Editor’s Note: This article was written by Standard & Poor’s analyst Darin Feldman, and is printed with permission.
In its 1998 annual report “Survival of the Fittest,” Superior National Insurance Group vividly depicts a treacherous, competitive workers’ compensation market that is intolerant of mediocrity. Describing the various threats to the workers’ compensation market in California, Superior postures as a competitor in an enviable position. Its dominant market presence in California, unparalleled technological expertise, disciplined operational management, and the financial backing of well-recognized capital providers were all thought to give Superior’s competition cause for concern.
Superior was correct in identifying the critical importance of a discernible competitive advantage in a market where almost everyone is a price-taker. Referring to those companies lacking that advantage and the financial strength it provides, Superior presciently stated that the Department of Insurance (DOI) is “clearly ready to take action against workers’ compensation underwriters who fail to measure up to high standards of solvency.” Superior was unwittingly scripting the preface to its own downfall.
On March 3, 2000, California Insurance Commissioner Charles Quackenbush ordered the seizure of Superior, the second largest provider of workers’ compensation in the state. With its acquisition of Business Insurance Group (BIG) in 1998 from Foundation Health Systems, Superior more than tripled its direct in-force premium and emerged as California’s largest private sector workers’ compensation provider. With $669 million of in-force premium, $1.7 billion in assets, and $224 million in reported equity, Superior no longer eluded its competition’s radar. A well-entrenched distribution system, a reputation for technological excellence, and access to Zurich Reinsurance Centre Holdings Inc. (Zurich), one of the world’s largest insurance enterprises, gave Superior a market presence that the competition could not ignore.
How could such a seemingly well-positioned company fall into a downward spiral eventually landing in regulatory intervention? Superior’s problems are valuable for analytic review, serving as reminders that critical credit risk factors are often left unexamined when operations appear to be running smoothly.
Finally, Superior’s seizure clearly has ramifications for the California workers’ compensation system. Superior’s demise will either sober the market into rational competition or, because of the large block of business it made available, prolong a cycle of below-cost pricing.
The Root of the Problem
If 1998 was Superior’s “Year of Records” 1999 would have to be labeled its “Year of Despair.” Although it is difficult to identify any single event as the trigger of Superior’s downfall, its inadequate reserves were a fundamental problem. When Superior purchased BIG in 1998, it wisely secured reinsurance protection against potential adverse loss development.
With more than $210 million of protection, Superior was free to focus on integrating its operations and transitioning to the future. A reserve guarantee amounting to almost 40% of BIG’s carried reserves certainly seemed like reasonable assurance. As the guarantee was made by Inter-Ocean Reinsurance Co. (Inter-Ocean), management could be assured that the reinsurer, as an independent party, had put their stamp of approval on the reserves. It would ultimately be their money on the line if they were wrong. In fact, they were wrong. The magnitude of the error was such that Inter-Ocean became convinced misrepresentation had occurred and, as a result, attempted to rescind the contract.
Soon after closing the transaction, Superior posted additional reserves that exhausted Inter-Ocean’s entire $175 million reinsurance limit. After several months of public dispute, Superior and Inter-Ocean, with the aid of Zurich, agreed to honor the contract. As a concession, Zurich, who has a sizable financial stake in Superior, agreed to assume some of Inter-Ocean’s loss.
This agreement eliminated a major uncertainty for Superior, but the company was still caught in a spiral. Although the reinsurance dispute was not the cause of the company’s problems, it accelerated the speed at which they were exposed.
The Beginning of a Crisis
The reinsurance dispute certainly had capital implications for Superior. It did not, however, directly affect its liquidity. The losses under the reinsurance contract were still only reserves; Superior would not have to pay them for a fair amount of time. Nevertheless, a crisis quickly ensued. As required by the California DOI, companies writing workers’ compensation in California are required to keep deposits on hand with the state that are roughly equivalent to the amount of their policyholder liabilities.
A company’s deposit requirement can be reduced if an admitted reinsurer in the state has provided coverage to the primary company for the applicable losses. Superior therefore, in posting reserves against its reinsurance contract, did not have the burden of keeping $175 million of deposits on hand with the state for those losses. The responsibility would be borne instead by Inter-Ocean. But when Inter-Ocean attempted to back out of the contract, it was unwilling to post the requisite deposits.
Faced with the possibility of inadequate funds to cover the losses, the California DOI withheld the release of excess deposits that Superior previously had been entitled to receive. Because Superior had already been in a negative cash flow position with limited borrowing capacity, it relied on unencumbered balance sheet assets to fund its obligations. Once the DOI decided to withhold the excess deposits, a liquidity crisis was sparked.
To alleviate some of pressure from the liquidity squeeze, Superior began to commute reinsurance contracts with various parties to get short-term cash in return for taking back liabilities that it once ceded. As a result, Superior increased loss reserves in the third quarter of 1999 by $60 million. Part of the increase was attributed to the commutation while another portion came from a strengthening of its existing reserves.
Given the competitive conditions of the California workers’ compensation market and the highly publicized estimate from the California Workers’ Compensation Insurance Rating Bureau (WCIRB) that a $3 billion reserve deficiency existed in the state, everyone expected that Superior would have to further strengthen its reserves.
Although the DOI had not yet been officially supervising Superior, its Financial Surveillance Branch was in close contact with the company to address various concerns, chief among them the adequacy of reserves. Superior then engaged an independent actuarial firm to conduct a loss reserve review that would ultimately take a few months to complete. In the interim, Superior was confronting other problems.
Superior’s quarterly filing for the third quarter of 1999 indicated that it was in violation of several covenants on its bank loan of more than $100 million. At that point, on Nov. 22, 1999, Standard & Poor’s lowered the financial strength and counterparty credit ratings on Superior National Insurance Co. to ‘BB+’ and placed it on CreditWatch with negative implications (a downgrade from ‘BBB’ and a stable outlook).
A payment default had not yet occurred, but the creditors were understandably anxious. In the fourth quarter of 1999, Superior opted to defer a dividend payment on its trust preferred securities. This action was not only within its contractual rights but also a prudent decision considering the company’s cash crisis. The holding company, Superior National Insurance Group Inc., had virtually no assets other than its investment in the insurance operations.
In addition, it was unlikely that the regulator, concerned as it was, would allow the Superior insurance companies to make a dividend payment to the parent. Creditors were therefore questioning how Superior would make its next interest payment. However, Superior successfully made the scheduled interest payment and shortly thereafter settled its dispute with Inter-Ocean favorably.
Both events provided Superior a temporary sigh of relief. However, Standard & Poor’s again lowered its ratings on Superior National Insurance Co., on Dec. 22, 1999, to ‘B+’ and CreditWatch with developing implications, reflecting the various business, capital, and earnings issues the company still faced. In addition, a reserve review was still underway and, in the meantime, tensions between Superior and another of its reinsurers were quickly escalating.
United States Life Insurance Co. (U.S. Life), Superior’s quota share partner for larger premium workers’ compensation accounts, was attempting to force a commutation on the business it had reinsured. Admittedly, the business Superior had ceded to U.S. Life was probably very unprofitable and would be extremely problematic for Superior if the commutation materialized. The California DOI subsequently ordered an investigatory hearing into the business practices of U.S. Life. While the results of the hearing are certainly not academic from U.S. Life’s perspective, for Superior they are.
As the reserve review progressed, the California DOI made the alarming discovery that Superior’s reserves were severely underfunded. The deficiency is rumored to be as high as $400 million, which would instantly render Superior insolvent. As the DOI was “clearly ready to take action against workers’ compensation underwriters who failed to measure up to high standards of solvency,” Superior was ordered to be put under regulatory supervision.
Superior’s Risk Profile — Analytic Issues
Although many carriers in the California market are quietly cheering for the regulatory takeover of Superior, its creditors, policyholders, and shareholders obviously do not share that enthusiasm. Policyholders have been assured of full payment on claims, but the claims adjusting process is now left to regulatory devices. Creditors who hope to have some recovery on their investment must wonder what will be left to salvage considering the estimates of the reserve deficiency.
For the equity investors, a tax deduction is probably the most positive outcome. Although many of the constituents were harmed by Superior’s problems, the risks it faced were not surprising. High financial leverage and uncertainty of reserves combined with Superior’s significant dependence on reinsurance and its geographic concentration in the California market presented real risks.
To some, these risks were partially mitigated by the fact that Zurich, which indirectly has a large equity stake in Superior’s stock, would come to its aid as needed.
Pressures of Financial Leverage
In terms of financial leverage, Superior financed its acquisition of BIG with a combination of debt and equity. Upon closing the transaction, Superior marginally reduced its total financial leverage, defined as total debt and preferred stock to total capital, to about 46.5% from 47.9%. Although this amount of leverage is far from an aberration within the property/casualty (P/C) industry, it was certainly a potentially burdensome level, particularly in the context of all the other risks Superior faced.
The burden of more than $200 million in combined debt and trust preferred securities required Superior to meet fixed debt servicing obligations of about $20 million annually. With less than $50 million of annual pre-tax income, the company had only a limited margin for error in its operations. More importantly, however, as for any insurance company, the 46.5% financial leverage Superior was trying to manage was only as good as the quality of its reserve base.
As problems with Superior’s reserves began to surface, leverage that previously was thought to be manageable quickly seemed frightening. By the third quarter of 1999, Superior’s financial leverage increased to 55%. After an additional reserve shortfall in the fourth quarter, the leverage amount was no longer even meaningful, considering that Superior’s entire equity base had been depleted.
Although it is an extreme case, Superior’s problems provide a good example of why financial leverage for a P/C insurance company is a risky proposition. P/C companies cannot afford the luxury enjoyed in most industries, in which the cost of goods sold is known, the value of liabilities is fairly accurate, and cash flows are somewhat predictable. Reliance on Reinsurance A P/C company may be able to take on greater financial leverage if its operating leverage is conservatively managed.
The most common industry standard for measuring leverage is net written premiums to surplus, a ratio Superior maintained at a fairly modest level of about 1 times (x) at year-end 1998. Another benchmark, gross premiums to surplus, is often given much less weight because it is assumed that the only risks retained by a company are reflected on a net basis. This is untrue for a variety of reasons, some of which came into play as Superior’s problems unfolded. Superior’s gross premiums to surplus of about 2.5x was reasonable, but the large disparity between gross and net leverage indicated that it was relying heavily on reinsurance as a source of capital.
By the end of the third quarter, Superior’s reinsurance recoverables amounted to 3.8x the size of its equity base. Had Inter-Ocean rescinded its reinsurance contract, that action alone would have been sufficient to wipe out Superior’s equity. Although the dispute with Inter-Ocean was an unusual occurrence in the industry, it highlights the risks of using reinsurance as part of a capital management strategy even when the creditworthiness of the reinsurer is extremely strong.
In addition to the potential for assuming basis risk when the reinsurance coverage does not precisely match the underlying coverage on the primary policies, there is always a “willingness to pay” risk. Although this risk is extremely difficult to measure, companies can still manage it by not putting themselves in a position where the action of any one counterparty would be excessively detrimental to its well-being.
Along with everything else, Superior’s problems were compounded by its geographic concentration. With more than 75% of the company’s premium based in California, Superior was obviously subject to the vagaries of the competitive, regulatory, legislative, and economic risks of the state. Although it cannot be determined whether Superior would still have suffered with better geographic diversification, chances are that the magnitude of the problems and the speed with which they surfaced would not have been as great.
While the workers’ compensation market has been competitive throughout the country, no state has been as radically affected as California. Considering that Superior was so deeply entrenched in the state, problems of the California workers’ compensation market were bound to be largely reflected in Superior’s results.
Strategic vs. Financial Investors
Despite these issues, some may have believed that the equity sponsorship of the company would help absorb some of the risks. There was always the hope that capital would remain available, with Zurich, the insurance behemoth, holding a large stake in the private equity funds controlling Superior, including Insurance Partners, L.P., Insurance Partners Offshore, and Capital Z Financial Services Fund II, L.P.
Ultimately, Superior found itself in desperate need of capital with the partnerships deciding to cut their losses. Although no one can blame Zurich or any of the respective partnerships for forgoing additional capital contributions, their inaction highlights the important, sometimes unclear, distinction between a strategic and a financial investor.
It would be hard to argue that Superior was anything but a financial investment considering its size relative to Zurich’s. Although this conclusion is debatable, the fact remains that Superior was denied the financial backing from Zurich and from the private equity funds when it most needed them.
Implications of Superior’s Seizure to the California Workers’ Compensation Market — A Market in Turmoil
Superior undoubtedly had been operating in a fiercely competitive market. Since the mid-90s, employers in California have enjoyed a virtual freefall of workers’ compensation rates. Favorable loss trends in the early 90s and the repeal of the minimum rate law in 1995 helped shrink the premium volume in California to about $6 billion in 1999 from $9 billion in 1993.
Loss trends were supported by reductions in fraud and a weak economic environment that favorably affected claim frequency as higher skilled, less accident prone workers remained employed. To the dismay of California’s workers’ compensation carriers, the state recovered from its early-90s recession. Since then, California’s economy has continued to flourish, leaving the workers’ compensation writers behind. Since 1995, the downward trend in claim frequency began to stabilize while the average claim severity significantly increased.
According to the WCIRB, the average indemnity payment per claim has risen by more than 25% since 1995, while the average medical cost per claim has climbed by more than 12%. As premium rates failed to track the rise in claim costs, estimated accident year loss ratios have risen to more than 95% in 1999 from a low of 52% in 1993.
Loss ratios posted by the largest workers’ compensation writer in the state, State Compensation Insurance Fund (SCIF; market share of about 20%), provide a fairly good indication of what the pricing environment is like and reflect the declining rate adequacy in California. SCIF’s loss ratio has remained in the range of 115% since 1997, climbing from 96% in 1993. Private carriers should be able to generate better results because they can select the risks that they write, unlike the SCIF, which by charter accepts all applicants.
Even so, SCIF competes for some business with private carriers and, as a consequence, California’s private compensation writers cannot stray far from SCIF’s prices. Considering that a pricing differential of more than 10%-15% cannot be sold by agents in the market, it is safe to assume that private carriers are being scarred by the same pricing dynamics as SCIF. Why have rates remained inadequate for so long? The answer always comes back to an oversupply of capital within the industry. And if overcapacity in the traditional workers’ compensation market were not enough, life and health insurance markets compounded the problem by participating in low-layer reinsurance programs (e.g., Unicover).
Although the Unicover fiasco is interesting in itself, the real significance of the situation is that carriers were able to prolong a cycle of inadequate pricing by having a large portion of the claims costs subsidized by naïve reinsurance capacity. These arrangements ultimately proved to be unsustainable and, as a result, many of the workers’ compensation writers in California have been posting results that reflect the mismatch between premiums and loss costs.
A Bubble Burst
Superior’s downfall was not the first sign of problems with workers’ compensation in California. The weakening financial state of the California workers’ compensation industry was already well-known. In 1997, declining rate adequacy had put Golden Eagle Insurance Co., California’s largest private sector workers’ compensation writer at the time, out of business. But other carriers were still posting fairly good results as reserve deficiencies were masked.
As poor results in the state become more evident, the DOI took action in 1999 by advocating a rate increase of more than 18%. Considering the political sensitivity of rate increases, especially for an elected commissioner, problems on the horizon must have looked severe for the DOI to make such a recommendation. The DOI recommended the increase, but it was an advisory rate that each company could reject, and in doing so possibly thwart the DOI’s intent.
However, with a large competitor out of the picture, there should be less incentive for the carriers to schedule large credits against base rates. As the advisory 18% rate increase had signaled to the market that rates may have finally hit rock bottom, Superior’s failure should actually help sustain upward momentum on rates. Given that employers in the California market had been forewarned about the possibility of an increase in rates, the failure of Superior, which had a highly visible profile, makes the premium increase an easier sale for the agent.
If it is easier for the agent to sell, carriers will find it easier to continue raising rates. In addition, because the DOI has been forced to take over two major competitors in less than three years, carriers will probably be more cautious in testing the patience of the regulators. As companies become less aggressive in pursuing business out of concern over DOI scrutiny, the upward momentum in rates should last longer than it would have had Superior not failed. It is still very uncertain whether the rate increases are sufficient from a profitability standpoint.
Nevertheless, the removal of a major competitor at least assures that the trend will finally be favorable.
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