Breaking the Cycle
Cyber attacks, commercial motor vehicle accidents, property and business interruption exposures.
Not only are prices rising fast and hard in the lines of insurance that absorb these risks, but coverage terms, conditions and limits are more conservative.
“Reinsurers can be expected to continue to constrict their capacity, which should have a knock-on effect in the insurance markets,” says Joe Peiser, commercial risk leader for North America at Aon.
The uptick in property claim frequency and severity is impelling reinsurance markets to reduce their loss exposures.
RenaissanceRe, citing climate change, reported a net loss of $325 million in second quarter 2022.
The uncertain economic picture also factors into property and casualty insurance market conditions.
In June, Aon reported that, for the first time since 2005, property catastrophe reinsurance capacity had contracted to a level where the aggregate demand by insurers could not be satisfied. “The increasing severity of climate change-induced natural catastrophes, combined with ongoing increases in the asset value of buildings and equipment in cat-prone areas, is driving higher losses,” Peiser explains.
The uptick in property claim frequency and severity is impelling reinsurance markets to reduce their loss exposures. “Reinsurers are definitely looking to attach at much higher levels and prices,” says Jason Palmer, head of U.S. captive management at WTW, referring to the threshold of loss at which reinsurance would begin to cover a loss.
With less recourse to spread risk through the reinsurance markets, insurance companies are forced to bear more risk on their balance sheets. To relieve the financial pressure, insurers increase pricing and narrow coverage terms and conditions. “When our clients go to the marketplace for commercial insurance, their self-insured retentions or deductibles are higher,” Palmer says. “We’re also seeing exclusions or sublimits being added to their policies.”
In some lines of insurance, the market response is “tamer,” Palmer says, but in other lines, such as property, business interruption and cyber insurance, the response is fierce. This is especially the case with cyber risks, due to a headline-grabbing spate of ransomware attacks in 2021. “With the potential for cyber attacks coming from all different directions, underwriters are having a difficult time rating the potential for loss,” Palmer says.
Hard Times Ahead
Welcome to today’s hardening insurance market. Robert Hartwig, a clinical associate professor of finance and director of the Risk and Uncertainty Management Center at the University of South Carolina, describes it as a moderate but obdurate hard market that has persisted for a number of years and shows few signs of softening. “With the exception of workers compensation, the majority of commercial insurance was in a hard market prior to the pandemic and, after a short period of flatlining, continues to harden in this era of climate change, ransomware, nuclear verdicts and reductions in assumed reinsurance,” Hartwig says.
In a July earnings call, RenaissanceRe CEO Kevin O’Donnell said the reinsurer experienced a net loss of $325 million in the second quarter of 2022, despite improved underwriting. He attributed the loss to climate change, specifically the difficulties of modeling a risk that is simply too slippery to grasp.
“While vendors [of catastrophe risk models] may have adjusted their views to reflect recent [loss] experience, we believe that they have not robustly captured the physics of climate change,” O’Donnell said on the earnings call. “From a risk-management perspective, this means that the vendor model outputs are likely to underestimate the risks that insurers and reinsurers are managing.”
These possible miscalculations may result in a reinsurer exposing more capital to loss than intended, resulting in lower than expected returns on this capital, O’Donnell explained.
Since the reinsurance markets ultimately bear the financial impact of climate change-induced property and liability losses, many reinsurers in recent months have constricted their capacity or pulled out of dicey markets like catastrophe-prone Florida. Reinsurer Scor, for example, reportedly will reduce its natural catastrophe exposure by 15% by year-end, on top of an 11% reduction in January. Axis Re, on the other hand, announced in June that it had exited the property reinsurance market entirely, shifting its focus to specialty insurance markets.
Higher prices accompany reinsurance capacity contractions. According to an index compiled by Guy Carpenter, property catastrophe reinsurance prices in the United States were nearly 15% higher during July renewals than they were in January renewals, marking the highest reinsurance rates-on-line since 2009. The rate increases were expected: 65% of market participants that make or provide input into reinsurance buying decisions anticipated that prices would accelerate during midyear renewals, with only 4% expecting rates to slow, according to a survey by Reinsurance News.
Aon’s midyear reinsurance renewal report summed up the situation for property reinsurance buyers as a “near-perfect storm,” citing a “collision” between rising insurer demand for reinsurance and significant capacity constraints. Although the casualty reinsurance market was stable by contrast, growing concerns over emerging risks and social inflation (a loosely defined term suggesting higher-than-anticipated insurance claim payouts) are generating more challenging liability reinsurance renewals, the report says.
“Nuclear verdicts,” Peiser says, referring to unusually high jury awards surpassing what insurers consider reasonable or rational amounts, “are emboldening the plaintiff bar, leading to the financing of litigation involving product liability, product recalls, employment liability and other kinds of alleged discriminatory practices.”
Aside from reinsurance pricing dynamics, the uncertain economic picture—inflation, supply chain delays, flat retail sales and decreasing consumer confidence—also factors into property and casualty insurance market conditions.
These varied financial pressures affect CFO decision-making on capital outlays and budgets. Rising insurance premiums to offset reinsurance market contractions are compounding these deliberations. In response, many insureds, counseled by their brokers, are retaining more risk internally through higher deductibles and self-insurance alternatives like captives.
“The principal driver in forming a captive has always been the underwriting cycle when prices increase and coverage terms and conditions narrow,” Hartwig says. “This is the market situation we’re in today.”
State of the Art
Captive insurance companies owned by the businesses they insure have been around since the first one was formed in 1962. Not only do more than 95% of Fortune 500 companies own at least one captive, many midsize companies also have incorporated them, both onshore and offshore.
Given direct access to reinsurance markets, customized insurance protections, access to accrued investment income and the incentive to improve loss control, captives are a proven way to insure challenging exposures that give pause to traditional insurance markets. Since the captive absorbs lower layers of loss, owners are able to buy excess layers of insurance and reinsurance at lower prices, much like having a higher deductible in car insurance.
“When it is more difficult to buy limits of insurance at a reasonable cost, the use of captives increases,” says Nick Napolitano, captive practice leader at AssuredPartners.
Several brokers commented that, for troubled lines of insurance, clients are forming new captives, increasing the risk retentions in existing captives, joining group captives and leasing protected cells in rent-a-captive structures. “We’re seeing a decided uptick in different types of captives used for commercial property and business interruption exposures, cyber, D&O, general liability, commercial auto liability and medical malpractice,” Napolitano says. “Necessity is the mother of invention. Given the sharp contraction in reinsurance market capacity, it’s more difficult to buy limits of insurance at a reasonable cost. … It’s very safe to say that standard market rates have increased at least 7% each year over the last seven years.”
While a single 7% increase might not pose too great a challenge, Napolitano says, as it compounds over time, “it creates a ton of pressure for insureds.” As a result, he says, many middle-market and upper-middle-market companies have turned to the alternative risk transfer (ART) market, in some cases for the first time.
Peiser says the premium retentions in captives managed by Aon have catapulted 73% since 2018. “This includes a steep 361% increase in property damage and business interruption retentions over the period, a 26% increase in general liability retentions, and a whopping 650% increase in cyber captive premium retentions,” Peiser says, adding that he expects these trends to continue in the foreseeable future.
Cyber insurance covering ransomware attacks and extortion demands is a case in point. The high frequency and severity of ransomware claims made the coverage unprofitable for many carriers providing the insurance, compelling several to exit the line.
In several high-profile cases in 2021, the extortion demands by hackers were in the seven-figure range, with the business interruption exposures absorbed by insurers costing even more than the ransom paid. Aggregate insurance and reinsurance capacity subsequently shrank during the January 2022 renewals. Additionally, many carriers also tacked on 50% sublimits, reducing the available financial limits of protection for a ransomware claim by half.
The hard market conditions are compelling more companies to insure different layers of their cyber exposures in existing captives with enough capital and surplus to assume these risks, Palmer says. “We’re seeing all sorts of interesting ways this is being done, such as the captive participating in the primary and excess layers of loss or providing coverage for the exclusions and/or the deductibles in the standard cyber policy.”
Peiser shares this opinion, citing a 650% increase in premiums under management in a captive for cyber exposures over the past five years. “Bear in mind, though, that this increase is starting from a small base,” he says.
Peiser forecasts the present use of captives for cyber risk exposures will be surpassed by a greater volume of premiums absorbed by captives for climate change-related exposures.
“Cyber losses are high, but claim frequency seems to have declined a bit in recent months, and underwriters are beginning to get a handle on severity,” he says. “Climate change, on the other hand, is so unpredictable and all-encompassing, as it exposes multiple lines of insurance to significant losses. It will continue to daunt traditional markets.”
If liability claim severity for directors and officers (D&O), environmental impairment and commercial automobile risks increases, reinsurers will be less inclined to assume as much of these risks from ceding insurers as in the past.
As verdicts rise, so do liability claims. Although midyear 2022 liability policy renewals were relatively stable—due in large part to a long absence by U.S. courts during the COVID-related closures in 2021, which produced a backlog of cases—expectations are for January 2023 renewals to reflect reduced reinsurance capacity.
A case in point is D&O liability. “There was a reduction in shareholder litigation against directors and officers during the pandemic, but that’s over,” says Robert Hartwig, clinical associate professor of finance and director of the Risk and Uncertainty Management Center at the University of South Carolina. “A backlog of mega-suits is making its way through the court system, albeit slowly, such as COVID-influenced litigation against long-term care and senior facilities.”
Aside from the backlog of claims, other liability concerns for directors and officers include the fallout from special purpose acquisition companies (SPACs) that have yet to find a de-SPAC merger partner and the Securities and Exchange Commission’s recent ESG (environmental, social, governance) disclosure proposals.
The SEC has proposed that senior management disclose their organization’s greenhouse gas (GHG) emissions, the GHG emissions related to the energy and electricity they purchase, and GHG emissions produced across their upstream and downstream value chain, assuming these emissions are “material,” meaning reasonably likely to affect investors’ decision-making. This last disclosure proposal, known as Scope 3, is a potential litigation minefield, given the difficulties inherent in accurately providing the GHG emissions of suppliers, vendors, business-to-business customers and other entities in the value chain.
Board directors, meanwhile, would be required to disclose how the climate change-related risks of the companies they oversee affect the organization’s strategy, business model and outlook, as well as reporting their own risk-management processes to identify, assess and manage these risks. “The SEC disclosures will lead to more litigation, as will a company’s failure to achieve its stated pronouncements to achieve net-zero emissions by a particular date,” Peiser says.
Trial lawyers are targeting the trucking industry also, Hartwig maintains, citing an “astronomical increase” in jury awards in excess of $1 million. “Although the industry is pushing for reforms across the nation, state legislatures are dominated by trial lawyers,” he says. “This makes it likely that transportation firms, as a market, will continue to experience substantial commercial automobile insurance price increases. It’s the most persistently difficult line of insurance for carriers to manage, leading other lines in terms of rate increases or close to it the past five or six years.”
Liability insurance renewals are likely to remain a concern for the foreseeable future. “Liability is pretty much a U.S. phenomenon,” says Peiser, attributing market volatility in part to the speed at which information spreads via social media. “It’s a big factor in all kinds of liability losses,” he explains.
“The word gets out, wrongly or rightly, that corporations are bad actors that should be held accountable for something that happens, encouraging the plaintiff bar to pursue litigation,” Peiser says. The impact extends beyond liability, however, poisoning the well for customers and employees who buy into whatever negativity is spreading on social media about a corporate bad actor, resulting in lost market share and retention issues.”
Captives are being developed for other distressed lines of insurance experiencing significant capacity constraints. “We’re seeing the expansion of existing captive programs and sometimes new formations because of increased pricing, higher self-insured retentions and sublimits, and policy exclusions in property, business interruption and litigation liability policies,” Palmer says.
Peiser agrees. “After cyber, the biggest increase in the use of existing captives is for property and business interruption exposures, up 360% in the past five years,” he says. “Clients with captives are always grateful they have a captive when the market hardens, but we’re also seeing new captive formations and increases in the use of protected cell captives.”
A protected cell is like an apartment in a large apartment building in the sense that the captive is occupied by multiple companies in unrelated businesses. Each company takes advantage of the typical benefits of a captive without having to own the captive, hence the reference to such entities as rent-a-captive structures. The sponsor of the captive maintains a capital surplus to assume working-layer losses, above which reinsurance absorbs the remainder. Since each cell is legally separated from the other cells, assets are walled off from any liabilities incurred by the other cells, hence the reference to “protected.”
Hartwig concurs that protected cell captives have caught on. “I recently came across some numbers indicating that the number of captives overall increased by 2.9% in 2021, whereas the number of captives in individual cells shot up 5%,” he says.
Heterogeneous and Homogeneous Captives
Other types of captives are also growing in use. Napolitano tallied a 33% growth in the number of insured clients utilizing heterogeneous or homogeneous group captives. “That’s a pretty staggering figure, since group captives were once considered a novelty and only recently have become mainstream,” he says.
Heterogeneous group captives are composed of companies from diverse industries, such as construction, manufacturing, transportation and retail, whereas homogeneous group captives are made up of companies from the same industry. The chief benefit of a heterogeneous captive is portfolio diversification to spread the captive’s risk, while the chief benefit of a homogeneous captive is members’ similar insurance and risk management profiles, allowing for specialized loss prevention programs and customized insurance coverages.
“Homogeneous captives were created when a particular industry was unacceptable in a heterogeneous captive,” Napolitano says. “Commercial roofers, for example, couldn’t get into a captive, so they formed their own.”
Napolitano provides the example of a large middle-market client with a challenging over-the-road commercial automobile exposure. “They’re a distributor with a large fleet,” he says. “Two days before the renewal, the broker delivered a solution with a 44% premium increase, which translated to an additional $400,000 in cost. We introduced them to a homogeneous captive group for distributors with a 20% premium savings and another 40% in savings when the built-up equity from the unused loss runs was factored in. What appealed to them most of all, however, was getting off the hamster wheel of the insurance cycle.”
As attractive as that is, Napolitano suggests the growth in group captives may be having an adverse impact on the commercial insurance market. “There has been a mass exodus to the captive space, with the top 25% of performers shifting to a group captive,” he explains. “This creates a situation of ‘adverse selection,’ where traditional markets insure what’s left. I’m not sure how much this meaningfully contributes to the current hard market, but intuitively it makes sense that it plays a role.”