An Eye to the Horizon
The insurance industry is facing a variety of forces which catastrophically threaten its fundamental mechanics and the financial strength upon which our economy is dependent. Insurance companies comprise of some of the largest, and most valuable companies in the market. These critical financial institutions maintain the health and wellbeing our nations businesses, employees, families, and overall economy. Due to the impacts of the COVID-19 pandemic, their role is quickly being brought to center stage in our country’s socio-political conversation. The intent of Business Interruption coverage is the primary precipitating factor.
Lawsuits are being filed against insurers regarding the intent of Business Interruption coverage, and associated denied claims. Simultaneously, legislators are attempting to compel insurers to retroactively pay claims where coverage may not exist, was not intended to exist, and premiums were not actuarily contemplated to offset the risk.
Consider that small businesses alone are losing between $255 billion and $431 billion of monthly income as a result of the pandemic, against $6 billion in total monthly premiums for commercial property insurance, according to the American Property Casualty Insurance Association.
It is believed if some individual lawsuits award the plaintiff, precedents would be set, and trigger a wave of class action. In some form, this would necessitate government intervention and subsequent bailouts of the insurance industry. Despite the insurance industry maintaining an $800 billion surplus to cover all U.S. home, auto, and business insurance claims, it would not sustain the industry against the onslaught of class action suits or legislative intervention.
Understanding the Influences
With Insurance companies beholden to their shareholders, they look to generate and maintain profits in the following primary ways:
- Collecting more premium than the sum of claims paid out and their general business costs; The Combined Ratio
- Investment income from the invested premium and surplus funds
Irrespective of the legal issues threatening the industry, in an unforeseen manner, businesses are sweepingly reducing sales and payroll figures applied to the rates which generate their premiums, thus significantly reducing forecasted revenues of insurers. Further, the new, unforeseen, and uncertain economic headwinds facing our economy will reduce the forecasted investment income they also depend upon for profitability. This alone can be reason for insurers to look for rate increases. However, if these factors are coupled with potentially unfavorable legal and government action which will jeopardize their significant surplus funds, and flip the scales of their combined ratios, the insurance industry would crater under the magnitude of the opposing forces.
With some distinct differences, the current commercial insurance environment is not too dissimilar to post 9/11 circumstances: catastrophic actuarily unjustified losses, legislative action, economic pullback and uncertainty. A significant primary difference being the losses then were concentrated to specific areas and insured groups, rather than blanketed across effectively every commercial policyholder in the country. With that in mind, reference the chart below which outlines the rate changes over the past two decades.
The large spike, post 9/11, identifies the hardest insurance market in nearly half a century. If insurance could even be obtained by a companies seeking a policies during that time, rate increases approached +30% on average across the marketplace. With the current situation facing more dire and catastrophic influences, the industry is primed to experience a perfect storm of factors which lead into a hard market unlike ever before.
The Captive Solution
The value proposition of the captive insurance industry is inherently distinct from their counterparts in the retail insurance industry. The primary difference being the only shareholders, or members, of any captive insurance company are also the owners of the businesses insured by the captive. Another way of stating this, captives are 100% owned by the member group of businesses it insures. This insular group of captive member companies satisfy their insurance requirements, yet at the end of the year receive 100% of the captive’s underwriting profits, returned to them as a dividend.
Unlike retail insurers, who do not distribute profits to the companies they insure, captive insurance companies retain the profits for the shareholders for whom they are beholden. When those profits are threatened, the primary mitigation is through rate increases. As evidenced by the factors expressed earlier, retail policy holders are facing the threat of hard market rate increases of a magnitude which is difficult to fully grasp at this time. On the contrary, the shareholders of a captive insurance company are sheltered from those forces, they do not have the incentive to pass along premium and rate increases to enhance profits, only for those profits to be distributed back as a dividend after the policy term.
With its more scrutinous underwriting practices and distinct ownership structure, the group captive insurance industry is an inherently sustainable model in comparison to the retail insurance industry. More than 5,000 middle market American companies have left the traditional market in favor of group captive solutions, yielding a $3.4B business lines marketplace. AM Best reports, between 2014 and 2018, captives added $3.1 billion to their year-end surplus and paid $1.6 billion in stockholder dividends and $1.9 billion in policyholder dividends. Therefore, $6.6 billion during this period remained with the captives or was paid back to their policyholders and stockholders instead of going to the commercial market.
The predictability, control, and safety found in the captive market can be shelter from the hard market forces we face in the years ahead. If you are interested in further exploration of group captives, ensure you are aligning with experts experienced in captive placements. The Risk Assurance Advisors at J.Krug are here to assist you along that journey.
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Itasca, Illinois 60413
Article provided courtesy of mbbi.org, published June 9, 2020.