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As construction firms budget for the second half of 2014, one of the major expense items under review is insurance. Formulating an accurate picture of the future requires examining the impact of recent industry metrics.

2012 was the fifth year in a row with returns below 6 percent. This can be attributed to poor underwriting results and poor investment returns. However, policyholder surplus is at an all-time high, growing more than 28 percent in the last four years.

Although surplus is currently more than adequate, the insurance industry needs to continue to generate capital in order to remain healthy. Yet, to attract investors, the industry must provide an acceptable return on equity. Most investors seek at least an 8 percent return and ideally want 12 percent or more. The insurance industry’s 60-year average is 8.9 percent. In the last decade, the industry has only exceeded 8 percent five times, none of which occurred in the past five years. The industry has averaged a 7 percent return in the past 10 years and a meager 3.7 percent in the last five years.

In comparison, from 2003 to2007, the industry averaged returns of 10.3 percent. These hefty returns fueled competition and rates came down. For example, rates for the property and casualty industry dropped nearly 40 percent from 2004 through 2011. 2012 was the first year average rates increased since 2004.

With an average increase of 4 percent in 2013, rates have increased9 percent since bottoming out in 2011; however, they still will be 33 percent below 2004 levels.

The current environment can be characterized as a moderate hard market with poor returns and plenty of surplus. Insurance companies need to increase rates to improve returns, but the substantial surplus and aggressive competition are moderating what otherwise would be substantially higher rates.

Following is what companies can expect from different insurance segments in 2014.

Property, Liability, Auto and Excess
Most insurance companies want five to 10 points of rate on renewal. However, the industry remains competitive and insurance companies don’t want to lose their preferred customers. Preferred businesses should expect to see renewal rates ranging from flat to plus 5 percent. The safest option is to budget for a 5 percent increase. (Note that this is rate, not premium, which is determined by multiplying rate times exposure.) Non-preferred businesses (in high hazard industries or with poor loss experience) can expect larger increases.

Property risks in wind-exposed areas also are seeing substantial rate increases. Non-preferred businesses would be wise to talk with a broker or underwriter now to determine what to expect for the remainder of 2014.

Professional Liability

Rates vary depending on the industry and desirability of the risk. Overall, market trends are similar to the rate changes for property, auto liability and excess.Preferred architects, engineers and construction managers can expect flat to plus 5 percent. Similarly, preferred accountants and attorneys shouldn’t expect anything more than plus 5 percent, but higher risk professionals such as structural engineers, geotechnical engineers and environmental consultants may see rate increases higher than that. 

Executive Risk
Executive risk includes directors and officers liability (D&O), employment practices  liability (EPL) and fiduciary liability. While results for fiduciary liability have remained decent, experience for both D&O and EPL has been poor. The down economy and high unemployment have substantially increased the claims against directors and officers, and the number of employment-related lawsuits has escalated dramatically as well. On average, there are 10 percent to 15percent rate increases on these lines, but 25 percent or higher is not uncommon.

It is wise to start early on these renewals and market the program effectively with a specialist broker. Recognize that all of these policies are unique to each insurance company and coverage varies dramatically. Make sure to get appropriate coverage at the lowest realistic cost.

Workers’ Compensation
Workers’ compensation continues to be a huge challenge for the insurance industry,especially in California. Nationally, the combined ratio in 2012 was 108 percent, down from 114 percent in 2011. In California, the 2012 combined ratio was 117 percent—a substantial improvement compared to 137 percent in 2011.

If underwriters in California want a 5 percent underwriting profit, they need another 22 points (at least) of rate. This is in addition to the rate increases the industry has experienced in the past several years (35 percent). In 2009, the average rate charged in the state was $2.10 per $100 of payroll; since then, average rates have increased to $2.83.

While this is significant,it needs to be put into perspective. Rates peaked in 2003 at $6.29. From 2003  to 2009, rates dropped a staggering 67 percent. This was attributable to reforms that moderated expenses, as well as intense competition that mirrored the overall insurance market. The current average rate of $2.83 is still 55 percent less than it was in 2003. Even if the industry was able to get the additional 22 points needed to be profitable, average rates would still be 45percent below the 2003 rates.

Ultimately, what a company pays for workers’ compensation is determined by its net rates (i.e., the rate after application of insurance company credits or debits and the firm’s experience modification rate). Underwriters generally have latitude to adjust the base rate 25 percent to 40 percent based on how they feel about the account. This underscores the importance of a thoughtfully completed submission to the underwriting community.

Additionally, companies should have their 2014 experience modification rate projected. Recent changes in the experience modification equation have adversely affected some employers. The Workers’ Compensation Insurance Rating Bureau usually releases experience modifications 30 to 90 days prior to policy expiration; however, a competent broker can confidently project a firm’s rate five months out or earlier if there are few or no open claims.

Recognize that this discussion involves average rates. There are hundreds of class codes in California (and every other state) and each one is evaluated separately and has its own rate. Some class codes are going up to 40 percent or more, while others are decreasing. Overall, expect to see pure rate increases of 10 percent to 15percent in 2014 (before application of underwriting factors and experience modification).

It is prudent to begin discussions with underwriters early. Find out what their current base rates are compared to the ones on the company’s policy. Ask about the types of credits that can be expected and determine if the underwriter will be submitting another rate filing before the renewal period. 

Consistent with most of the financial markets, the surety industry remains profitable despite the increase in loss activities this year. However, the surety industry likely will continue to struggle in 2014. Further increases in loss frequency are anticipated, but hopefully significant and severe losses will be avoided.

While defaults have risen in the past two years, most of the surety failures have been isolated to trade subcontractors that led to the demise of a few general contractors. What cannot be ignored is the drastic increase in project financing disputes and payment bond claims. The magnitude of project financing claims may only be stalling the inevitable: more serious performance bond claims that have not yet been fully recognized. Many owners and contractors simply do not have the adequate financial strength to manage cash flow through financial disagreements.

Surety capacity remains plentiful. There is intense competition among sureties for small contractors,and large contractors are seeing rate reductions with tremendous mega-project opportunities.

Sureties have a growing cautiousness with mid-size contractors.Underwriters continue to scrutinize financial statements, including cash flow,work in progress, realization of estimated profits and overhead. Sureties are focused on under-billings, aged receivables, cash balances and availability of preferred bank lines of credit. To get the added comfort needed on stressed balance sheets, sureties are increasingly requiring project fund control agreements,cash infusions and other strict underwriting conditions. As losses continue to rise in 2014, sureties will be maintaining a closer eye on their credit partners. 

Health Insurance

All plans for non-grandfathered small groups (two to 50 employees) changed in 2014.The medical benefits, prescription benefits, networks, age bands, rate adjustment factors, waiting periods, taxes and fees are different in the case of every insurance carrier, resulting in rate increases of 20 percent to 40percent.

It is possible that the cost for coverage will be less than the projected 20-plus percent in the fourth quarter of 2014. Some provider networks also may be changing this year.Insurance carriers are asking for greater discounts from hospitals, medical groups and doctors, and are offering patient exclusivity in return. Similarly, hospitals and doctors are joining together and forming Accountable Care Organizations. Smaller networks with greater discounts equal lower medical premiums. The narrow network options should be considered when renewing in2014. 

Jeff Cavignac is president and principal of San Diego-based Cavignac & Associates; Patrick Casinelli and Jim Schabarum are principals of the firm. For more information, visit www.cavignac.com.   

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