Commercial Liability: One Bad Apple

Just two years ago, CU spoke to industry insiders who saw companies heading into the dangerous waters of commercial liability, despite the shockwaves being felt as a result of as bestos and other liability exposures south of the border. Now, Canada’s commercial buyers are facing the same capacity-depleted market, price hikes and reduced coverage that have plagued the U.S. market and forced huge reserve charges for so many companies.

In January 2003, Travelers Property Casualty Corp. added a then unprecedented US$2.5 billion to its reserves, equal to almost all of the company’s 2002 operating earnings (see chart 1). This was followed by ACE Ltd. shoring its reserves by US$2.2 billion, which was followed by The Hartford Financial Services in boosting its reserves by a gross US$3.9 billion. Much of the reserve action taken by insurers relate to asbestos exposure.

But, marketwatchers warn that these reserving moves may just be band-aid solutions, as rating agencies and research firms remained unconvinced companies are adequately covered. Between May 2002 and May 2003, Standard & Poor’s (S&P) downgraded 23 U.S. commercial lines carriers, again as a result of asbestos claims fears. Seven of those downgrades were by two or more notches, and not one commercial carrier saw its rating upgraded during the same period.

The market for U.S. liability risks has changed massively. Asbestos and environmental risks (including mold) are now the subject of widespread exclusions, and long-tail claims are the subject of intense government wrangling over how to stem the tide of lawsuits. For those areas where cover is still available – directors’ and officers’ (D&O), other professional liability, umbrella, errors and omissions (E&O), and even general liability – rates continue to climb despite significant price increases over the past few years while capacity continues to remain scarce.

These market trends have made their way across the border in Canada. In its 2003 market review, brokerage Willis notes that 2003 increases are expected to be 50% or more on primary liability, up to 100% on umbrella and excess, 100% on E&O, 50%-100% on D&O and 75%-200% on excess D&O. “Throughout 2002, Canadian insurers followed the overall global market trends of increasing rates and retentions along with restrictive terms and reduced capacity,” states the Willis report. “In addition, virtually all insurers have taken the opportunity to ‘clean out their books’ and concentrate on those classes of business where they believe their expertise will allow them to underwrite profitably.”

There is also the influence of Canadian companies’ involvement in cross-border risks. Whether importing and exporting with the U.S., running an operation south of the border or holding a listing on a U.S. stock exchange, Canadian companies have felt the market crunch. “Accounts with direct U.S. exposure were treated especially harshly as fewer and fewer Canadian underwriters would consider these risks. This resulted in an under-supply of market and, subsequently, a dramatic increase in premiums,” the Willis report notes.

While liability net written premiums grew to more than $3 billion for 2002, losses also rose to top $2 billion last year (see chart 2). Adverse loss development in the liability line was $247.9 million in 2002, according to Insurance Bureau of Canada (IBC) figures (see chart 3). This compares with total Canadian p&c industry profit for 2002 of $312 million.

BUILDING CAPITAL

The commercial lines experience in Canada has been better than most other classes of business. It has also performed significantly better than the U.S. market. That is to say, the commercial liability experience in Canada has not been terrible. But, global liability losses have trickled down as reinsurers try to reinforce their balance-sheets, hiking rates for primary companies who in turn pass increases along, points out Donald Chu, an analyst with S&P in Canada. “The [commercial liability] market’s improving, but we’re still seeing substantial rate increases in most lines.”

Those rate increases have been the cause of growth in premium volume in the market, as opposed to new capacity, confirms Nelson Rivera, managing senior financial analyst with A.M. Best. There is great divergence amongst the top liability writers in Canada (see chart 4) in terms of loss ratios, and he points out that these ratios have been skewed by the lack of capacity being put into the market. And, while there is not the dearth of capacity seen in the “liability crisis” of the mid-1980s, “most companies have chosen areas they don’t want to be in anymore, or maybe they shouldn’t have been in the first place”, says Tony Iatesta, director of liability for Zurich North America Canada. “They seem to be reshuffling the deck of cards. [What capacity there is,] is a lot more expensive than people thought it would be, and it’s very restrictive”, he adds.

Companies are getting better at identifying what lines they do not want to be in, agrees Shawn DeSantis, senior vice president of commercial lines at ING Canada. Shareholder expectations are making companies “shy away” from volatile liability risks. Insurers are asking, “do we want a lot of business on our books that is going to result in severe ups and downs?” While the commercial property market started earlier and went deeper in terms of the hardening turn, “it appears the focus this year is going to be on liability”, says Iatesta. “Liability still has some catching up to do, it’s still in correction mode.”

The Bermuda market, sources say, is having little effect in tempering the upswing in liability pricing. “It’s picking and choosing its spots, but for your average Canadian company it hasn’t had much effect,” DeSantis comments. Most of the Bermuda writers are unlicensed in Canada, and it has been difficult to find anyone to front this business, points out David Mew, national director of broking for Aon. Generally, the Bermuda market has been limited to the toughest industries to place, such as oil and energy, and on excess rather than primary layers.

However, Iatesta notes, the new Bermuda writers have one advantage in that they are not tied down by legacy issues such as asbestos. “When you look at liability, it’s the old business that kills you. They [Bermuda] don’t have to deal with that tail business.”

SOUTHERN EXPOSURE

Given that there is generally a two to five year lag between issues hitting the U.S. radar and then making their way north to Canada, no doubt Canadian insurers have their eye on the American experience as an omen of things to come. The U.S. market is in a maelstrom, with legislators tackling various forms of tort reform from class actions to asbestos to medical malpractice.

In the U.S., it’s the “big three” liability issues at the forefront: asbestos, D&O and workers’ compensation, says John Iten, director at S&P. Despite reserve adjustments made to deal with these issues, these have been insufficient, specifically in the workers’ compensation line. “We do expect additional reserve strengthening that could affect financial strength ratings.”

Last year saw U.S. industry reserves rise by more than 8% while pricing in liability lines had climbed by the end of the spring 2003 renewals by 41.6% on medical malpractice, 27.4% on professional liability, and 30.8% on D&O, according to Conning and Co.

Nonetheless, a recent Conning study estimates U.S. p&c reserve deficiency at US$38 billion, of which US$35 billion is in commercial lines. And, much of this can be attributed to liability lines (see chart 5). “The survival of some insurers and reinsurers may well depend on their ability to accurately reserve and appropriately price, ” the Conning report comments.

“These [reserve] charges for legacy issues have delayed the recovery of earnings that we and a lot of other people have been looking for,” says Iten. As a result, S&P has given a negative outlook on the U.S. industry. “It [industry recovery] is just taking longer than we thought. Even six months ago we thought the outlook would turn to stable.”

In th e face of this, companies such as AIG have come out publicly to call for changes to the U.S. tort system. But the process has been slow, and while some class action reform has been achieved, asbestos litigation legislation has stalled and medical malpractice has fallen to the states themselves to tackle in lieu of federal action.

HAUNTING UNKNOWNS

Sources agree, it is Canadian companies with a U.S. exposure who are facing the liability crunch most harshly. Due to the amount of lawsuits facing Canadian companies doing business in the U.S., these operations are now recognizing this risk in their pricing, says DeSantis. “We [Canadian insurers] have been a bit lenient compared to our U.S. counterparts [in terms of pricing].”

Essentially, the border has become “blurred” for liability risks, says Iatesta. “With our main business partner being the U.S, we really can’t differentiate with there being a border.” And, even in Canada, the legal environment has changed with the acceptance in most provinces of class action legislation and contingency fees for lawyers. Pricing in certain classes is reflecting this change, DeSantis says. “That is strictly driven by the legal environment that’s starting to appear in Canada, which is much like that of the U.S.”

It is the “unknowns” that make pricing and reserving in the liability market so difficult. “When you rated something in the 1960s, you didn’t foresee class action suits 30 years later, in 2000 cash [value],” Iatesta notes.

While DeSantis says most claims departments can reserve properly for liability, it is a challenge, he admits. He uses the example of sexual abuse claims hitting the Catholic Church in Canada, based on incidents dating back decades. “They [insurers] are not writing it anymore, but now they’re seeing this on their books [from prior years]. What is the next ‘sexual abuse’ that I’m not seeing today but will come back to bite me five or six years from now?”

The issue dominating the asbestos reserve debate in the U.S. at the moment is an S&P report challenging the level of reinsurance recoverables on which insurers are counting on. “Successive rounds of massive reserve increases at primary companies not only fail in aggregate to capture the size of the industry’s shortfall, but anticipate an unrealistic level of reinsurance backing,” the report states. Of the top 13 commercial carriers, 45% of their asbestos exposure has been ceded to reinsurers. The report goes on to say that reinsurers have not made corresponding reserve strengthening moves.

The most obvious example, notes Iten, is the ACE reserve strategy, which places most of the exposure at the feet of its reinsurers. “Are reinsurers being notified and accounting for those losses?”

Canadian insurers did take liability reserves in 2002, Rivera says, often on these same “incurred but not reported” (IBNR) losses that are confusing the situation in the U.S. “It’s a much more difficult segment to reserve for,” he confirms, and there is reserve deficiency in Canada. He adds that reinsurance recoverables are a global issue. “Canadian insurers are pretty conservative in terms of whom they reinsure with, but you never know who can tank out on you. Who could have foreseen Gerling Global Re, for example, exiting the market.”

PRICING EXPOSURES

Insurers are certain of some of the risks they are exposed to and now want to avoid, and D&O is topping the list. “D&O is probably the toughest segment of the liability market,” comments Mew. “Almost all markets writing D&O have cut back.” Either the company has made the decision to reduce its exposure, or the decision has been made for it by the loss of reinsurance cover. Those companies remaining can charge what they want, with some corporate insureds seeing 100%-200% price increases, he adds. Companies seeking big limits are also struggling to access them.

It is telling that about 25% of AIG’s US$1.8 billion reserve top-up in early 2003 was attributed to D&O exposure. Rating agency A.M. Best comments, “the majority of companies writing D&O coverage already have experienced severe deterioration in underwriting and will continue to report poor underwriting results through 2003. As well, the adverse fundamentals currently affecting D&O loss costs will result in a continued deterioration of calendar-year underwriting results for most D&O insurers in 2003.”

Insurers have found that past pricing is simply not appropriate given the new D&O environment, with shareholder lawsuits involving potentially large numbers of people seeking significant payouts, notes DeSantis.

The 2003 market outlook by broker Willis notes that about two dozen U.S. D&O cases have seen claims exceeding US$100 million, not counting the financial failures of 2002, and “carriers have learned the hard way that attaching high in the first US$100 million is not a risk-free proposition.” But, D&O is not the only concern of insurers – among the top underwriting issues is construction liability risks. Much like D&O, construction liability is a rising claims tide leading to market withdrawal and price hikes. Insurance companies are becoming much more specific about what they will cover, for example, shying away from such classes as roofers, notes DeSantis. Losses in this category are mounting, he confirms. “I’m not sure our pricing today is hard market pricing, but we’re pricing more for the exposure…for the past few years, consumers and businesses have been getting a pretty good deal.” As in D&O, some niche writers have come into play, charging a premium for the coverage and being highly selective about who they will cover.

“Very, very few underwriters in Canada want to offer any capacity at all and if they do it’s very expensive,” says Mew of the roofers market. He says “fringe markets” will cover some small risks, but large construction concerns are struggling to find cover.

D&O, construction and cross-border risks represent the “big three” for Canadian liability insurers, notes Rivera. Other risks catching insurer attention include liquor and tobacco liability, and of course, asbestos and environmental. Tillinghast-Towers Perrin estimates worldwide asbestos liability at US$200 billion, with insurers on the hook for US$120 billion, split evenly between U.S. and non-U.S. carriers.

Asbestos has been seen as less of an issue in Canada, but the U.S.-style of advertising for potential asbestos claimants is being seen north of the border, perhaps signaling a rise in litigation. Rating agencies are looking at Canadian insurers’ potential exposure to asbestos, Rivera confirms. Canadian insurers and reinsurers have tried to tackle the asbestos issue through exclusions, along with environmental concerns such as mold. But these can only deal with future claims, and they will only protect against “known” exposures, notes Iatesta. “What comes back on you is the things you don’t know about”. He points out that the industry cannot put exclusions on exposures it is not even aware of.

Of the future, Mew says the hope is the market will flatten out in 2004, but this will be determined by three forces. Insurers continue to await an upswing in the investment market to relieve pressure on underwriting. There is the hope that insurers will want to maintain good business in their books and will treat that business with some care. And there is also the question, “can people really afford to keep paying these price increases?”