By Donald Cleveland
To many business owners, insurance is a four-letter word. An empathetic insurance agent or broker, however, can understand the frustrations. Many times insurance policy terminology is mysterious and trying to find the actual coverage in the document is difficult. How could an average businessperson understand that coverage for contractual liability is found as an exception to an exclusion in his policy? The organization controlling most property and liability policy language, the Insurance Services Office (ISO), tried to comply with regulatory mandates in the middle 1980s to simplify policy language but almost 30 years later it seems to have failed. So, insurance remains a pain-in-the-neck subject, but it is really essential to doing business in the modern world. There are a number of reasons why businesses need to take a second look at the fundamental explanations of why insurance is necessary. None of the reasons are small.
First, many policyholders think first about their business’ potential for a big loss or damage and not about the costs of the legal system in which we operate. Our system of seeking damages in the United States is greatly influenced by the number of licensed lawyers practicing law here. There were 1,143,358 lawyers licensed to practice in 2012. When lawsuits for damages are filed, many lawyers use a shotgun approach. Everyone who might be connected to a potentially negligent party or product is sued. If you are not hit in the first round of litigation, you may find you had a contract which required you to indemnify a party that has been sued. You will then be targeted in the second round. So, you or your business will be required to hold harmless or indemnify the party with which you have the indemnity contract. If you or your insurance company doesn’t defend or volunteer to indemnify the contract issuer, the issuer will sue you, your insurance company or both.
The courts in the US have let it be known that the “duty to defend is higher than the duty to indemnify.” This means that an insurance company, after making its initial assessment on coverage for a particular claim must step forward and provide the insured business with a defense. The defense is essential because many times the water treatment specialist insured is simply not liable and is not the cause of the alleged damage. Frequently insureds are sued, but no damages are ultimately payable to the plaintiffs. In this respect, one of the primary reasons for purchasing liability insurance is to cover the cost of hiring attorneys in the event someone rightfully or wrongly, sues you or your business.
Your insurance company must defend when the policy provides coverage for the allegations made by the plaintiff. The author has personally been associated with suits where defense costs have ranged from $25,000 to $1 million. My clients, the insured defendants, were in the end found to be innocent of the allegations. It’s safe to say that more insureds will use defense coverage in their liability policies than will use coverage for indemnity claims. The cost of being defended is almost the primary reason for purchasing insurance. Paying for the big loss is a second issue. This is an important matter when it comes to rating liability insurance coverage and calculating the premium. When a water treatment specialist wants $100,000 in liability coverage, the first $25,000 is the most costly part of the coverage. That’s because there is a very high probability that the insurance company will pay out the $25,000 for defense. Most lawsuits are settled for $25,000 or less, with the bulk of this figure paying both sides’ attorneys’ costs. The remaining $75,000 of the water treatment specialist’s $100,000 is much cheaper than the first $25,000, because the chance of it being paid out is much less than the first $25,000 used for defense.
Second, let’s look at a basic definition of insurance. Insurance is a process where a large risk exposure is transferred to someone else in exchange for a proportionately small premium payment. Some examples we have seen are:
- A business owner is spared paying lifetime medical benefits for an injured employee, plus lost wages, home modifications, buying a handicapped-equipped vehicle, paying for the education of three children and numerous other expenses totaling $6 million, because the owner had purchased a workers compensation policy and paid a premium of $30,000.
- A water treatment business owner avoids paying $750,000 in water damages caused by leaking pipes, because the owner purchased a $4,000 liability policy.
- Another business owner has his $2.5 million building and contents replaced after a fire had destroyed it, because he paid a $7,500 premium.
Therefore, insurance is an asset of the water treatment specialist’s business. It will protect or even save the business and the personal assets of the owner when there is an unforeseen event.
Third, within the proportionately small premium payment concept, there is the fundamental idea of risk sharing. Few people can afford to pay the types of damages outlined above, but society demands the damages be paid. So, to help businesses grow and prosper without the danger of being ruined by an unfortunate event, people and organizations band together and pool their money in formal institutions. Implied in becoming a member of these institutions is a promise that one person will allow another to use some of his money in the event of a claim.
If a claim for $1 million needs to be paid, it takes 200 policyholders paying a $5,000 premium each to cover the loss. In this respect, 199 people have, at least conceptually, agreed to pay the claim of one insured person. This is the simple math. It takes a large number of premium paying policyholders to make one of these institutions work. Since the institution (fraternal society, mutual insurance company, stockinsurance company) also has to pay for administration, acquisition and other costs (which average 26 percent), it would really take 252 policy holders to cover all costs and pay the one $1 million claim.
Looking on a broader scale, according to a recent Insurance Journal article, auto physical damage losses for insurers in the United States were 70.57 percent of the premiums they received in 2012. If we add insurers’ administration, acquisition and other costs, the average combined loss and expense ratio for US insurance companies insuring auto physical damage in 2012 was 96.57 percent of premiums paid. The insurers made what is called an underwriting profit in this case of 3.43 percent of total premiums received. It will always take the large numbers of businesses or people who have no claims to support the small group of businesses or people who do have claims. This is where the law of large numbers works in the insurance business. GEICO is a good example. According to Insurance Company Reviews, published by About.Com. GEICO has 11 million policies in force covering 17 million vehicles. The Lizard has, in effect, a large risk-sharing pool.
Fourth, there are specific influences on insurance availability and requirements around the world. The most important influencers of insurance availability and regulation are known as the risk management push and the hard/soft market cycle. Despite the collapse of the real estate market and world recession that started in 2008, the property and casualty insurance segment has not had a hard (meaning expensive or unavailable) market since the mid-1980s. This has positively affected most water treatment specialists, by increasing the availability and affordability of the types of insurance needed to go to work or set foot on job sites. It’s simply hard to get a job without proof of liability insurance.
The real estate and savings and loan crises caused insurance companies to lose large amounts of their assets and their non-premium income streams in the mid 1980s. Prior to 2000 when interest rates began to drop and again in 2008 when real estate values collapsed, insurance companies had been accustomed to earning considerable amounts of non-premium (mostly investment) income. This enabled the insurance industry to suffer greater that 100-percent combined loss and expense ratios as described above and still make annual operating profits. So, an insurer could pay $107 in claims for every $100 in premium received but with the benefit of high-yielding investment returns, still make a profit. The recent economic and real estate collapses, together with the persistent low-interest rate environment would normally cause a hard market. The rapid recovery and growth of the stock market, however, has allowed soft insurance market pricing to continue to date.
Regulators generally do not want companies to accept total premiums that exceed three times a carriers’ capital and surplus. In the 1980s for example, premium writings were restricted because the non-premium income dropped severely. The real estate, stock market as well as interest rates all fell sharply and reduced the capital and surplus of insurance companies. Insurance became a scarce commodity and casualty premiums in particular for businesses jumped as much as 2,000 percent. Businesses were really being hit hard. Congress helped provide some relief by passing the Risk Retention Act of 1986. The Act opened the door for businesses in similar industries to combine and capitalize their own liability insurance companies. This removed part of the scarcity created by severe pollution, asbestos, chemical and other liability losses in the standard insurance market. The hard market cycle ended in the early 1990s and has not reappeared since. As a result, insurance premiums have been relatively affordable and most coverages have been available since that time.
A risk management push is now taking place, however. Property and business owners and their risk managers are always looking for the most complete forms of indemnification to avoid retaining risk and liability. They want to transfer as much risk and liability as possible. Like other professional groups, property and business owners and their risk managers have their own associations and meetings where they listen to the latest ideas and exchange checklists, contract clauses and notes.
Two new and challenging risk management concepts affecting the water treatment industry have arisen as a result of such group or association exchanges. One is a checklist used by general contractors, which was apparently developed by either an owner or a general contractor. Many of our insured water treatment specialists have been asked to complete this new checklist and provide a Certificate of Insurance verifying the existence of all insurances contained in the checklist before entering the job sites. One of the requirements on the checklist is liability insurance policies must not have a XCU Exclusion. This exclusion in fact deals with operations that perform excavations, tunneling or boring and may use explosives in the projects. (X = Explosion, C = Collapse, U = Underground). These exposures are not at all common to the water treatment industry, but this doesn’t matter to the general contractor’s risk managers! If the XCU exclusion is in the water treatment specialist’s insurance policy, that specialist will not get on the job.
Other standard checklist questions that aren’t related to water treatment include:
- Does the policy have a residential work exclusion?
- Does the policy exclude frame construction?
- Does the policy have height restrictions?
- Does the policy have a scaffolding exclusion?
The second risk management push affecting our water treatment clients is coming from building owners and managers. While the requirements are not as exotic as the XCU Exclusion above, they do affect the cost of our clients’ doing business. Building owners and managers are requiring higher liability limits from water treatment specialists and stronger insurance companies standing behind the policies. The most frequent demand for liability limits is a minimum of $5 million per occurrence. This can mean that an average water treatment business might be compelled to buy an additional $4 million in excess liability insurance to go on the job site. Some larger complexes are requiring total liability limits of $10 million. They are also demanding that the insurance company providing coverage must have an A.M. Best rating of A-VII or better. The VII measures the policyholders’ surplus or surplus of the carrier. A rating of VII means that the company has a surplus of between $50m and $100 million. Generally, owners or risk managers will not accept an insurer with less than $50m – $100m policyholders’ surplus.
Fifth, some insurance companies offer assistance to their insured businesses with loss control inspections. While some policyholders might look at the inspections as a nosy intrusion into their business, they are actually there to help the insured prevent losses. While the inspector is making the inspection for the insurance company, the inspection report, with any suggestions for loss mitigation, is also given to the policyholder. Such simple things as storing oily cloths in a confined area, extension cords on the floor running across a hallway or foot traffic area, safety shields missing from grinding or milling machinery, lack of forklift training, patterns of repetitive motion injuries and company drivers with DUI records are some common inspection observations. If the insured works with the inspection information to make corrections, many potential claims will be eliminated. When compliance is shown, underwriters tend to give risk management premium credits to the insured on the next renewal. Following the inspection recommendations assists the insured. Injuries to friends, employees and clients are avoided and property loss is greatly reduced. It is a win – win situation.
About the author
Donald Cleveland is the President and chief underwriter for WaterColor Management (WCM) a Managing General Underwriting agency and Coverholder with Lloyds of London. He has served in that capacity since 2012. Prior to his activity with WCM, Cleveland served as the Manager of the Special Risks and Professional Liability Divisions of the Florida Branch of Meadowbrook Insurance Company. He also served as the Director of Risk Management for the Largest Public Construction Authority in the United States, and managed the risk on approximately $1 billion in construction each year for nine years and $58.5 billion in project finance during the same period. Questions about this article or other related issues can be directed to Donald Cleveland at WaterColor Management by telephone at (256) 260- 0412 or by email at [email protected].