Nothing in financial management is more valuable than knowing what lies ahead; the same applies to risk management. Insurance coverage is one of the biggest line items for business owners. Whether property, workers compensation, general liability, automobile, or other coverages, managing risk exposure is central to making the right choices for business continuity. It allows better and more confident choices.
Currently, all indicators point to a continued hardening of the insurance market across nearly every line. While we have no crystal ball to see into the future, here we’ll look at key factors that help to understand trends and what is likely ahead so we can set clear expectations for risk mitigation strategy and planning.
SOFT AND HARD MARKETS
In a soft market, insurance companies are concerned about growth, so they are aggressive with terms and conditions—which means they’re aggressive with policy pricing. They lower deductibles and may even include additional coverages. This is a time when competition for new business is high among insurance companies.
In a hard market, insurance companies are concerned about profitability. They raise rates, cut back on coverages offered, and decrease capacity. We’re starting to see this for larger accounts where insurers are pulling back on the amount of coverage they’re willing to offer. The contraction increases demand, which means less competition for insurers. This is a main driver of the hard market.
This current hardening market and increased pricing is occurring for a number of reasons: interest rate decreases, nuclear verdicts, natural disasters worldwide—hurricanes, California wildfires, flooding in Nicaragua— and loss cost trends in commercial auto all have an impact on U.S. rates.
One of the biggest drivers of the hard market is interest rates. Investment income is one of the key vehicles insurance companies use to maintain profitability. Low interest yields have been an accepted reality for some time for insurers and reinsurers—currently, the lowest ever seen in the yield environment—which means a change is required in reserve strategies.
To provide some perspective, in December 1990, interest rates on a 10-year Treasury bill were at 8.22%. In December 2020, rates were at .92% interest. For insurance companies, investment strategy such as using a 100% combined ratio is no longer plausible, and considerable adjustments have had to be made, especially over last eight years.
“If you look at some of the metrics around 10-year U.S. treasuries, for example, you see that there is no chance to rely on the asset side of the balance sheet over the next few years performing,” said Jonathan Isherwood, CEO of Reinsurance, Americas for Swiss Re, in a Carrier Management article.
A recent report from The Hales Group (Chart 1 on page 2) illustrates what insurance companies are facing today. Interest rate yields have decreased from 6% 20 years ago to 2% and even lower today. Insurance companies, like other businesses, exist to make a profit and provide a stable, viable market for their customers. In order to earn return on equity (ROE)—in this example, 12%—they rely on both investment and underwriting earnings.
Historically, insurance companies often operated with underwriting losses because they could earn more on investments than they lost on the underwriting side. For example, workers compensation is a long-tail line—meaning insurance companies can invest their reserves on claims for a long period before they must be paid out. In Chart 1, workers compensation is shown having an average 3-year duration for investment earnings.
Twenty years ago, insurance companies could have a combined ratio (the cost of claims plus insurer expenses) of 102% (i.e., paying out $102 for every $100 taken in) while earning 6% in investment returns. That formula resulted in a 12% return on equity. Fast forward 20 years, and to earn the same 12%, the insurance company must have a combined ratio of 90.2% with a 2% investment return on their reserves. To achieve these results, pricing has to rise.
Why aren’t interest rates being raised? Good question. The federal government is not in a position to raise interest rates because the national deficit would balloon, and the U.S. is not in a position to debate this in the current climate. If interest rates were to go up to 3% or 4% (still low compared to historic numbers), the impact would be detrimental due to the deficit, which is driving our interest rates right now, so the federal government is going to keep rates down artificially.
Taking it even further, in Europe, some central banks have a negative rate policy, allowing rates to fall slightly below zero on their bonds. This conceivably could happen in the U.S. with the precedent set globally.
SOCIAL INFLATION & NUCLEAR VERDICTS
The rise in social inflation and nuclear verdicts is a major factor in driving the hard market. Rising litigation and jury awards together have been pushing up casualty claims and their corresponding losses.
Nuclear verdicts are those that surpass $10 million, and social inflation is described as “the convergence of societal and legal trends to the tune of increased litigation, broader definition of duty to care, legal decisions tipping in the plaintiff’s favor, and larger jury awards,” according to AmWins.
For perspective, products liability verdicts in 2018 were $5,090 million; in 2019, they topped $11,633 million, according to the National Law Journal’s Top 100 Verdicts report.
“It is primarily the noneconomic factors that explain the increase in nuclear verdicts and so contribute to social inflation. These include a general anticorporate environment, expanding concepts of liability, greater willingness to settle conflicts via the legal system, attorney advertising, application of psychology-based strategies, litigation funding, broader insurance policy interpretation, and more generally, a plaintiff-friendly environment,” according to Swiss Re.
Over the last few years, insurers and reinsurers have responded to these trends by increasing premiums, reducing exposure, and withdrawing from industries experiencing greater losses. However, the pace is expected to accelerate.
“We see that coming through in 2020 and the expectation is that will move in through 2021 and probably even in 2022 given the scale of the inflation that is seen in some of the judgments,” said Swiss Re Reinsurance CEO Moses Ojeisekhoba at a recent S&P Global conference.
Additionally, interest rate cuts to combat the economic downturn from COVID-19 “clearly has an impact on longer-tail lines” such as casualty. “I think that exacerbates the issue without a doubt,” said Ojeisekhoba.
Understandably, natural disasters play a key role in market conditions. Most of the costliest natural disasters in the U.S. have occurred in the last 15 years, including Hurricane Katrina, which amounted to $161 billion in damages. However, losses outside of the U.S. also are having an impact on insurance rates.
Fitch Ratings concluded that, “A number of (re)insurers have pre-announced 3Q20 catastrophe estimates that are material, with losses attributable to a series of events experienced in the U.S. in the quarter, including Hurricanes Isaias, Laura, and Sally, the Derecho Windstorm, and wildfires in California and Oregon. A handful of global (re)insurers may also include losses from the August Beirut explosion in 3Q20 results.”
Additionally, Reuters recently reported an estimate of over $8 billion in insurance and reinsurance wildfire losses in California, Oregon, and Colorado, with an additional $5 billion in total economic losses expected.
Losses are no longer isolated by country, so insurance advisors and business owners must be cognizant of the global landscape when contemplating risk management strategy.
LOSS COST TRENDS IN COMMERCIAL AUTO
Combined ratios in the last several years have been between 100% and 115%. This is not optimal for the industry, which strives for profitability and ratios in the low 90s. Additionally, losses for the last decade were significantly underestimated and policies were priced too low over the past five to six years. Now, insurance companies are faced with increasing rates to a more adequate level, leaving insureds rightfully anticipating rate increases and pressure on retentions and limits.
For commercial auto, not only are bodily injury claims higher, but also the cost to repair vehicles has increased due to the complexity of technologies on board and their replacement costs. Fender benders are no longer simple as the cost to repair even small accidents is considerably higher than in the past.
We must consider the uncertainly and ripple effects of COVID-19. Miles driven are down so both commercial and personal auto are getting a little bit of relief, but that is going to change as economies open up again. Additionally, with courts backlogged due to pandemic-related proceedings, it could be years before some cases see trial.
THE INSURANCE BROKER’S ROLE
The role of the insurance broker has changed over the years to go beyond brokering transactions to serving as valued advisors, providing education and risk management strategy as well as helping clients manage expectations so they can become better consumers of insurance.
For example, in the past, employee benefits was sold similar to property and casualty insurance. Agents brought in spreadsheets and played with deductibles and premiums, winning business from one agent to another. Today, employee benefits has evolved to encompass all of the services around data analytics, health, employee communication, and employee engagement. A broker’s goal now is to help clients to be better, wiser consumers, which doesn’t necessarily mean trying to get the best price for the year ahead. The aim is to help clients engage their employees and use business practices to help create a long-term bend to the curve of their health insurance spend.
Now that we’re looking at a hard market for the next few years, the same change in approach applies to property and casualty. To battle the impending market difficulties, business owners need help becoming better consumers. That’s where risk management strategies, such as the use of RiskScore and an effective safety program, will play a pivotal role. These strategies aid in identifying and implementing practices that the insurance industry agrees will help bend their loss curve long term.
When you look at what drives insurance pricing, it’s a function of what you do, how big you are, and how you run your business. An insurance broker must be able to explain to the insurance companies, for example, that not all restaurants are equal and their client is better than average, and then demonstrate why.
Based on what the insurance companies have told us, RiskScore has a real impact on claims long term. Why? Utilizing the information revealed through RiskScore and working with our risk services division demonstrates a commitment to ongoing safety, onboarding people the right way, and training team members correctly. Over the long haul, these business owners are going to be better risks than those who ignore these disciplines.
ADDRESSING A HARD MARKET
An understanding of where there is control over key areas is critical when addressing a hard market smartly. It breaks down this way:
- Business owners control their company’s products and services.
- Business owners control the size of their business.
- Business owners control their processes.
- Insurance companies control policy coverages, rates, and capacity based on marketplace conditions, which are not under their control.
- Insurance brokers in their advisory and advocacy capacity can aid in risk mitigation practices, help educate on marketplace conditions, and bridge the gap between insurance companies and business owners.
Based on a company’s products, services, and size, insurance brokers negotiate terms and conditions (deductibles and coverages) for their clients. When brokers help with risk management and loss control processes, such as with RiskScore, their clients are going to pay best-in-class rates. Though rates may be going up because of market conditions, they’re going to go up less than they would have if they were not best in class. They’ve become a better risk for the insurance companies.
How this all will unwind over the coming years is the billion-dollar question. As we keep an eye on how things play out, knowing what you can control and where to find help is how we fight this hard market.