Specialty Insurance Blog

Employment Practices & Risk Management

Risk management has a very significant impact on employment practices liability loss experience, and will impact employment practices liability insurance (EPL) premiums.  One of the best risk management practices is the proper maintenance of personnel records.

Personnel records provide some of the key documentation necessary in defending employment claims, and in many states employees have the right to review part or all of their own personnel file.

Troutman Sanders has an excellent summary on some of the key points for best practices in maintaining personnel files (see here).  Note that state laws regarding disclosure of personnel files, and other employment requirements, are not consistent, and local counsel should provide the last word on personnel records and other employment practices risk management.

Key points:

• Maintaining performance records deserves a special mention, because they are often critical to an employer’s ability to get a lawsuit dismissed or win at trial.
• Watch out for information that identifies an employee as a member of a protected class…keep this information separate to help defend against any suggestion that a manager considered the demographic information in making a personnel decision.
• To ensure that you are fully complying with these [ADA/HIPAA] laws, keep all medical-related documents in a separate file.
• Investigation records should be kept in a separate file.

Employers committed to risk management, who utilize best employment practices, will reduce wasteful and unnecessary employment litigation, and keep their EPL premiums at a lower level.

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The Power of the Internet – & Insurance?

The internet has opened up new frontiers for highly specialized groups as well as the masses, but has its true power had any significant impact on the insurance business? 

Many so called experts predicted the demise of insurance agents through disintermediation by the internet.  What they did not understand was the valuable role insurance agents play in a transaction, and disintermediation has not occured.  But new internet changes could still impact the way we conduct business, and one such change is beginning to gain some traction.

All of us are familiar with the big names in internet change:  YouTube, Wikipedia, Google, Facebook, Amazon,…  These and other innovative internet applications have provided new ways for individuals and businesses to communicate and process information.

One fascinating trend, although not new, that is just starting to get some real traction is using the internet to harness the distributed knowledge of individuals to create collective information.  Where the power of individuals working collaboratively is more powerful than any single organization is able to build on its own.

The most obvious example is Wikipedia, a web based encyclopedia written collaboratively by volunteers from all around the world.  Created in 2001, Wikipedia has 65 million visitors monthly, more than 75,000 active contributors working on more than 13,000,000 articles in more than 260 languages.  This massive compendium could not have been created without the contributions of many different experts.

A second example is specialized, called CellarTracker, which allows an individual to maintain an online inventory of their own wines.  What is unique about CellarTracker is that there is one underlying database which is created through the sharing of information between members.  For example, if you want to enter a particular bottle into your inventory, you first see if someone else has already entered that particular wine.  If so, you choose it and add the wine to your inventory.  Each member has their own set of information based on their own wine collection, but the combination of this information creates a huge database.  The database structure facilitates sharing comments and notes, and adding external data such as pricing.  Started in 2004, 81,000 members have added their 12.8 million bottles of 626,000 different wines from more than 51,000 producers.

A third example is much more narrowly focused, really in the Long Tail, and is a Google Earth project on North Korea called North Korea Uncovered (see here, and articles here & here).  The site began with an individual began gathering information on North Korea from pictures and first hand accounts and mapping them.

Spying on North Korea would seem to be a job for intelligence services, but one PhD student at George Mason University has exposed many of the secrets of the insular regime from his home computer. Piecing together clues from news reports, photos, and eyewitnesses, Curtis Melvin and colleagues have annotated Google Earth's map of North Korea with hundreds of labels, documenting everything from mass graves to a waterslide. "It's democratized intelligence," he tells the Wall Street Journal.

So where is the insurance business?  The internet in particular, and technology in general, have been integrated into our daily business processes.  But are there any examples of similar collaborative approaches – combining the collective knowledge of the many – in the insurance business?  Are there any ideas or early stage organizations?  Please let us know.

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OB/GYN Liability

Medical malpractice insurance for OB/GYNs is a very difficult healthcare segment to underwrite.  Not surprising, the insurance market for this class is very thin.  Some of the highest severity claims occur in this segment – for obvious reasons.  An excellent discussion of why, with statistics and data, was presented in an article from Willis Healthcare Practice (see here, & here for the article).  There is not much for us to add.  This article is well written.

 

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Black Swan Theory in Insurance

Black swan theory was bound to show up in the insurance industry, but so far there has been limited discussion.  Do you know what a black swan is?  Black swans are important in assessing future insurance losses, but are they adequately represented in the models? 

The term originates from a book called The Black Swan: The Impact of the Highly Improbable by Nassim Nicholas Taleb (also see here, or see Recent Books on the left of this blog).  Wikipedia provides a good definition (see here):

a large-impact, hard-to-predict, and rare event beyond the realm of normal expectations

The book was written from the perspective of investing (Taleb was a hedge fund manager), but the concepts are particularly important for the insurance industry.  A central thesis of his book is that models are defective and lead to incorrect conclusions because black swan events are not contained in the data and are therefore assigned a probability of zero outcome – obviously incorrect. 

While there has been quite a bit of discussion of insurance modeling, there has been little discussion of black swan events and the ability of predictive models to adequately assess severe catastrophes for insurance purposes (see here and here for two such articles). 

However, two articles came to our attention recently.  The first (see here) is a response to some comments made by Taleb in an interview (see here).  Taleb notes:

My idea in The Black Swan is to make people think of the unknown and of the potency of the unknown, particularly a certain class of events that you can’t imagine but can cost you a lot: rare but high-impact events.

The author makes an excellent pitch for combining predictive modeling techniques with outcomes not envisioned in historical data, and makes 4 suggestions for planners (see here).

In the second (Risk & Insurance commentary, see here) the author is concerned that the black swan theory may result in less risk management and assumes that because black swan events occur we should or will not consider past history. 

I fear they may increase paralysis in risk management and further promote inaction.

But black swan theory is telling us that modeling, which relies on historical data, is only part of the story.  In fact, the future will be a combination of prior history, reflected in historical data, and new events, which can and at some point will lead to more volatility – sometimes better, sometimes worse.

The important point is that black swan events are not contained in historical data, and therefore traditional predictive models cannot provide complete picture of the future.  The second piece is equally important:  these events can be so large that they will dwarf other outcomes if they occur, although the probability of occurrence is extremely small.

Unfortunately, we have seen a number of these black swan events in the insurance business in the last few years, 9/11 and Katrina being two such examples.  Maybe a more flexible approach to modeling and a focus on risk management could be beneficial to the insurance industry.

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Coastal Risk Management

Insurance exposures within coastal communities are rising from climate change and development.  Increasing populations and property values, higher sea levels and more violent weather are all working to threaten insured property and challenge property insurers.  The insurance industry response has been focused on financing the aggregation of coastal exposure in a manner that does not risk insurer solvency.  Most of the political response has been focused on affordable insurance options, and one such result, which nobody in the insurance industry believes is effective or reasonable, is Citizens in Florida (see here & here).

Very little attention has been paid to risk management and the impact a risk management approach can have on adverse outcomes.  Both pre-loss and post-loss risk management tactics are critical components of successfully financing risk, yet there is little will within the industry or political segments to promote risk management.

A recent paper by The Heinz Center and Ceres has brought a group of diverse organizations (sponsors) together to generally agree on an approach to address the coastal threat that includes a heavy emphasis on risk management (see here, and here for the entire report).  Some key points:

Over half the U.S. population lives in coastal counties and almost half of the nation’s gross domestic product – $4.5 trillion – is generated in those counties and in adjacent ocean waters.  Further, insured property values along the Gulf and Atlantic coasts have been roughly doubling every decade.

Wharton has demonstrated that homeowners in Florida could reduce losses from a severe hurricane by 61 percent, resulting in $51 billion in savings, simply by building to strong construction codes. Putting this in perspective, the same cost reductions applied to Katrina damages would have reduced the $41.1 billion worth of insured property losses to about $16.1 billion. Similarly, the National Institute of Building Sciences showed that every dollar spent on mitigation saves society about four dollars on recovery costs. Despite this evidence, nearly all U.S. coastal cities and towns lack adequate land use requirements and building code standards to realize these savings.

Five hundred commercial clients of the insurer, FM Global, experienced approximately 85 percent less damage from Hurricane Katrina as similarly situated properties. This significant reduction in the amount of damage was directly attributable to hurricane loss prevention and preparedness measures taken by these policyholders. The return on investment is striking – a $2.5 million investment in loss prevention resulted in $500 million in avoided losses.

While risk management will not eliminate the exposure, it can go a long way towards making the cost of insurance reasonable.

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Mark to Market Accounting

You may have heard about mark to market accounting, also known as fair value accounting, but did you know that this accounting theory has contributed to the economic crisis and can lead to professional liability insurance losses?  Unfortunately, this particular accounting technicality, FAS 157, may have contributed - some say caused - the credit crisis, and may lead to more litigation.  These claims are starting to make the rounds in professional commentary and on blog posts.

Mark to market, or fair value, accounting is the new standard for GAAP accounting contained in FAS 157.  I have put some links on this subject below.  An excellent article from Duane Morris (see here) outlines some of the issues relating to causes and potential litigation from the application of FAS 157.  Additional articles are available here, here, here and here.

FAS 157 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

Fair value accounting sounds great in theory, but it creates some very significant and real problems in reality.  FAS 157 requires asset values on balance sheets be adjusted to reflect the current market values.  For example, a bank is required to write down a loan on an asset where the value of the asset has fallen below the loan amount regardless of whether the loan is performing.  In times like these, when asset value are falling, FAS 157 requires massive write downs on loan portfolios even if they are performing.  These write-downs create a real loss of GAAP capital, and can impair the financial strength of the institution with the technically impaired assets.

Take another example.  A venture capital firm invests in a new technology company that is expected to take a number of years to get to profitability (ie it is burning cash as it develops the technology).  The VC firm must make a market-based estimate each year, and sometimes more frequently, of the market value of its investment.  Typically, the market value of early stage companies would be zero (0), even though the investment might be performing exactly as expected.  [Note that this example assumes no interim rounds with outside investors that would set a market price.]  So the VC firm must, according to FAS 157, write the value down to zero (0) early in the process.  That might be okay for the VC firm if everyone understands what is going on, but it does not reflect long-term economic reality.

Now, some are anticipating that the fair value, or mark to market, valuation approach will add volatility to reporting company financial statements, and that this will lead to increased litigation against directors and officers, accountants and other professionals.  Obviously, increased litigation will drive up the costs of professional liability insurance.

If significant restatement activity results from increased levels of scrutiny, legal implications can be anticipated, as history has shown during other periods of financial results restatement activity. This could result in additional litigation through shareholder lawsuits.

It is too soon to tell whether the increased litigation, and increased professional liability insurance pricing, are coming.  But the controversy around FAS 157 continues.

Info & Articles on FAS 157:

FAS 157
Private Equity Guidelines
PE Blog Post – Fair Valuation
VC Valuation Committees
VC Perspective on 157
General Commentary on 157
General Commentary on 157
General Commentary on 157
VC Perspective on 157
Tuck School Valuation Survey
Tuck School Valuation Article

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Specialty Lines & Technology

The internet is having a profound impact on how society interacts and how business is conducted, and this extends to the insurance business.  Companies like GEICO and Progressive operate online as well as in person – the client chooses.  Has the use of technology impacted the specialty lines insurance segment as well?

A recent article in Insurance Journal highlights some of the challenges, and the perceived lack of progress, in the specialty lines market (see here).  Our perspective – different – is noted below.  The article is a summary of an interview with Jeff Ward, a director of London Market reform technology specialists TriSystems.  Key points in the article:

• the wholesale market is miles behind the retail market...they haven't even come close to the level the retailers have.
• In most cases - other than certain specialty lines - a potential wholesale buyer gets only limited information.
• The London market basically doesn't do business electronically
• It [electronic transactions] may not work for complex risk[s]...They will probably always require face to face negotiations, but there's a great deal that can be done electronically. Much of the actual work is not so complex that computers can't handle it.
• For wholesale business, a true global electronic market is probably many years away. Retail will get there first.

This characterization of the specialty lines market is only partially correct, and not because the specialty lines market has failed to adopt technology.  The specialty lines market (see here) is composed of insurance accounts that do not neatly fit into the rigid underwriting boxes of the standard markets due to more risky exposures, unique operating characteristics or adverse loss experience. 

The key is the underwriting approach in the specialty lines business - art, not science.  It is all about risk assessment.  Different underwriters will look at the same account differently, and will want to review different information.  And because the exposures presented can vary substantially, underwriter requests for information are not always consistent.  Additionally, the terms that are provided are not consistent between accounts or between underwriters, and are often negotiated.  This makes it difficult to neatly define the information needed by underwriters for large parts of the specialty lines business.

The article points out that some complex risks may require face to face negotiation.  Maybe, maybe not.  But today many complex risks are negotiated by specialty brokers, like Mercator Risk, and specialty underwriters without face to face meetings.  How?

Specialty lines brokers and underwriters are actually heavy users of technology.  The primary method of communication today, and of exchanging exposure and quote information, is email, and many specialty lines organizations (including Mercator) are completely paperless.  Negotiation of complex risks takes place every day via email and phone.

Most specialty lines rating and quote systems today are electronic, at least in some form.  They differ substantially from their standard market peers in that they allow for significant customization of rating and terms by underwriters.

While most of the business written in the specialty lines business is customized, there are significant segments that are handled completely electronically, online, by end to end underwriting and rating systems.  Mercator, through its MercatorPro division, provides online quoting for its retail insurance broker clients on its website for some lines of business.  The challenge for the specialty lines business is that some percentage of the business gets rejected from these systems due to the exposure variations or coverage adjustments inherent in specialty lines business.  Specialty lines brokers like Mercator have built in processes to efficiently handle this rejected business to ensure that, in most cases, the specialty lines applicant receives terms.

Bottom line, the nature of the specialty lines business is the driver of the differences in the use of technology, not a failure to adopt technology.  The use of technology in specialty lines is significant and continues to grow, but how technology is used will not exactly match the commodity-like approaches of the standard lines businesses.

Readers should note that this subject is very complex, the specialty lines business large and equally complex, and that this short commentary does not do the subject justice.

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Fraud

With the economic downtown, the frauds come to light.  Fortune has chronicled four alleged frauds and the ringleaders.  What is most interesting is the people behind the schemes, and how they pulled if off for so long.  Audacity?

Madoff - Trader (here & here)
Dreier - Lawyer (here)
Stanford - Money manager (here & here)
Salander - Art dealer (here)

None of these people were in the insurance business.  Recently and within the actual insurance business itself (ie AIG’s problems were/are, we are told, not in the insurance entities), the amount of fraud by insurance practitioners is not anywhere near the same scale.  That doesn't mean the insurance business has been without problems.  A few years ago we had the Near North/Segal scandal (see here & here).

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Hard Market – Not Yet

There has been much talk about the coming (imminent) hard market, led by public financial institution directors & officers (D&O) liability insurance (see prior post).  It is nowhere in sight.  Except for a few select segments, competition continues, rates are flat or down, and insurer marketing reps continue to press for more business.

Willis recently published a report confirming this, and suggesting that a hard market was not just around the corner.  The report, Marketplace Realities & Risk Management Solutions: A Different Kind of Cat – Spring Update (see here, here, here & here), notes three factors for a continuing competitive environment:

• Prior years’ results have produced significant surplus, so the industry is well capitalized
• Competition, sparked by new entrants
• Competition from and with AIG

Their comment on AIG is important.  While there have been reports (accusations?) about AIG aggressively cutting prices to retain business in the face of not so positive press, the report suggests that competing insurers have tried to use the situation to their advantage and have been aggressively targeting AIG business.  The result: both AIG and their competitors are driving pricing down.

This perspective on the market was echoed during a financial analyst’s conference call for Brown & Brown (see here & here).

• Despite a premium price increase push by insurers, rates remain competitive, especially for new accounts with good risk profiles
• [Executives] described an insurance environment nationally that continued to see premium rates that are flat to down[ and…] very few lines that exhibited any signs of premium increases anywhere throughout the country.

The Willis report noted that insurance buyer’s perspectives have changed, and that we can expect more diversification and an effort to mitigate counterparty risk.

The world has changed. The giants are vulnerable. Putting too many eggs in one basket is dangerous – no matter who’s holding the basket. In the short run, the push for diversification stirring up the marketplace may encourage competition. In the long run, however, we see the potential for a change in the way buyers and sellers interact in the insurance marketplace. Hard market or soft, we believe that buyers are more than ever looking beyond price and investigating the strength behind – the foundation beneath – the insurers they may want to buy from.

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D&O Market Under Pressure

There has been considerable discussion about a market turn (hardening) in the D&O (directors & officers) liability insurance market, but this is only happening in segments and for organizations that are exposed to significant losses from the economic crisis.  Financial institutions are obvious examples of organizations that will attract underwriters scrutiny and likely see significant increases and tighter terms.  We are seeing rates increases for financial institution D&O, both public and private, and some increases in public company D&O.  However, private company D&O and non-profit D&O remain competitive.

A recent article in CFO magazine provides an excellent summary of the current D&O marketplace (see here). 

• Given the volume of lawsuits and the possibility of other large settlements, insurers are skittish in the extreme, and not only regarding D&O coverage; errors and omissions, fiduciary liability, and employment-practices liability are also under scrutiny and are similarly tightening.
• The financial firms named as defendants in a securities class-action suit last year represented … nearly a third of all large financial firms.
• For industries outside of financial services, it's a completely different story. D&O insurance premiums remain largely unchanged, with the same coverage terms, conditions, and limits.

The article notes a critically important point about D&O insurance:

Directors and officers on the losing side of a securities class action are personally liable financially for both legal defense costs and the ultimate payout or settlement.

Buyers and their representatives should not lose sight of the fact that the primary purpose of D&O is to protect the personal assets of the directors and officers, and Ds & Os should ensure that their protection is maintained.  In addition, concerns about exposure are not one way:  insurer solvency is very much on the mind of buyers and their representatives:

We're counseling clients to reduce, reallocate, or remove from their D&O programs any insurance companies that have been downgraded by the rating agencies in the past 12 months - says Lou Ann Layton, managing director at insurance brokerage Marsh.

As with most parts of the insurance cycle, underwriters will look closely at D&O renewals and try to gauge exposure.  The market process for D&O is working, as prices for higher risk accounts are rising, and other accounts, perceived by underwriters as presenting less exposure, are not.  The resulting renewal will reflect the market’s conclusion.

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