Commercial Liability Lines: Bright Sunshiny Days?

Financial reports issued over recent months on the U.S. property and casualty insurance industry suggest that insurers south of our border may be facing a collective deficiency on claim reserves of about US$50 billion. A large percentage of this anticipated loss relates to commercial liability exposures, primarily in the areas of asbestosis and environmental risks. It is ironic that this unexpected loss development, which has already eaten into the surplus capital position of the industry, may actually spur a sustainable medium-term firming of the price cycle, particularly on the property side of the business, observes Douglas Leatherdale, CEO of The St. Paul Companies and chair of the International Insurance Association (IIA).

Canadian insurers, however, face no such reduction in excess capital as a result of reserve strengthening. Although the relationship between excess capital and its influence on weak pricing has become a contentious issue within the industry, the Insurance Bureau of Canada’s chief economist Paul Kovacs admits that, “excess capital is a part of the problem”, to why Canadian price firming across nearly all lines of business has been significantly weaker than in the U.S. and European markets. Specifically, Canadian pricing on general commercial liability covers has barely moved over the past two years, broker and company spokespeople say. In contrast, much of the price correction action in the U.S. has been focused on commercial liability covers.

A major factor separating the Canadian and U.S. liability coverage markets is the hostile tort environment of the latter. Does this mean that Canadian insurers are immune to similar developments occurring south of the border? Hardly, say the commentators CU spoke to. They point to several cost trends surfacing within liability risks, the most notable being the increasingly aggressive litigation environment developing in Canada.

Abundant capacity

Unlike the liability crisis of the mid-1980s which sparked the last price cycle hardening – an event that prompted many large commercial insureds to withdraw from traditional insurance – the current price strengthening underway is not being driven by a reduction in capacity, Kovacs notes. There is ample underwriting capacity available in the general commercial and professional liability markets, he adds, and insurers are being cautious in their pricing to avoid a mass withdrawal of business. Faced with the economic slowdown, Canadian businesses have also become extremely sensitive to cost increases – including insurance. As such, the combination of available capacity and buyer resistance to price increases has had a significant influence on tempering rate adjustments on commercial lines overall, Kovacs says.

Jeff Roth, senior vice president at Marsh Canada, confirms that underwriting capacity mostly remains strong in the general commercial liability market. In contrast, capacity reduction in the property classes has become very evident, he adds. “What we are seeing today will likely continue into 2002.”

Another commerical broker suggests the availability of capacity within commercial liability lines has dampened rate increases. Rising loss pressures have, however, introduced a more cautious approach to taking on risks, he adds, with product liability and municipal programs bearing the brunt of rate adjustments. “Municipal programs are becoming a lot more expensive, I think the [contaminated] water issue is going to escalate.” Furthermore, a greater number of Canadian insurers are beginning to realize that there is a “tail” to underwriting liability business. And, while this has not been as pronounced as in the U.S. with asbestosis and environmental covers, Canadian insurers are beginning to feel the bite of long-term losses associated with healthcare.

Another development within the commercial liability sector is that insurers who were regarded as general underwriters are now refocusing their books of business along specialty lines, the broker observes. Paul Martin, president of wholesale brokers Cross Border Underwriting Services, adds, “an interesting trend developing in the market is that companies are trying to focus on specific areas of risk within liability. They [insurers] are looking much more so at long-tail costs, and whether they can gain critical business mass.”

Sandra Osato, regional manager of risk management for Royal & SunAlliance Canada, also sees a greater number of insurers moving toward commercial liability in light of the losses stemming from general property risks. This shift is being driven by a focus on specific areas of the business, namely professional risks like “directors and officers” (D&O) versus general commercial liability. While specific liability classes like D&O and Errors and Omissions (E&O) have received some price attention, general liability remains significantly under-priced, she says. “A lot of the business is sold as a package, which masks the true cost of losses. But I think insurers are beginning to realize that there is a ‘tail’ to the book [general commercial liability].”

Osato concurs that the ongoing excess underwriting capacity in the liability lines has undermined adequate pricing. “We don’t have a capacity shortage. This is not like the liability crunch of the 1980s. Unless insurers adopt a more reactive approach to the changing legal environment in Canada, then we could see some casualties.”

Testy legal system

“It used to be that you’d have to be extremely unlucky to lose on general [commercial] liability [in Canada],” notes Fred Shurbaji, underwriting manager at Chubb Insurance Co. of Canada. However, the litigation environment in Canada is changing, much along the lines of developments in the U.S., he adds. “The legal climate in Canada is under review.”

Shurbaji believes that U.S. related tort decisions will likely play a greater role in how Canadian courts deal with similar events. In addition, class-action lawsuits have only recently begun to have an impact on the Canadian legal system, and subsequently insurer exposures under commercial general liability (CGL) policies and professional liability covers. The case of contaminated water at Walkerton, Ontario is a prime example of a time-consuming and expensive class-action that has alerted insurers of the potential dangers lurking in business that in years past would have been a fairly basic risk to write. But, he adds, “I don’t believe that past long-tail risk exposures such as asbestosis will spill over from the U.S. into Canada. At least nothing that is going to keep me up at night.”

Tort law in Canada is currently undeveloped, and determining the true impact of insurer’s liability exposures will depend on the direction taken by the courts, says Harold Hopf, assistant vice president of claims at Swiss Reinsurance Co. Canada. While some of the “mega tort” awards arising from events in the U.S. may never occur in Canada, there are enough emerging tort actions for insurers to take notice. “You can’t pick up the paper today without reading about sexual abuse. The big problem is that the kind of risks associated with claims today were not expected a few short years ago. Who did not want to insure the Red Cross, a church or the Boys’ Scouts of Canada?”

Setting aside the “dark unknown” of cyber-related risks that insurers and reinsurers are still trying to come to terms regarding product development and cover restrictions, there are a host of new liability risks that could potentially become the insurance industry’s next big nightmare, Hopf observes. Typically, he notes, medical and drug liability is rapidly becoming a huge concern, the advent of class-action lawsuits and what this could mean for Canadian businesses and insurers, consumer privacy laws, and not least of all several legal actions that have occurred over stock price losses and insurers’ exposures through D&O covers. “If we look at the Canadian legal horizon, I don’t think we can ignore developments south of the border.”

Probably the most significant change in today’s liability underwriting market to years past is that nothing can be expected, says Hopf. Five years ago, insurers could underwrite a liability risk at a premium based on past years’ experience. Today, all an insurer can hope is that the premium charged will cover last year’s loss, but the big question is, “will it cover tomorrow’s [loss?],” he adds. A significant issue underscoring this worsening legal environment is growth of legal contingency fee arrangements among plaintiff lawyers. “It’s only been a few years since we’ve [Canada] allowed for legal contingency fee billing.”

From a U.S. perspective, the Insurance Information Institute’s (III) chief economist Theo Hartwig points out that the average jury award in several major categories of liability insurance now exceeds US$1 million, which is almost double the level of 1993. “Most affected by these trends are medical malpractice, long-term care facility liability coverages, E&O for accounting firms, and construction defects covers.”

Litigation handling costs are definitely one of the more serious considerations impacting on liability business, Osato agrees. This, she believes, has much to do with the kind of litigation strategies developed by U.S. plaintiff lawyers to push legal actions with the sole intent of forcing insurance companies into a settlement to avoid costly court cases. A similar litigious attitude toward insurers is beginning to surface in Canada, she observes. “A stubbed toe is definitely worth a lot more today than five years ago.”

Liquor-related liability claims are another prime example of how Canadian court interpretations of policy wordings have moved in favor of plaintiffs, notes Ross Haight, a vice president at Marsh Canada. He believes that similar situations to some of the high-profile drunken driving cases where the employer of the plaintiff has been held liable will become more prevalent. “We have also not heard the end of the ‘defective condos’ [originated in B.C.] lawsuits either, and patent infringement [through international and Internet exposures] is something that no one even really knows how to deal with yet. I think the so-called ‘new age’ of the 21st century is definitely going to increase the complexity of the liability side of the business.”

Export exposure

Canadian insurers are terrified of exposure to the U.S. legal system, says Martin. Although general commercial liability rates in Canada have been slow to move, Martin notes that clients with U.S. exposures have been hit this year with liability rate increases of 25%-plus (see cover article for August 2001 for further details). “The [insurance] market in Canada is very tight when it comes to U.S. sales.”

However, Shurbaji believes insurers in Canada are over-exposed to potential U.S. liability losses arising from product covers. “Export exposure leads me to believe that we’re in for a rude awakening.” Furthermore, Shurbaji expects the potential of U.S. loss exposures facing Canadian insurers will spill over from general commercial liability covers, typically manufacturing, product and service risks, and excess of loss covers, to encompass professional liability coverages such as D&O. “Many Canadian companies have tried to get New York and Nasdaq stock exchange listings to raise capital. The exposure to U.S. shareholders and class-actions through D&O policies is great.”

“Nearly all of our insureds now have international or U.S. exposures, and we’re seeing more losses from claims that previously were not there,” says Osato. As such, she agrees that the Canadian market’s price rating on international commercial liability exposures is inadequate.

Environmental lurks

According to rating agency A.M. Best, U.S. p&c insurers are likely looking at an estimated US$56 billion in future environmental claims. A significant cost concern is whether government-mandated cleanup costs are covered under CGL policies written prior to 1986. As the III observes in a special report on “Environmental Pollution”, “nobody knows how much of the price tag for cleaning up the nation’s hazardous waste sites the insurance industry ultimately may be required to pay”.

In 1980 the U.S. introduced the Comprehensive Environmental Response Compensation and Liability Act, known as the Superfund law, which provided for limited government financing for hazardous waste cleanups. The legislation also provided the Environmental Protection Agency (EPA), which was appointed to oversee and investigate incidences, with significant policing powers and the ability to attach responsibility for hazardous cleanup costs retroactively and onto numerous parties. Initially, when Superfund was introduced, it was believed that the number of cleanup sites was around 400 – subsequent investigation has revealed the true number to be around 35,000. As the III points out, “under the Superfund liability scheme, each party has major incentives to transfer as much of the cost as possible to someone else. The EPA spends huge sums on researching history of the site and tracking down the responsible parties so that it will not have to pay for the cleanup, and EPA designated parties in turn go after other potentially responsible parties to lower their ultimate liability. The responsible parties also litigate issues among themselves and the EPA. As a result, it is not unusual for a hundred or more lawyers, working for different clients or on different aspects of the case, to participate in a single site plan and for hundreds of different insurance companies to be involved.”

Hopf notes that Canada currently does not have federal legislation similar to the U.S. Superfund. Canada does, however, have a large number of hazardous waste sites which will eventually have to be cleaned up. As such, he notes that Canadian insurers have not yet been exposed to third-party cleanup liability claims. But, this situation could change in the future once focused action is taken in the form of an environmental cleanup policy. “Once someone decides what to do about hazardous cleanups, then the courts will decide who is responsible.”

Financial view

Despite the lackluster attention thus far to industry pricing of commercial liability business, plus the lack of “mass torts” as witnessed in the U.S. market, Canadian insurers are becoming more cognizant of the potential tail losses resting within their liability books, says Joel Baker, general manager of A.M. Best Canada. Specifically, insurers strengthened liability reserves by more than $150 million between 1999 and 2000, representing an average of 4% of net premiums earned over that period. While the loss ratio on liability lines has declined marginally over the past year, significant adverse developments on prior-year claims connected to pollution, sexual abuse and condo construction defects have materialized, the rating agency states. “A.M. Best doesn’t expect significant improvement in the line’s results before 2002.”