Insurer Stability Key When Choosing CoverageThe recent flood of insurer insolvencies hasleft heads spinning in the property-casualty insurance world.

The major insurance rating agencies have reported that nearly 40insurers were placed under supervision of regulators or intoliquidation in 2002.

Familiar names like Reliance, Superior National and PHICOamongothersare no longer spoken except with regret.

But reports and studies, no matter how shocking, cant begin tocompare with the awful feeling a risk manager gets when rumorsstart to fly about the financial security of an insurer orreinsurer that either is–or was a part of–his or her riskmanagement program.

Even when risk managers desire to deal only with insurers thatare highly rated financially, the number of potential players maybe decreased substantially because of the nature or difficulty ofthe risk. Some insurers simply may not want to participate on aparticular risk.

And after the playing field is honed down to companies that wantto write the business, risk managers must weigh many factorsinaddition to financial strengthwhen choosing which programs andcarriers to recommend. Chief among them, of course, is the extentand type of coverage being offered.

But the need for good judgment doesnt stop there. Pricefrequently becomes a factor that at times may be given more weightthan the insurers financial stability. And explaining the need topay a higher premium for coverage from a rock solid insurer may bea difficult task in many corporations.

So risk managers are faced with many tough decisions whendeciding which program to recommend. For, after all, insurance andreinsurance is just thata promise to pay future claims according tothe manner negotiatedand the future may be a long way off,especially with casualty insurance.

When I was working as an independent agent, we recommended onlyinsurers that were rated “A” or better by A.M. Best. That is,unless there was no other insurer available and willing to writethe risk.

Then the proposal was accompanied by the obligatory disclaimerstating that the decision to deal with the particular insurer wasleft up to the insured. But if there were no other options, wasthere really a choice?

Some insured clients insisted on cut-through endorsements toreinsurers when lesser-rated primary insurers were the only onesavailable. Cut-through endorsements, when available, permit theinsured to recover directly from the reinsurer named in theendorsement in the event that the primary insurer becomesinsolvent. They were (and still are) difficult to obtain. So theywere not available to the majority of insured businesses.

Other clients perhaps decided to rely on the state guarantyfunds to provide coverage in the event the insurer went under.

But how much will guaranty funds actually pay? And what are thedifferences among the various state guaranty programs?

Most state guaranty funds (keep in mind that state laws maydiffer) include both claims for losses and for the return ofunearned premium as “covered claims” against the guaranty fund.Most funds cover direct, or primary insurance written for aninsured, intentionally excluding insolvent reinsurers.

In other words, primary insurers are on their own in regard tothe financial stability of the reinsurers with which they deal.

Warren Buffett, chairman of the board of Berkshire HathawayInc., made this point clear in his 2002 letter to shareholders. AsMr. Buffet pointed out: “Cheap reinsurance is a fools bargain. Whenan insurer lays out money today in exchange for a reinsurerspromise to pay a decade or two later, its dangerousand possiblylife-threateningfor the insurer to deal with any but the strongestreinsurer around.”

Obviously, then, any risk manager who chooses to rely on acut-through endorsement to a reinsurer or backing up aself-insurance program with reinsurance must be absolutely sure ofthe financial strength of that reinsurer. Because theres no safetynet guaranty fund for that reinsurer.

Likewise, its important to remember that state guarantyassociations do not cover risk retention groups, captives andnonadmitted insurers. This isnt to say that these types of riskfinancing options should be overlooked. But it does mean that theirfinancial strengthindependent of any state safety netsmust becarefully considered.

Most state guaranty funds also exact a deductible on eachcovered claimfor both losses and unearned premium.

Among the states that levy a deductible, amounts range from alow of $10 to a high of $250 per claim.

But the maximum amount payable per claim, rather thandeductibles, may have more of an impact on corporate insureds.

Every state places a cap on the maximum payable per claim by theguaranty fund, although workers compensation claims are paid infull by either each states guaranty fund or state workers compfund.

The lowest state cap is $100,000, which isnt a lot, especiallyfor a casualty claim. The majority of state guaranty funds will payup to $300,000 per covered claimstill not a tremendous amount intodays litigious society.

Perhaps the biggest shock, however, especially for largerbusinesses, is that more than half the state guaranty fund lawsinclude a net worth provision. This provision excludes largerentities from the class of covered claimants.

This exclusionary provision is triggered by as low a net worthas $3 million in the state of Georgia, with a majority of statesadopting the NAICs model act provision of $50 million net worth onthird-party claims.

Its clear from this discussion that state guaranty associationlaws are designed to protect smaller insureds, as seen by the lowdeductibles, relatively low maximum amount payable per claim andthe net worth provisions. Larger businesses often are left standingon their own, without even the guaranty fund safety net providingmuch assistance.

There also are other limits on what the guaranty funds will pay.Many states, if not most, exclude payments for punitive damages,pre-liquidation fees from attorneys and adjusters, interest onjudgments, penalties and noneconomic losses.

And then theres the question of what triggers guaranty fundaction. The vast majority of states require a final order ofliquidation with a finding of insolvency as the trigger. So thereis no recourse for insureds to most guaranty funds between thefinding of insolvency and a final order of liquidation.

Most insurance departments try to salvage insurers throughrehabilitation efforts before resorting to a liquidation order.

In the case of the Reliance companies liquidation, thePennsylvania insurance commissioner placed the companies intorehabilitation four months before ordering liquidation. The mailingof claim packets was begun three months later. And thats just tostart the process. Similar time frames are seen in otherinsolvencies.

All in all, insured businesses may have the advantage of asafety net of state guaranty associations. But the process ofinsolvency is a painful onefor risk managers, employees of thefailed companies and claimants who expect to recover for theirlosses.

For large corporations, the relatively small amount of guarantyfund coverage and other limiting factors reduce the impact of thissafety net.

All of this reinforces the idea that the financial stability ofinsurers should be prime among the factors considered when placingorders for coverage.

The first question risk managers should ask is not “how muchwill it cost,” but, rather, “will the insurer be around in five or10 years to pay my claims?”

Diana Reitz is the editor of the National UnderwriterCompany publication, The Tools & Techniques of Risk Management& Insurance, as well as the Risk Funding & Self-InsuranceBulletins, both available at www.nationalunderwriter.com/nucatalog.

Reproduced from National Underwriter Property &Casualty/Risk & Benefits Management Edition, May 26, 2003.Copyright 2003 by The National Underwriter Company in the serialpublication. All rights reserved. Copyright in this article as anindependent work may be held by the author.