United States: The Hard Insurance Market: Taking Advantage of a Bad Situation

The current hard insurance market, characterized by substantial price increases and restrictions in coverage, is having a substantial impact on businesses, reminiscent of the hard insurance markets in the mid 1970s and 1980s. This naturally poses short-term challenges that must be addressed. It also presents long-term opportunities for businesses interested in finding solutions to these repetitive business cycles in the insurance industry.

Unlike the previous two hard markets, the insurance industry is in relatively strong financial shape. Although the insurance industry clearly has incurred substantial losses due to September 11 and the drop in the equity markets, and a few insurers are in trouble, a general shortage of capital and underwriting capacity is not the issue. Instead, most insurance companies still are willing and anxious to write business. They are just being much more selective about the risks they will insure, more restrictive about the limits they will provide, and more aggressive about the premiums they will charge.

Another impact of the hard market is that some insurance companies are not providing the defense and indemnity coverage to which companies are entitled when claims are made under existing policies. This presents an additional set of challenges in submitting claims and getting insurance companies to satisfy their legal obligations to their existing insureds.

This alert is the second in a two-part series dealing with issues concerning the hard insurance market and its impact on clients and friends of the firm. The first part focused on recent guidance issued by the Internal Revenue Service that effectively provide safe harbors to establish captive insurance companies. This alert provides broader strategies for dealing with the insurance hard market as well as additional information on captive alternatives.

• The Immediate Challenge - Increased Premiums
• and Coverage Restrictions
• The Captive Alternative
• Submitting Claims and Recovering the Benefits of Your Insurance Policy

At renewal time, companies are commonly experiencing sharply increased premiums, with sublimits or exclusions of certain risks, and reductions in overall policy limits. The explanation offered by the insurance industry is that this merely represents a correction for the low prices and generous limits they offered during the sustained soft market, but this does not soften the blow.

Companies can try to help themselves in several ways. In order to best deal with underwriters, you must first make sure that you carefully analyze and fully understand the nature of the risks you are trying to insure. You must also be able to demonstrate an excellent loss record and the steps you have taken to avoid costly claims. In the end, insurance underwriters make a subjective judgment about the risk presented by your company, and the higher level of comfort they have in your business, the more reasonable they are likely to be. Make sure that your application and underwriting submission are thoroughly prepared. Also involve your risk managers and top management to help make the case that your products are safe and that your business is relatively risk free in comparison to others in your industry.

Although you may not want to change your insurance providers, be sure that you discuss with your broker the possibility of submitting applications to several different carriers so that you can obtain competitive quotes that will provide you with some negotiating leverage and bargaining power. Make sure that your broker is accessing all available markets and not just the carrier(s) with which it may have the best relationship or that may pay the highest commission. Also, there may be group captives and risk retention groups that were established in previous hard markets that your broker may not be aware of or may be prohibited from recommending due to the marketing restrictions imposed by their firms. Having competitive quotes from alternative sources will help you negotiate the best deal possible, even if you decide to renew with your existing carrier.

The impact of premium increases also may be tempered by accepting substantially increased per claim deductibles or by self-insuring certain risks. You must evaluate the likelihood that there will be claims in the layer or risks that you keep in comparison to what you would pay in extra premiums for more extensive coverage. If you really represent a good risk, and you are willing to take the chance that you will continue to have good claims experience, you should benefit and take advantage of this strategy.

A further benefit of increasing your deductible or self-insured retention is that you will have the opportunity to take control and manage your own claims. Working with good outside counsel and claims administrators, you may be able to enjoy substantial savings, since you know your product and industry better than insurance adjusters. You will also be able to retain special coordinating legal counsel who can do a much better job with your claims than typical insurance defense lawyers. Also, by taking direct control of your claims, you will be better able to analyze what may have gone wrong, and you will have greater incentives to institute safety and loss control programs, and implement risk management procedures that will reduce future claims.

Finally, when considering the coverages and limits you may be offered, be careful to review your policy wording to make sure you are getting what you have been promised. Depending upon the carrier, it may be possible to negotiate the policy language and to manuscript special endorsements for your protection.

As discussed in greater detail in our previous alert, there may be great tax and business advantages for some companies to consider setting up or joining a captive insurance company that is owned or controlled by the company and other insureds who purchase insurance or reinsurance from the captive.

For companies whose corporate structures permit, a single parent captive may be an alternative to consider for insuring the parent and its other subsidiaries. Among other things, the captive becomes a mechanism for handling the large deductible or self-insurance layer. The overall costs of insurance should be cheaper, because the captive will be able to save administrative expenses that are normally charged by the insurance company and built into the premium. The captive also will be able to keep underwriting profits and investment returns that normally are retained by an insurance company.

Tax planning is particularly important in connection with the formation of a captive. If the right conditions are met, payments to the captive are tax deductible in contrast to a situation where a company might otherwise be required to accumulate after-tax dollars in reserves to fund future losses for large deductibles and self-insured layers. Finally, a captive offers the opportunity for tax-free accumulation of reserves for unpaid losses and possible tax exemptions for small captive insurance companies.

Another great advantage is that the captive will have direct access to the reinsurance market to obtain higher policy limits at possible cheaper prices. Companies will thus have the ability of going both to the direct insurance market with a higher deductible (funded by the captive) or to the reinsurance market in putting together their best package possible. Also, as noted above, a company will have the advantage of taking control and handling its own claims with the substantial benefits described above. Finally, a captive can write its own policies and design its own overall insurance program.

A group captive (or risk retention group) is basically the same concept, except that it is normally owned by a number of companies with the same risk or in the same industry. Oftentimes group captives are organized by a trade association or other umbrella group for the industry. Group captives allow their members to spread their risks, and to aggregate their buying power with reinsurers. Assuming that the group is selective in what companies are invited to participate, the overall claims experience should make the captive more profitable than its commercial counterparts. Such groups are particularly appropriate when their risks are misunderstood by the traditional insurance market and they otherwise would be charged higher premiums than what is justified by their actual risk.

The federal Liability Risk Retention Act of 1986 offers qualifying group captives substantial freedom from state regulation other than the licensing jurisdiction. For companies that must provide proof of insurance to their companies, and if perception or the captive’s lack of a rating may be an issue, a fronting arrangement can be negotiated with a licensed admitted carrier. Qualification under the Act also relieves the group captive from complying with all but the anti-fraud provisions of federal and state securities laws.

Setting up a single parent or group captive (or risk retention group) is a long-term, complex undertaking that should not be lightly considered or undertaken. It requires considerable effort in collecting premium and claims histories, and a feasibility study must be performed by an independent actuary in order to validate that the program makes sense in light of projected premiums, administrative and underwriting expenses, and likely claims and loss development. Whether you go on-shore or off-shore, the licensing authorities will need to be convinced that the proposed captive makes economic sense and that the program is substantial enough to warrant their approval.

One of the many factors that companies must consider in deciding where to seek a license is the minimum premium, capital and surplus requirements of the licensing jurisdiction. For companies or groups who may be unwilling or unable to satisfy these requirements at the outset, it may be desirable to consider a so-called rent-a-captive organized by others. Also, if cash flow is an issue, a captive generally can be capitalized with a letter of credit and it may be possible for the captive to make loans back to its parent.

Finally, a captive should not be considered unless it will be viable when the insurance business cycle eventually returns to a soft market. In addition, the initial organizational costs and the annual operating costs can be substantial. Those single parent and group captives that have survived from previous hard markets have done so only because they made economic sense and provided risk management and claims control advantages under all market conditions. Captives promise long-term benefits in terms of stable insurance costs and coverages, and the ability to take control of your insurance destiny, but only for companies prepared to make long-term commitments.

Another result of the insurance hard market is that some distressed insurance companies are increasing their use of reservation of rights letters or denying coverage in order to avoid paying legitimate claims. For this reason, it is important for companies to take great care when notifying their carrier to make sure that the claim is characterized in such a way that it will make it difficult if not impossible for the insurance company to deny coverage. Review by legal counsel is strongly recommended for all substantial claims.

Anything less than a complete acceptance of the claim by your insurance company should be carefully reviewed and challenged when appropriate. If you have a preference about which law firm you would like to represent you, check your policy language and, if necessary, see if you can negotiate a compromise.

Companies that receive a reservation of rights letter should review it with legal counsel and challenge the insurance company’s actions if appropriate. Also, in most states, if the insurance company issues a reservation of rights letter, you will have greater rights in most states to select your own counsel. Insist that the insurance company retain legal counsel to defend you that will be concerned only with protecting your rights and that will not have any conflict of interest due to the reservations of rights.

It goes without saying, of course, that strong measures must be taken if an insurance company improperly denies coverage. Oftentimes, a strong legal letter reminding the insurance company of its good faith obligations and possible exposure to punitive damages for wrongfully denying coverage will do the trick. Other times, assuming the economics make sense, a lawsuit should be filed to recover the insurance benefits to which the company is entitled.