Risk Management Precarious Times

As the world watched the Twin Towers of the World Trade Center (WTC) crumble on September 11, the result of terrorist attacks, the human tragedy was overwhelming. But within days, it also became clear that the business of insurance, already struggling, had been changed forever. Quickly insurers were tallying losses and concerns began to rise over solvency, capacity and terrorism coverage.

Risk managers preparing to renew their commercial policies were suddenly thrown into the disarray, and are still, in many respects, reeling. Recently risk managers gathered as the Ontario Chapter of RIMS (ORIMS) hosted its annual Douglas Barlow Professional Development Day, and the issues of the post-September 11 insurance market were foremost in their minds. Speakers warned of a vastly different scenario facing risk managers than in past years. Beyond the already anticipated rate hardening, they could expect tightening terms, a lack of available coverage and a much more cutthroat bargaining atmosphere.

Taking a toll

There is no doubt insurers were already in financial trouble prior to September 11 and all indications were that this was beginning to trickle down to clients. Loss ratios were rising, return on equity in the North American markets was predicted to be below 3% for 2001 and shareholders worldwide were clamoring for change. Hardening was beginning to become apparent in the reinsurance market and insurers were bolstering themselves for a tough negotiation period as autumn took hold.

In the summer, risk managers were hearing predictions of 25-30% increases across the board, notes Lovel Vining, director of insurance and risk management for CIBC. They were also hearing talk of limitations, including cyber exclusions being written into contracts. “You couldn’t get anything thrown in,” he notes, and underwriting standards were expected to be much tougher.

And then the world changed, and with it the insurance market. Largely this change took place in the reinsurance market, which is predicted to be on the hook for 65% of the reported US$30-50 billion tag for September 11, reports Garry McDonell, senior vice president for Aon Reed Stenhouse. With the reinsurance market largely unregulated (unlike insurers who are required to include certain coverages in their contracts), and a few major global players with a great deal of market sway, insurer reaction is largely a product of reinsurance market action. “They [reinsurers] will set the direction and the rest of us will follow,” says McDonell.

The amount of risk capital required to support insurance is now much greater, says Heather Masterson, director of corporate marketing for American International Group (AIG) in Canada. Insurers now have to realistically prepare for the worst case scenario because that is what they faced on September 11. “We can no longer say ‘this can’t happen’, because it has.” Risk managers certainly saw a hard market coming, perhaps as early as five years ago, admits Ed Martingano, risk manager for Oxford Properties and president of ORIMS. “We have to go back into the 1980s to see rates the same” as they are now, he says. Rates have been continually dropping since that time, so that even the current hard market may not bring them back up to previous levels. “This isn’t about a single event [September 11], but a longer-term dysfunctional industry,” he adds.

Wayne Hickey agrees. The chair of the Canadian Risk Management Council, and supervisor of risk and insurance for Teck Cominco, says that beyond the September 11 effects, insurers should be looking at how they can temper the big fluctuations of the insurance cycle. Risk managers would likely be happier to pay reasonable annual increases than to be faced with big hikes following soft markets such as the most recent one where rates were unsustainably low. “We [risk managers] only had it easy because insurers gave it [coverage] to us at that cost. They were competing with each other and now we’re going to pay for it.”

He wonders if there is not some way for the industry as a whole to deal with the rate issue, without being accused of price fixing. Examples such as OPEC do not bode well for such solutions, he admits, and it is unlikely that the kind of cooperation necessary for industry-wide change is going to surface. Despite the already hardening market and the long-term problems of the industry, Hickey notes that September 11 “just drove it into chaos”. Martingano agrees the terrorist attacks and their impact on the industry, which is currently being seen in the disastrous 2001 results for most insurers, was like “adding gasoline to the fire” of the already smoldering market.

“[The market]’s not hardening,” says Vining, “it’s [already] hard…it’s stiff.” And rates are not the only issue. Limitations, capacity issues and tighter terms are also coming fast and furious down the pike. “It’s nasty out there. It’s difficult to maneuver, it’s difficult to manage.” And many risk managers, he admits, have never faced a market such as this.

Martingano admits risk managers may be having a tough time coping. “We don’t like being in a position where we can’t plan [because] the change is so fast and so severe.” Risk managers were used to viewing a 15% increase as substantial, he says, and now this is perceived as a small increase by comparison. “Where in July you might have shuddered at a 25% increase, now I’d look like a hero if I could get that,” Vining laments.

Across the board

How long will the current pricing issues, which Joan Cummings, senior vice president of RiskCorp Inc. accurately describes as “ugly”, last? Predictions vary. Masterson says increases will certainly run through 2002 and 2003, as insurers will not see results in terms of earned premiums for at least another year. Vining thinks it could be 2005 before risk managers see a let up in hardening. In a recent report, U.S. rating agency Fitch predicts a return to soft pricing no later than 2003.

The current hardening of the price cycle, which was originally predicted to be mainly focussed on “losing” lines of business, has swept across all lines. Part of this is in reaction to September 11, where losses were seen on a variety of lines of business — life insurance, workers compensation, aviation, property (especially commercial property) and business interruption. After the WTC, one of the hardest hit developments was Brookfield Properties, which saw extensive damage to buildings surrounding the Twin Towers, including its Liberty Plaza development. Senior vice president Katherine Vyse notes that beyond the property loss, business interruption coverage did become a big issue for the company and its tenants. Another recent report from PriceWaterhouse Coopers even went so far as to suggest that more than one-quarter of the final loss tally insurers face for the WTC attacks could be in business interruption exposures.

Martingano notes that real estate developers have been among the hardest hit by the increases, where companies face multiple expiring policies on different projects and are looking at increases as high as 80-300% on certain covers. Property is seeing the biggest increase among the lines, he adds.

But, other businesses are also being heavily impacted by increases on lines such as aviation, liability (including commercial general liability), property, medical and workers compensation, adds Hickey. Companies with operations in the U.S. are “being hit on both sides”, especially in terms of workers compensation. Masterson notes that the oil, gas and energy sectors are also being hit, being seen as vulnerable terrorist targets. Such sectors have been seen by some as vulnerable to swings in the economy given the turmoil in the Middle East as well.

In general, it is no picnic for risk managers, regardless of the line of coverage or their type of business. McDonell reports 15%-150% increases in directors and officers (D&O) coverage, 60%-150% in aviation, 10%-40% for marine. Overall, he predicts hikes of 40%-45% will hit risk managers as they renew their contracts.

Masterson adds that corporate buyers should also expect the trend to short-term contracts, rather than such things as three-year deals, will continue and increase now.

Companies will face not only the unavailability of terrorism coverage, but also cyber exclusions, environmental exclusions and more. “Forget the throw-ins, we’re talking about the big stuff,” Vining notes.

Tightening the screws

There has been some criticism of the insurance industry, suggestions that insurers may be using September 11 as justification for rate hikes and limitations that are too fast and too severe. Whether or not the increases and coverage changes are seen as fair, they are certainly taking their toll, and insurers themselves are not immune. Not only are they dealing with arguably the most challenging reinsurance market ever, but they are also facing intense pressure from their own shareholders, and living under the threat of another terrorist attack or other catastrophic event and the impact on reserves and solvency potentially.

When Brookfield Properties faced its own renewal, just weeks after September 11, RiskCorp, acting on the developer’s behalf, found itself facing an insurance market in disarray. “October 1 came and went and we had no concrete answers on capacity, terms and pricing,” says Cummings. And by October 15, the company had only one offer on the table. After deciding to go with their original October 31 deadline, rather than seeking an extension, the company was forced to go with one insurer and excess coverage, and proceed without terrorism coverage for the time being. Says Cummings, “We had no other choice at the time.”

Martingano says that insurers are having difficulty coming to grips with the new market. “It’s been difficult for the industry to re-examine underwriting so quickly,” he says. While the current rate hikes may be severe, in the context of September 11 and given the global nature of the insurance industry, insurers may have little choice. “Part of it is a knee-jerk reaction and I think to a certain degree it’s understandable, when you see the amount of the losses and see how much capacity has to be put back and how quickly.”

And long-term relationships between insurers and their corporate clients are expected to mean a lot less in current negotiations. McDonell admits that as insurers face pressure from shareholders to better the bottom-line, they will be making more hard-line business decisions. Underwriting rules will be applied more stringently and no one will be spared increases. It is extremely difficult to get “broker wordings”, or terms that favor the client, into contracts, as insurers are simply less willing to negotiate.

“Those of us who expect to be looked upon kindly are not finding this to be the case,” says Hickey. Even “good risks” are “getting nailed”, but perhaps feeling fortunate if they can get coverage at all for certain risks. Capacity is in a critical state, already showing signs of flagging prior to September 11 and now in a horrible state. McDonell sees the US$24 billion in new capital that has come into the market recently in response to the hardening market as “naive money”, that may not be around long-term.

The closure of Copenhagen Re and other small reinsurers, others cutting lines of business and the drought in retrocession markets is being felt by insurers, Masterson says. This lack of capacity is in turn being translated into the primary market and being felt by risk managers. Several insurers have cut lines of business, sold unprofitable lines and for certain covers there simply is none to be found.

Cummings says big developers such as Brookfield face big capacity concerns and could be looking at “Swiss cheese” coverage, with a lot of gaps. Martingano agrees, noting that with so many contracts to renew on various projects capacity is key. Without the capacity, lending agreements may be impacted and projects halted, as was the case with one recent large development in Washington, when the expected coverage could not be found.

Terrorism concern?

Of course, the most pressing issue is the lack of terrorism coverage, however, there is some question of just how big an impact this issue is really having. Are lenders shying away from projects in the absence of coverage?

Martingano admits the up until now stakeholders have not been pushing very hard for a solution, making it that much more difficult to lobby the government to step in and offer a solution itself. The CRMC, with RIMS, has lobbied the federal government, along with the Insurance Bureau of Canada (IBC) to come up with a terrorism reinsurance pool option. Led by Lloyd Hackett, director of legislative, risk management and public affairs for the CRMC, they have pushed for business interruption, some lenders’ interest, fire following, and property coverage for terrorism.

In the case of Brookfield, Vyse says that the lack of coverage has not been an issue so far. Cummings reports that when cover was sought, they found it “unorganized, unavailable and expensive”. Vyse says investors understand that the problem is widespread, but in terms of how lenders will view the issue, this remains to be seen as most of the developer’s lending agreements have yet to be renewed.

As such, sources are predicting the government may not step in anytime soon. The Canadian government is clearly looking for a U.S. lead, but the U.S. has not shown signs of addressing the issue seriously since Congress broke for the year end. What coverage is available is priced prohibitively. “Companies have to seriously look at terrorism coverage and whether it’s worth it,” says Hickey. The real question, Martingano contends, is whether companies, insurers and the government in particular are willing to wait for another terrorist attack to find out if coverage is really necessary.

ART-istic solutions

In the face of this rough and tumble insurance market, risk managers have their work cut out for them, clearly. Placed in the role of the messenger, they are forced to deliver nothing but bad news to company boards and senior management. “One thing is an advantage,” notes Hickey. “You don’t have to be in insurance to understand what happened September 11. They were forewarned there was going to be trouble in paradise.”

McDonell adds that insurance may also be “bought and at any price”, given that about 50% of the September 11 losses were uninsured. The biggest hurdle facing risk managers is the chaotic state of the insurance market itself, says Martingano. “I don’t know how much I’m going to be able to buy, I don’t know the terms…how do I deal with ‘I don’t know what’s coming?”

While he had begun explaining the hardening process prior to September 11, he found executives “quite shocked” by the 20%-35% increases expected at that time. “Then, after September 11, everybody inherently knew things were going to change.”

Another issue that faced risk managers was the lack of time to seek out other risk financing alternatives. This has forced many corporations to simply take much larger deductibles in the face of rising insurance costs. Masterson says programs that used to have a $25,000 retention have been rising up to levels as high as $2 million. Insurers have also been increasing deductibles, but these were probably too low before, says McDonell.

Some companies will be taking “gaps” of retention to reduce costs, explains Hickey. A program that might have three or four layers of excess coverage will now have layers of coverage and layers of retention.

There remains hesitancy about moving into the alternative risk transfer (ART) market however, sources report. This is in part a reaction to the lack of time to investigate these options and also a lack of knowledge of where the market is headed. “The real unknown is where prices are going to settle back down to…what are our long-term premiums going to be?” says Martingano. “I don’t want to set up a captive and find out in two years that [insurance] rates have halved again.”

But Vining says these alternatives should not be seen as a “flight” option in bad times, but a “conscious choice” for risk managers. “The move to captives is part of th e risk strategy that all companies need to look at”, regardless of whether it is a soft or hard market.

Hickey is among those who caution insurers and reinsurers that alternatives may become attractive in a prolonged, intense hard market. And he is not alone. The recent Fitch report also suggests that ART options may be more popular now. The rise of captives and other options during the previous hard market should serve as a warning that money that leaves the insurance market may not return anytime soon.