The Truth Behind the Insurance Crisis

LCT Staff
Posted on August 1, 2001

Insurance premiums, which have remained relatively constant in recent years, have been on the rise. Experts predict that increases are expected for the next several years. The numbers of companies that provide insurance for this industry are becoming fewer and fewer. What is going on? Why is this happening? What can an operator do to keep a low premium? Will this trend ever end?

For the last few years this industry has seen a stable insurance market. There were plenty of companies in the market, and insurers were frequently underwriting multi-million dollar policies. However, when the IPO market dried up and the economy took a nosedive, insurance companies were forced to change their practices.

Insurance companies have been faced with the grim reality of having to choose one of three options:

They can expand their operations to cover larger markets. This means moving away from the smaller, specialized markets, such as the limousine industry, and into a larger commercial industry.

A second option is to continue working in the specialized market and to rely on pure premiums. This means that their profits are derived almost entirely from the premiums that they’re taking in. So, in order to compensate and recoup some of the losses, insurers require a higher premium.

The third option is to just go out of business. For some smaller insurance companies this is the only option.

Why Does a Slow Market Have Such an Impact on Insurance?

Insurance companies participate in what is called reinsuring. This is a practice that has been around for years, and it is when insurers, in a sense, sell off some of the risk of an insurance policy. For example, an insurance company writes a policy for a client, and then a reinsurer can be paid by the insurer to underwrite that policy for a greater amount, thus taking on some of the risk. The reinsurer then takes a portion of the premium and invests it in the market to make a profit.

“Reinsurers basically provide us [insurance companies] with our raw material,” said Randy O’Neil, senior vice president of Lancer Insurance. “Reinsurers insure insurance companies.”

Reinsurers were underwriting policies and investing with a great profit in the late ’90s. However, they were blindsided by the slowdown.

“There were a lot of players clamoring for the business, and reinsurance costs were low,” explains Jeff McAnany, vice president, TIB Insurance Brokers. “Consequently, this made primary insurance costs even lower. Meanwhile, they were getting nice returns on the investment end of it.”

“Some companies, the ones that don’t want to stick around too long, were investing the premiums they collected, and were able to somewhat soften their underwriting loss,” O’Neil said. “It’s kind of cheating when you know that you’re not pricing the product properly and hoping to make it up on the investment side.”

As you can imagine, companies that had invested heavily in the market saw drastic losses. Larger insurance companies in larger markets were able to adjust, and they quickly initiated contingency plans to compensate. However, smaller companies, which tended to invest more in the markets to increase and subsidize their profits, were the hardest hit. Many simply closed their doors.

Was the Market the Only Thing to Blame?

The sudden slowdown of the economy greatly impacted the insurance world; however, it was not the only factor as to why premiums were raised. “Market conditions and how insurance companies make money certainly do affect the costs, but the biggest thing that we see is that business is under-priced,” says Michelle Silvestro, assistant vice president and marketing manager for National Interstate Insurance Company. “It doesn’t take a rocket scientist to understand that if an operator averages $100 thousand in paid losses every year, and they’re only paying $90 thousand for their insurance, something doesn’t add up.”

“This is what thinned out the herd over the last couple of years in the insurance business,” O’Neil said. “The ones that are left had to adjust their prices to reflect the realities of the costs of claims.”

When an insurance company writes a policy, it, in a sense, makes an educated guess as to what should be charged. This is based on knowledge of the particular market, the loss history of the person requesting the policy, the financial stability of the business, proper maintenance records, etc. This estimated policy is what the insurance companies refer to as pure premium.

“When we price an account, our accounts get priced for a four percent profit margin,” Silvestro says. “So, if I guess right as to what I think their losses will be, then I’ll make four percent. If they have more losses than what I expect in pure premium, then that comes out of my percent.”

In addition to the individual operator’s criteria, there are other factors that insurers need to take into account when writing a policy.

“The biggest components, other than what insurance companies pay to claimants, are the expenses associated with handling those claims, which are loss adjustment expenses,” Silvestro says.

The key, Silvestro says, is “underwriting responsibly.” However, it is this under-pricing of a business coupled with a bear market that has caused reinsurers to take a second look at underwriting policies.

“We write anything that we quote in-house up to $5 million,” Silvestro says. “We used to have arrangements with some of our reinsurance partners so that they gave us pretty much full reign to quote up to $10 million. And they didn’t question anything that we would be doing. Then, all of a sudden, they started saying, ‘nope,’ ‘forget that.’ Well, they started seeing bad losses because the pricing was so low. But it wasn’t that there were bad losses as much as there was under-priced business. Currently, that’s the big argument. But because of that, reinsurers aren’t giving anybody that kind of authority. And they’re raising their rates 30-50 percent.”

So, if insurance companies underwrite a policy responsibly, shouldn’t they then make more of a profit? According to Silvestro, they are making a profit … sort of.

“It’s profitable from an underwriting standpoint, but that’s before anybody takes money out or puts money in for investing in the market,” she explains. “That’s what doesn’t show up in underwriting results. It’s just claim payments and premiums collected. This can be seen when you’re looking at underwriting profits for insurance, and you hear the term combined ratio, such as ‘our industry has a combined ratio of 125.’ What that means is that for every dollar that a particular insurance company receives in premium, they pay out $1.25 on claims.”

Is there Anything Else that Caused Increases?

An added wrinkle to the effects of insurance companies underpricing business is that large claims, filed two to three years ago when the economy was better, are now being paid out. “Big losses don’t develop for two to three years at least,” Silvestro explains. “You don’t see pay out on a big claim until a few years after the accident. And that’s when insurance companies start realizing the losses.”

Insurance companies have a policy, called reserving, that helps alleviate this problem. Claims adjusters size up what they deem is the maximum pay out for a claim, and reserve that money. The money comes from a pool, which is set aside for claim expenses. However, it is up to the various insurance companies to determine when and how much to reserve, and for some companies this can be a real guessing game. Silvestro believes that is where the insurance companies that specialize in smaller markets have the greatest strength. “You can reserve for it, but you still have to take everything into account,” she says. “In order to reserve you take educated guesses. That’s where specialty insurance companies come in. There are a few of us left that understand that an accident with four fatalities in New York is going to be a lot different than an accident with four fatalities in Iowa.”

Silvestro adds that it is up to the insurance company to know the industry that they’re working in.

“You have to know your business and know the jurisdiction that your customers operate in,” she says. “There are different laws for every state. You have to take that into consideration when you underwrite. You need to look at what your exposure is from an insurance perspective.”

New York and California are the two states hardest hit by higher insurance premiums. Many of the smaller insurance companies in these two states have closed up shop.

“If you look back in the last 10 years in New York, you probably could count 10-15 insurance companies that quoted to the limousine business, and you can now probably count a number of those that are out of business completely,” McAnany says. “It comes back to under pricing. Consequently, in order for those that are left to survive and make a profit, they are forced to raise their rates.”

In addition to the under pricing, another factor is making it more difficult to write policies for limousine companies in New York. “It’s hard for an insurance company to insure limousine companies in New York because most of the calls for insurance are for car services,” Silvestro says. “We get limousine accounts from New York all the time, but a lot of them just turn out to be car services. These black and silver car services can really ruin it for legit limousine operators. I don’t think that the TLC in New York differentiates enough between them that the rules are different. As far as we’re concerned, car services are just taxicabs that aren’t yellow.”

What Can Operators Do to Keep Premiums at a Minimum?

However difficult this situation may become, insurance is one thing that operators cannot do without. But with premiums continuing to rise, what can an operator do to keep his or her premium the lowest it can be? The truth is that there are many things that operators can do, and most are common sense.

“The biggest things that companies can do are hire and train their drivers,” Silvestro says. “The issue becomes, if I’m paying a driver $8 an hour, how good is that driver going to be? How much can I pay a driver? There has been a driver shortage in this industry for a long time.”

Another obvious factor that operators need to concentrate on is ... for more on this topic, check out the August issue of LCT.

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