Many of our Engineering clients are starting to budget for 2014. One of the major expense items is insurance and the purpose of this article is to explain where the industry is in the insurance cycle and what you can expect to see in 2014. Recognize that these prognostications are general in nature. Every firm is unique and rates will be affected by individual loss experience and other factors that collectively make up a company’s risk profile.
In order to look forward, we need to understand how the industry’s cycle works and what drives it. Like many industries, the insurance industry is cyclical. However, the insurance cycle generally runs independently of other business cycles. Insurance companies make money in one of two ways:
- Underwriting profits
- Investment income
An underwriting profit is achieved when losses plus all expenses are less than premiums. When you divide the former by the latter, you come up with what is called the combined ratio. A combined ratio of less than 100% means there is an underwriting profit, and a combined ratio of more than 100% means there is an underwriting loss.
Insurance companies also make money on the interest they earn on reserves they have set aside to pay future claims. These reserves are known as an insurance company’s policyholder surplus. During periods of substantial investment returns, insurance companies may be willing to underwrite at a loss because they can make up the deficit on the investment side.
Policyholder surplus is critical to understanding the economics of the insurance business. While demand for insurance remains relatively constant, supply (surplus) fluctuates up and down. If surplus goes down, insurance companies become more selective on which accounts they will consider, the industry becomes less competitive, and policy terms become more restrictive. This is known as a “hard” market. Conversely, if surplus goes up, the industry becomes more competitive. Rates go down, underwriters are willing to consider risks they wouldn’t consider in a hard market, and they are willing to offer broader coverage in order to attract business. This is referred to as a “soft” market.
So where in the cycle are we and what does this mean for 2014? Although surplus is currently more than adequate, in order to remain healthy the insurance industry needs to continue to generate capital. In order to attract investors, however, the industry has to provide an acceptable return on equity. Most investors seek at least an 8% return and ideally want 12% or more. The insurance industry’s 60-year average is 8.9%. Unfortunately for the industry they have not exceeded an 8% return in the past five years averaging a meager 3.7% over that time frame. What we have right now is a moderate hard market, lousy returns, but plenty of surplus. Insurance companies need to increase rates in order to improve returns, but the substantial surplus creates aggressive competition which is moderating what would otherwise be substantially higher rates. So what can you expect in 2014?
Property, Liability, Auto and Excess
For preferred risks, we expect on average to see renewal rates ranging from flat to plus 5%. We would suggest using 5% as a budget number increase. Note that this is rate, not premium. Premium is determined by multiplying rate times exposure (property values, sales, payroll, etc.). For non-preferred businesses (high hazard industries or poor loss experience), you can expect larger increases. Property risks in wind-exposed areas are also seeing substantial rate increases. If you feel your firm may be considered non-preferred, it would be wise to talk with your broker or underwriter now, to get their thoughts on what you can expect.
Rates vary depending on the industry and desirability of the risk. Fortunately for engineers, the market is currently saturated with insurance companies which has created a competitive environment. Overall, however, market trends are similar to the rate changes mentioned above for property, auto liability and excess. Preferred engineers and construction managers can expect flat to plus 5%. Once again however, if you have a poor loss history or practice in what are considered challenging areas (residential -- especially for-sale multi-unit for example), increases can be substantially higher.
Executive risk includes directors and officers liability (D&O), employment practices liability (EPL) and fiduciary liability. While results for fiduciary liability have remained decent, experience for both D&O and EPL has been poor. The down economy and resultant high unemployment has substantially increased the claims against directors and officers and the number of employment-related lawsuits has escalated dramatically as well. On average, we are seeing 10-15% rate increases on these lines, but 25% or higher is not uncommon. It is wise to start early on these renewals and market your program effectively with a specialist broker. Recognize that all of these policies are unique to each insurance company and coverage varies dramatically. Make sure you get appropriate coverage at the lowest realistic cost.
Workers’ compensation continues to be a huge challenge for the insurance industry, especially in California. Nationally, the combined ratio in 2012 was 108%, which was down from 114% in 2011. In California, the 2012 combined ratio was 117% and this was a substantial improvement over 2011, which was 137%. Over the last four years, the combined ratio in California has averaged 132%. Comp rates nationwide are for the most part increasing, but this varies dramatically by state. While on average you should expect to see 5-10% base rate increases, in California you should expect 10% or more.
An insurance policy is a contract between an insured and an insurance company. In exchange for the premium, the insurance company agrees to bear risk as spelled out in the policy. So what can you do to manage your insurance program and negotiate the most favorable rates?
Proactively manage your risk:
- Make sure you have:
- An effective client evaluation process.
- That you proactively negotiate your contracts.
- That you aggressively manage problem situations early on.
- Make certain you have an effective and compliant safety program.
- Your safety culture needs to be supported by senior management and supervisory employees responsible for implementing it need to be rated and evaluated on their efforts in this area.
- Start your renewal process early. Discuss marketing with your broker and engage your underwriter as well, if appropriate.
- Work with the right insurance company--one that offers risk control services and proactive claims management in addition to a policy and reactive service.
- Work with the right broker. Brokers vary dramatically in the services they offer. Unless you have a full-time risk manager, your broker needs to coordinate your risk management efforts.
The insurance industry will continue to vacillate between hard and soft market cycles and there isn’t anything you can do about it. What you can do, however, is proactively manage your operations to lower the frequency and severity of claims that drive your insurance and risk management costs.