Professional Liability: Will the Cycle Remain Unbroken’

By Frederick J. Fisher, J.D. | October 25, 2004

Some say it’s over—the hard market, that is. Certainly in some areas of professional liability this is true. Many renewal premiums in 2004 are flat, or are even dropping by 10 percent or more. Not withstanding the legislative effects of the Sarbanes-Oxley Act of 2002, publicly traded D&O premiums have seen significant decreases given increased competition in the marketplace. It didn’t take long!

Already many professional liability lines are seeing increased capacity to underwrite; new markets are coming in to take advantage of current pricing, and in some lines, premium reductions can be seen. Certainly there are some professionals that are finding limited market capacity, but it is only a matter of time before that too changes.

The period from 1994 though 2000 saw one of the longest “soft market” terms in history. And while the market soon became hard, it hasn’t taken long for the profits to rise, surplus capacity to increase and competition to start again, reversing a trend towards profitability and underwriting soundness.

To understand what led to the longest soft market ever seen one must first analyze what went wrong before asking, “Will this happen again?” Can another soft market be prevented, leading to less severe swings above and below the profit line?

Several factors no doubt contributed to the disastrous soft market and underwriting losses that were experienced by so many, sometimes leading to the demise of what had been perceived as stable and profitable insurers. These factors included:

• Poor historical or misunderstood loss data resulting in poor pricing.
• Poor management or supervision of some MGAs (often the MGA being the only one making money).
• Poor implementation of underwriting guidelines.
• Unsuccessful underwriting teams moving from one market to another.
• Cash flow-oriented underwriting.
• Poor claims reserving, IBNR estimation and actuarial estimation.
• Ineffective or inefficient claims management thereby increasing losses.
• Corporate profits fueled by high interest rates and investment gains (both realized and unrealized) allowed to offset underwriting losses (until Wall Street analysts stepped in).
• Political expediency for politicians getting voter mileage from soft market pricing.

So, what happened during the hard market besides the obvious?

First, certain positive changes have occurred in the MGA model. These changes may become permanent and reverse a common and unrealistic approach to underwriting soundness and profitability.

Many MGAs writing or managing a professional liability program no longer enjoy the autonomy they once had. Many are subject to strict review and compliance with underwriting guidelines and pricing in real-time, i.e., they are linked to the insurers’ computer systems giving rise to immediate underwriting review and approval. Gone too are remittance procedures allowing for a float of up to 60 days for the net funds to actually be received by the company. As a result, and only time will tell, the MGA model may prove more successful then ever before.

However, other MGA issues may continue. Only two things can be true about an MGA’s book of business—it’s successful or it is not. If so, why do some MGAs seem to change markets every five years? Something has to be wrong in the forecasting model showing potential profitability when in fact there may be none. And if the book of business is not successful, why would another market want it even if increased premiums would off set the losses?

Hopefully these lessons have been learned by some, yet given recent carrier changes, one must wonder if the lessons have indeed been learned.

Unfortunately, actuarial forecasting is not an exact science. Certain assumptions may sometimes prove false. This can be true when cumulative loss runs show losses far exceeding premium. Yet missing from the analysis is a fundamental answer, i.e., the loss runs are accurate, but were these results preventable? Perhaps the policy form was poorly worded, giving rise to adverse appellate coverage decisions.

Or perhaps the claims department was exerting no management controls over the defense counsel or even routinely allowing the insured’s private (and experienced) counsel to defend suits. Thus missing from the forecasting model are adjustments for these other contributing factors. Only qualitative claim auditing would discover these issues.

No doubt staffing is an issue too. With too few claims personnel, claims and claim expenses spiral out of control. With too few underwriters, profitable business never gets quoted. There are many instances of tremendous growth with many insurers, yet one must wonder about low submit-to-quote ratios evidencing that the profitable growth could have been better. In other words, in a hard market, when your shingle is still out—that’s the time to staff up. It’s absurd to staff up underwriters when the market is soft and pricing is unprofitable.

So, having observed several cycles since 1975, what can we expect now, given some positive changes?

Unfortunately as this market stabilizes, many of the previously listed soft market recipe items are already again in place, and after only three to four years of underwriting profitability.

For instance, despite positive changes in the MGA model, most professional liability premiums are still written on a “direct basis.”

Many markets are trying to “hold the line” on pricing, end up discounting 20 to 25 percent as new markets enter the marketplace. Hopefully these new markets will hold off, yet how does one attract the business otherwise? And how does a stable incumbent market fend off a potentially fly-by-night newcomer?

More importantly are underwriting units. Why keep a unit intact with a not-so-good track record with current pricing being the only difference contributing to the new-found success? Sometimes networking does not seem like such a positive thing.

Claims handling attitudes have still not matured despite well documented and quantified statistics that verify the fact that claim expenses should be equal to or more than loss payouts—otherwise loss payouts often quadruple as a result.

Again, claims personnel have too many files on diary at many carriers, far more than the 125 to 175 standard proven to allow claims to be controlled properly, leading to lower payouts. Usage of local, knowledgeable, experienced adjusters has again been abandoned in favor of local claims counsel at triple the cost.

It is predictable that in the next four to five years the recently obtained profits will be given back as reinsurers decide that their newfound capacity cries out for production and the competition for the dollar continues to drive pricing down, or a return to coverage enhancements already proven to increase losses.

Time will indeed tell the story, but 2006 is already looking a lot like 1996.

Frederick J. Fisher, J.D., president of E.L.M. Insurance Brokers Inc., has been actively involved in the professional liability arena for
almost 30 years. In addition to experience in underwriting, adjustment, investigation and resolution of professional liability claims, he is active in the Professional Liability Underwriting Society (PLUS), has been a member of their Board of Trustees, and has
served on several committees. He can be reached at (310) 322-1301, or ffisher@e-o.com
.

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Insurance Journal West October 25, 2004
October 25, 2004
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Professional Liability