally, any proceeds obtained from the reinsurer are paid to policyholders generally on a pro rata basis, not directly to the insured whose specific risk was reinsured.

The insurance industry has already experienced a period of insolvencies. From 1984 to 1989, U.S. property/casualty insurers averaged 18 insolvencies a year, whereas the average from 1980 to 1984 was six a year. In today's uncertain economic climate, great care must be used in selecting an insurer and in maintaining insurance with that selected company.
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No portion of this article can be reproduced without the express written permission from the copyright holder.
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Title Annotation:includes related article
Author:Peterson, C. Richard; Cox, Roger F.
Publication:Risk Management
Date:Jun 1, 1991
Previous Article:Congress readies to act on regulation reform.
Next Article:Who is to blame for the P/C quagmire?

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