Insurance Outlook 2023 - An Opportunity for Captives

Albion Risk Consulting, S.A. follows trends in the insurance market, along with social and economic developments, to create opportunities for our clients to mitigate against the rising cost of external premium and ultimately reduce their total cost of risk. By accounting for changes in the market anticipated two to three years in advance, our clients are better situated to maintain adequate levels of capital and implement captive insurance solutions when appropriate.

Premiums for most lines of coverage have steadily increased over the past 5 years. In 2023 that increase is suggested to be an average of 9.3% across all lines. Capacity issues and further increases will likely continue for at least the next few years.

There are several issues likely to drive insurance market conditions in the short and medium term, including but certainly not limited to:

• Inflation

• Regulation

• Sustainability

• Diversity

• Technological change

• Geopolitics.

Inflation

Inflation has been the primary reason for premium increases over the past few years. Even though the rate of inflation is likely to decrease within the next year or so, the amount of any reduction is unknown. Moreover, since inflation has already resulted in a significant increase over the past few years, any additional inflation will be painful.

Higher inflation in recent years, coupled with natural catastrophes and geopolitical issues, has also called into question reserve adequacy for property and casualty insurers in the US. This has pushed up claims and led to questions regarding reserving. This may in turn mean reduced risk appetite, capacity and require more premium to cover prior losses leading in turn to a continued hard market.

Reinsurers have also faced issues as the result of their bond holdings reducing in value just as climate-based losses have increased on a global scale leading to increased costs of reinsurance and limitations of capacity that is then passed on to primary carriers.

We expect that insurance premiums will continue to increase in the short term with inflation being a significant driver, although there are several other issues that may come into play as well.

Regulation & Climate Influence on Insurance Products

Both State Farm and Allstate recently announced an intent to cease writing new business in California for property insurance due to wildfires and increased costs to rebuild exceeding inflation. Allstate reported that its decision was driven by regulatory action or lack thereof. Specifically, the insurance department in California failed to approve rate increases quickly enough.

Another insurer, Allianz, in their Allianz Global Insurance Report 2023 includes the note:

“To close the huge protection gaps – in NatCat, cyber, health or pension – mobilizing more premiums might not be enough; avoiding risks in the first place will become more and more important.”

As insurers choose to avoid certain risks, typically more systemic in nature, so too does supply reduce whilst demand increases due to the increased prevalence of loss. The outcome is that, if there are insurers willing to take on the risk, premiums are likely increase significantly.

Insurers may simply resort to offering risk management services in lieu of certain insurance coverage. For example, again from the Allianz Global Insurance Report:

“The value proposition of insurers will evolve, from pure financial compensation to risk management and holistic service offerings to prevent and mitigate risks.”

Although it is unclear exactly what Allianz would offer as “risk management and holistic services,” in its 2023 Insurance Outlook, Deloitte suggests that insurers could offer risk mitigation services such as:

• Provide risk advisory services to improve clients’ climate mitigation \understanding and approach.

• Create new risk-transfer offerings to enable capital flows toward green solutions.

• Support sustainable decommissioning of carbon-intensive assets.

• Develop solutions for reducing climate liability and environmental litigation.

Ultimately, it seems that climate risks are pushing commercial insurers to offer risk management services in lieu of actual coverage.

Sustainability

Moving from insurance to risk management for certain risks is seen as a shift, at least in part, by insurers drive an Environmental, Social and Governance (“ESG”) agenda to their customers and to create a more sustainable approach to risk.

ESG is not just something that insurers need to push to their customers. Insurers are already committed to sustainability in their own business approach.

There is a multipronged approach to ESG from regulators, shareholders and industry groups that seemingly provides a systemic way to ensure insurer conformity.

The SEC is expected to introduce regulations relating to ESG disclosures in the coming year. Grant Thornton on their website in an article entitled “The new SEC climate rule and evolving ESG landscape” from June 8, 2022 note that:

“The SEC’s proposed rule on climate disclosure confirms that ESG reporting is a business reality and not a trend that will fade and go away. In March of 2022, the SEC proposed the Enhancement and Standardization of Climate-Related Disclosures for Investors, a rule which would require companies to include certain climate-related information in registration statements and financial reports. The SEC’s action to standardize climate reporting takes into consideration feedback from investors as well as replies to a request for public feedback issued in 2021. According to a potential timeline included in the Proposal, using an example Final Rule issuance in December 2022, the timeline will be quick: Large accelerated filers with a calendar year end will need to be compliant with most of the proposed requirements for fiscal year 2023.”

ESG is something that all major insurers are going to be subject to, at least in terms of transparent reporting of their approaches to its sustainability goals.

The greatest influence on ESG to date has been from shareholders groups. The largest shareholders of most listed insurers include BlackRock, Vanguard, and State Street. As institutional investors, these three companies do not own shares directly, but are still able to exercise control by way of proxies. Together, these three companies control investments totaling roughly $20 trillion and arguably have a controlling interest over the entire S&P 500.

According to the New York Post in an article published on 7th April, 2023:

"In 2018, BlackRock CEO Larry Fink, who oversees assets worth $8.6 trillion and has been called the “face of ESG,” wrote a now-infamous letter to CEOs titled “A Sense of Purpose” that pushed a “new model of governance” in line with ESG values.

“Society is demanding that companies, both public and private, serve a social purpose,” Fink wrote. “To prosper over time, every company must not only deliver financial performance, but also show how it makes a positive contribution to society.”

Fink also let it be known “that if a company doesn’t engage with the community and have a sense of purpose, it will ultimately lose the license to operate from key stakeholders.”"

Bear in mind that these institutions may be influenced by their own investors, including lawmakers who oversee government pension funds. These lawmakers include those from California and New York who have mandated that those investing their pension funds divest from fossil fuels and the oil and gas industries. The power of these lawmakers is significant and can drive a more focused political influence to ESG investing and in turn boardroom influence.

A UN initiative known as the Net-Zero Insurance Alliance (“NZIA”), has brought together a group of the World’s largest insurers and reinsurers established to accelerate the transition economies to net-zero emissions.

An extract from a press release from Sompo Holdings, the international insurance group and member of NZIA stated in a press release on June 28, 2022:

“In order to accelerate and implement our efforts on "SOMPO Climate Action", toward achieving net-zero greenhouse gas (hereinafter "GHG") emissions, the Sompo Group joined to "Net-Zero Insurance Alliance (hereinafter "NZIA")" which aims to achieve net-zero GHG emissions in its underwriting portfolio, and established a policy for ESG-related underwriting, investment, and loan.”

This group, as well as looking internally to improve emissions, also sees the need to drive initiatives to its customers.

However, the push by NZIA to force net-zero has attracted criticisms from certain quarters. In the US the NZIA has encountered scrutiny with potential antitrust issues leading the legal argument. On May 15th, 2023, a group of Republican Attorney Generals wrote to NZIA members suggesting that the organization may be in breach of state and federal laws.

In the letter, the Attorney Generals state that the "push to force insurance companies and their clients to rapidly reduce their emissions has led not only to increased insurance costs, but also to high gas prices and higher costs for products and services across the board, resulting in record-breaking inflation and financial hardships for the residents of our states."

In the short to medium term, as the ESG movement stabilizes, some insurers are likely to see turbulence on their balance sheets in the same way medium size banks have in recent times. Indeed, in its 2023 Insurance Outlook, Deliotte acknowledges the bumpy road ahead for insurers to implement ESG protocols:

“This task is unlikely to get easier anytime soon, with each element posing its own potentially thorny economic, legal, and reputational risks.”

The challenges faced by insurers to implement ESG protocols are expected to increase the cost of capital and premiums for most commercial insurance lines including Commercial Property, Workers’ Compensation and General Liability.

Diversity

ESG is not limited to environmental issues including efforts to mitigate climate change, its broad scope encompasses numerous social issues. Diversity, Equity and Inclusion (‘DEI”) is an ever more important consideration for businesses and institutions. DEI is a way to encourage social justice. A company’s approach to DEI may lead to developing legal actions from employment law to Directors and Officers’ exposures for civil rights issues. In the near future, Insurers are likely to become more selective (if not discriminating) by increasing rates and application of exclusions to those companies that do not conform to expected DEI standards.

An additional risk that may be particularly associated with DEI in the future is reputational risk, an exposure that commercial insurers merely touch on with Crisis Management policies. However, there is little available that protects a corporation’s income stream if it is interrupted by social justice advocates highlighting non-compliance with DEI requirements.

ESG is now an omnipresent issue whether corporations realize it or not. There seems little way to avoid its impact. It will have a paradigm shifting approach to business for all US corporations from large to small and commercial insurance will be a method to drive compliance.

We consider clients should prepare themselves for difficult times ahead. Where insurance is available, premium costs are likely to increase for some time to come and, at the same time, certain currently insured risks will no longer be available from commercial insurers.

Technology

In addition to ESG, there are other developing risks that will likely see important change. With an ever-growing reliance on technology to function, businesses face evolving cyber risks. With the increasing interconnectivity that information technology brings, certain systemic risks are being scrutinized by insurers.

Lloyds of London announced in 2022 that their cyber liability policies would no longer provide coverage for hacking and extortion by foreign government sponsored actors. Further, there is discussion by insurer groups relating to the exposure that cloud computing provides. Coverage for these systemic risks are expected to soon be things of the past.

When discussing cyber these days, it is important to consider the impact of artificial intelligence as part of the opportunities and risks that it will create. We expect insurers to address AI exposure with increased rates as well as limitations to the applicability of cover.

Day-to-day changes to the technological risk spectrum represent one more reason we expect rates to continue increasing with coverage to be more limited in scope.

Geopolitics

Finally, with geopolitical instability and a worldwide recession on the horizon, we expect reinsurers to continue to increase prices that will find their way to the consumer.

Geopolitics is also likely to mean that supply chain risks will worsen and bring significant exposure to many middle market companies. Supply chain exposures are something the commercial insurers have chosen not to protect for the middle market and despite the developing risk and potential for premium we do not see this changing. However, supply chain issues in recent years are suggested to have caused construction defect risks to deteriorate as alternative materials are used to complete construction projects. We foresee that construction defect exposures will continue to be difficult to insure with commercial carriers.

Outlook

We consider that those companies in the middle market should prepare themselves for difficult times ahead. In the next year inflation and its continued pressure on reinsurers balance sheets and continues climate related losses, will continue to drive insurance rates higher.

As ESG initiatives gather pace, particularly driven by institutional shareholders, organizations such as NZIA and the SEC (should they finally introduce reporting requirements), we expect many issues for insurers. In the medium term, the bumpy road to implementation of ESG, as mentioned by Deloitte, is expected to drive pricing higher.

We also expect that certain progressive state insurance regulators will take greater note of the EGS status of insurers under their scrutiny.

The future is expected to see many challenges for middle-market insureds. Where commercial insurance is available, premium costs are likely to increase significantly for some time to come. At the same time, certain currently insured exposures will no longer be available from commercial insurers. Expect insurers to influence a company’s compliance with ESG standards including decarbonization and meeting diversity expectations.

We would encourage companies, particularly in the middle-market, to look at ways to take greater control of their own risk environment. No longer can companies expect commercial insurers to meet their risk needs to the extent that they have in the past.

An Alternative Approach to Insurance

A captive insurance company can help a company manage and finance the risks that it faces. A captive insurance company is an insurance company that is owned by the company that it insures. The company owns its captive and it decides the risk appetite, what risks to insure and premium costs. This provides the company with an ability to take a long-term approach to risk with less concern for changes in the commercial insurance environment. There are certain legal and regulatory requirements but to a great extent control remains with the company that owns the captive.

Albion’s advice is only to purchase from your captive insurance company those policies that you would otherwise purchase from a commercial insurer should terms be available for such coverage at preferential terms. That advice holds true even with, besides other things, the move to ESG compliance.

We believe the changes that are likely to come about for the insurance industry provide the right companies with an opportunity to use a captive insurance company to mitigate a turbulent future.

How Can a Captive Help?

A captive can help insure those risks that insurers no longer wish to cover as well as where premium costs become prohibitive as insurers commit to ESG.

The captive can additionally help to manage and finance risks such as technology or geopolitically influenced exposures.

Inflation is something that affects all of us. However, working with its own captive insurance company can help a company to manage and mitigate premium costs.

Some of the ESG influenced risks that we see being particularly applicable for a captive solution include:

• Deductibles for Commercial Property, General Liability, Auto, Workers Compensation and Healthcare. The captive can provide a backstop to the operating entity taking on greater deductible exposures by reimbursing for the deductible losses incurred. By taking on greater deductibles the company reduces the impact of inevitable premium increases.

• Difference in conditions exposures including such things as legal liability such as contractual liabilities or flood and earthquake property risk or events that can interrupt the income stream such as supply chain difficulties, all of which are excluded by commercial policies.

• Monetary deposits above Federal Deposit Insurance Corporation limits.

• Healthcare stop loss

• Employment Practices Liabilities including the ever-expanding risk associated with Wage & Hour regulations as well as DEI issues.

• Directors & Officers Liability including DEI issues.

• Reputation risk as social justice warriors become more active or in order to help mitigate an interruption following an event that diminishes the good name of a company.

• Cyber risks including the systemic risks that become less available from commercial insurers

• Construction defect insurance to provide cover as commercial insurers develop less appetite due to supply chain risks.

• Subcontractor default covering a general contractor for defaults by subcontractors where bonding becomes a problem.

• Administrative actions to protect against an increasingly authoritarian regulatory environment.

There are many more covers that may be

applicable to a particular operation for which a captive can look to provide bespoke coverage to meet its specific needs.

The difficulty comes with knowing when a captive solution may be correct for a middle market company. Waiting for critical changes to occur may mean a company will face difficulties plotting an effective approach to a captive insurance solution.

Reviewing options now with a captive insurance feasibility study may help a company to take a longer-term approach to limiting its reliance on commercial insurers and reducing its exposure to the changes to come.

Albion specializes in captive insurance solutions to the middle market and can conduct a feasibility study to help a company face the future with greater confidence.