Liability insurance crisis: coming to grips with long tails and deep pockets

By LINDA M. WAGNER

Last year the General Assembly reformed the public utility law and approved Illinois' entry into the world of interstate banking. This year they may have to act on reform of liability insurance, an issue no less volatile than another acted on last year — medical malpractice. Linda Wagner sets the stage for the issue of liability insurance.

LAST spring, Don Peloquin, the newly elected mayor of Blue Island, was abruptly initiated into what has become known as "the liability insurance crisis." "On April 9, I was sworn in," says Peloquin, "and on May 2, I got the policy cancellation notice." The canceled liability insurance policy left city officials scrambling for weeks until they finally found a new insurer, who demanded a 100 percent increase in the price of Blue Island's coverage. That led Peloquin to seek a 30 percent tax increase, which outraged the voters who'd just placed him in office. "I was a new mayor and they were saying it was my fault."

The source of Peloquin's problem lay far beyond Blue Island's borders. It stretched from coast to coast in the United States and across the ocean to the British Isles, home of that venerable institution, Lloyd's of London.

In past years, someone with a large or unusual risk to insure would often shrug his shoulders and say, "I can always go to Lloyd's of London, as long as I can afford the premiums." In 1984 and 1985 the insurance industry came to the rude awakening that, in a world of declining interest rates and a devalued British pound, even Lloyd's could no longer afford all the risks of commercial property and casualty insurance in the U.S. That was when the so-called "liability insurance crisis" crystallized and the policy cancellations began to fall like rain.

The industry's fundamentals

Several fundamentals of the insurance business must be explained before one can understand why cities, park districts and public transit system, day care centers and chemical companies, and many other businesses have been hit during the past 12 months with insurance rate hikes as high as 1,000 percent. Others have been unable to obtain coverage at all.

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The first fundamental is the insurance industry's need for reinsurance, Most U.S. insurance companies do not assume the full risk for the policies they write. Let's say, for example, that they may have reserves to cover 60 percent of the possible future claims against a policy; to provide coverage for the other 40 percent, they seek other investors who will reinsure them. These reinsurers are often Lloyd's of London syndicates — pools of individual investors from around the world who assume the risks of others in the hope that they'll make a profit from their investment.

Secondly, an insurance firm rarely makes a profit directly through underwriting policies. Its financial stability and greatest profits come instead from investing its customers' premium dollars and reaping the interest on the investments. In the late 1970s this strategy worked very well because inflation had sent the prime interest rate close to 20 percent, and insurance firms had many high-yield investments. The inflationary interest rates became an incentive for "cash-flow underwriting," that is, the acquisition of more and more premium dollars, even if acquired at an underwriting loss.

During that period, many insurance companies drastically cut their rates to bring more policyholders under their wing. Policies were often priced at 40, 60 or 80 percent below their actual cost in order to meet the fierce competition for premium dollars. The ensuing price wars between the insurance firms was not of immediate concern because the rate of return on invested premium dollars was so high.

A new federal administration made inflation its first target in 1981. Since then the prime rate and all interest rates that follow it have been cut by nearly half. While deflation was a victory for Reaganomics, it was the first signal of disaster for the insurance industry. With policy prices set low because of the price war, many firms were still losing money heavily on underwriting. As interest rates dropped, they could no longer make up for the loss through investments. In the civil justice system, meanwhile, inflation was still on the rise in the amounts that juries and judges were willing to award plaintiffs who'd suffered injury.

The peak of inflation in jury awards hit
insurance firms at about the same time
that deflation hit their
investment portfolios

The peak of inflation in jury awards hit insurance firms at about the same time that deflation hit their investment portfolios. Moreover, some companies, too eager to see profits in the late 1970s, had not kept adequate reserves for the portion of future claims they would some day have to pay.

That day arrived during 1984, when disaster struck with a $3.8 billion pretax operating loss industrywide, despite record investment gains. Suddenly several hundred insurance companies across the nation were being monitored by state regulators. Twenty firms were declared insolvent.

This brings us to the third fundamental — bankruptcy in the insurance field. When a series of bankruptcies hits any industry, it's bad news for the economy in general. In most industries, it may bode well for the firms who've managed themselves efficiently and remain strong, because they'll probably assume the business of their bankrupt colleagues. In the insurance industry the remaining firms are also required by state law to assume the unpaid claims against the policies underwritten by the now-defunct firms. With the risk of insolvency spread as wide as it was in 1984, this prospect loomed over the entire industry in much the same way as the stock market crash of 1929 spread a panic throughout the world economy.

U.S. firms looked to Lloyd's of London as their deus ex machina. As the insurers of the insurance firms, the investor syndicates were tapped heavily in an effort to maintain profitable balance sheets. But another unforeseen economic factor had been thrown onto the international insurance scene. The British pound, which once stood at $2.80 U.S. dollars, had been drastically devalued to stand at only $1.03. Although it's now back up to about $1.40 (at this writing in mid-November), the reinsurance capacity of Lloyd's of London now stands at about half what it once did vis-a-vis claims against U.S. insurance policies.

In 1984 this combination of factors led to the failure of a Lloyd's of London syndicate. With the reputation and stability of a 500-year-old institution in jeopardy, Lloyd's spoke a loud, resounding "NO" to future underwriting of liability coverage for many types of businesses and units of governments in the U.S.

The liability crisis had arrived from London. It was passed on by American underwriters to commercial insurance consumers through mid-term policy cancellations, refusal to renew policies, and/or rate increases ranging from 25 percent to 1,000 percent.

Limited municipal options

The city of Blue Island was one case. Blue Island had been insured through the Governmental Insurance Exchange (GIE) of Bloomington. The GIE pool had been formed in 1978 after a cyclical downturn, similar to but less drastic than the one in 1984, had left a number of municipalities without insurance. In the more severe situation of 1984, even GIE refused to continue Blue Island's policy because of claims filed against the city between 1979 and 1984.

Blue Island has settled two of these claims out of court. In the first, Blue Island offered $490,000 to a police shooting victim whose damaged spine has left him confined to a wheelchair. In the second, the paraplegic victim of a collision with a police vehicle received a $350,000 settlement. The third case, in which a collision with a fire truck left two people dead, has not yet been settled.

When Blue Island's liability insurance policy came up for renewal on May 1, 1985, GIE notified the city that it could not find a reinsurer for the entire pool of municipalities if Blue Island remained in the pool. Although GIE agreed after some tough negotiations to extend its coverage through June 30, the town was left scrambling for a new underwriter.

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The Illinois Municipal League, which has a similar pool, said it couldn't help because it was having problems with reinsurance itself. A.J. Gallagher, a leading developer of self-insurance packages, tried to bring a Lloyd's syndicate directly into the solution, but by then investors had grown too nervous about the U.S. liability insurance market.

'If insurance companies are
going to back out of the market,
the government should require
them to carry a certain
number of municipalities'

Finally, Carroon and Black of Chicago developed a self-insurance package for Blue Island, with excess protection of up to $1 million covered by Evanston Insurance. Blue Island must now pay a deductible of $150,000 on any one claim, or a $600,000 deductible toward total claims in any year before its excess protection even comes into play. Moreover, it now costs the city $335,000 a year for just $1 million of coverage. Any claims over the million would have to come out of Blue Island's coffers. City officials felt it necessary to spend additional money for an extra $5 million in excess umbrella coverage, especially because of its exposure from the most recent accident.

To cover all the new insurance costs there was only one solution — a tax increase. "The words 'tax increase' strike a negative chord with the public," says Blue Island Mayor Don Peloquin. "I'm not for tax increases, but I know you've got to pay bills." Officials asked the city council to approve a 30 percent tax hike, 98 percent of which would pay only for the higher insurance costs."The taxpayers can't relate to it," says Peloquin. "They can't understand why a city can't get insurance when they can."

Blue Island residents outraged at the proposal, turned up in force at the council meeting whose agenda included the tax increase. "The general public feels it's not going to see anything if it spends this money — only a piece of paper," says Peloquin. The council approved only a 4.2 percent tax increase, and the city ultimately decided it could not afford the extra umbrella policy. Until May 1986 the insurance premiums will be paid largely through a 2 percent utility tax that Blue Island assessed as a temporary emergency measure. In January (this month), the city will issue a full-blown public bid for a new underwriter, but the city's budget director fears that 1986 will be another bad year for those seeking liability coverage.

"Small towns are behind the eight ball," says Peloquin, who sees the insurance industry's poor management as a central cause of his dilemma. "If insurance companies are going to back out of the market, the government should require them to carry a certain number of municipalities. The government should require an insurance pool.'' But Peloquin is also sympathetic to the industry's argument that our society has become too litigious. "People now seem to think you can sue everybody. It's like a lottery."

The Cook County suburban village of Robbins learned the hard way that it's unwise to go without any insurance coverage at all. Last May, after its coverage was canceled and it could not afford a new policy, Robbins was ordered by a federal judge to pay a 1984 judgment totaling $750,000 won by a former village police officer. The order left Robbins with "more problems than insurance," according to Village Attorney Phillip Williams. Over $125,000 was drained from Robbins' general account to pay for the claim. Water and sewer tax receipts, the payroll fund and even the proceeds of the Robbins Flea Market were seized to meet the bill. The result — a new administration had to lay off about one-fifth of its work force and cut back hours for those who remained.

Stiff consumer stance

"The time has come to halt the trend," says William Dart, coordinator of the Illinois Coalition on Insurance Crisis (ICIC) and vice president for governmental affairs of the Illinois Manufacturers' Association (IMA). "We're faced now with actual loss of jobs and cuts in government service, including police protection." Dart points out that spot gasoline shortages may occur if some gas carriers cannot obtain liability coverage and that parents face a daily dilemma when their day care centers lose their coverage.

Dart assembled the coalition of business associations and units of government who've been plagued by the liability insurance withdrawals and rate hikes. ICIC represents a middle-of-the-road commercial consumer response to the issue, while more radical solutions have been proposed by the Coalition for Political Honesty in Chicago and the National Insurance Consumers Organization (NICO) in Washington, D.C.

NICO President Robert Hunter says, "There's no crisis except the one that's being manufactured." Hunter speaks with some authority as an actuary who's worked in the insurance industry and has advised two U.S. presidents on the development of no-fault auto insurance. Yet he thinks U.S insurance firms are in a kind of conspiracy with Lloyd's of London to restore excessive profits to the industry. He insists there's "no statistical justification" for the "massive pullout" from the liability insurance market. While he acknowledges the dramatic impact of cash-flow underwriting practices, interest rate declines and the devalued British pound, Hunter says the market has already adjusted to the 1984 financial crisis.

"Lloyd's is a major reinsurer, and you have to worry about it if they depart the country," says Hunter. "However, it's clear that the stock market has already reflected that, and [insurance] stock prices are now soaring to new heights." Hunter points to recent reports by A.M. Best's insurance service, "the industry's bible," which has determined that the insurance industry is adequately financed for growth.

Even the industry acknowledges that its $3.8 billion pre-tax operating loss in 1984 was balanced by "record realized capital gains of $3 billion and tax credits of nearly $2 billion," according to 1985, A Critical Year, published last May by the National Association of Independent Insurers. The result was a net income after taxes of nearly $1.5 billion, hardly a catastrophic loss. Fearing the disappearance of tax credits and the inability to sustain such high capital gains, the publication goes on to advise its members, "Action must be taken during 1985 to ensure a return to profitability in insurance operations "

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ICIC Coordinator Dart readily accepts the industry's profit motive."Certainly, they do have a right to make money. Although," Dart quickly adds, "they lost $4 billion in 1984 and it seems they're trying to get it all back in '85 and '86." Dart is familiar with many industries that have suffered for years for their past mistakes.

Lloyd's has threatened to pull out
of the U.S. liability market entirely
unless every state accepts
this new proposal

Hard-line consumer advocates, like Pat Quinn of the Coalition for Political Honesty, are calling for a fighting posture by insurance consumers and taxpayers. Quinn's interest in the issue stems partly from his role as commissioner of the Cook County Board of (Tax) Appeals. He says property taxes throughout Cook County have risen, on average, by 13 percent this past year. He claims that most units of government — cities, towns, park districts, school boards — trace the increase to rising liability insurance costs. "The bottom line," says Quinn, "is that if the insurance prices for a unit of government go up, we pay higher property taxes."

When speaking of insurance companies, Quinn says, "you have to be leery of their claims. Every five or six years there's a 'crisis' in insurance, supposedly, and they raise their rates. I don't think we as consumers should sit by and watch the rates go through the roof when independent experts often find they [insurance firms] run their businesses inefficiently."

Quinn says the solution is a Consumers Insurance Board (CIB), which would function like the Citizens' Utility Board (CUB) for which he crusaded several years ago. "I think we need independent actuaries, accountants and experts to represent we [sic], the buyers of insurance, to help unravel the mysteries surrounding the industry." Quinn says such an expert panel could be financed through voluntary member contributions to CIB. Its mission would be research, providing testimony before state regulators and legislators, and providing consumers with clear, objective price comparisons for insurance policies.

Quinn's coalition is petitioning the state to set up such a CIB, although he expects legislation to be stalled at least until the spring. In the meantime he's taking the idea to voters through municipal referenda. This past November the village of Hoffman Estates in Cook County passed a referendum for a municipal Consumers Insurance Board by a vote of 959 to 728. Quinn hopes the city of Chicago will place it on the ballot in March.

Quinn's idea for a consumer board is not well received by Illinois Sen. Emil Jones Jr. (D-17, Chicago), who is heading a Senate Select Committee on the state's liability insurance crisis. "What purpose will that serve? I don't see CUB doing a damn thing for utility rates," he added. "Why kid ourselves and try to give people pie in the sky?"

There are several voices more likely to be heard by Jones — and by House Speaker Michael J. Madigan and the governor. First is the IMA-initiated ICIC; second is the Illinois Department of Insurance; third is the Illinois Trial Lawyers' Association; and last, but never least, are the dozen active lobbyists for various insurance industry firms and associations. (There are 61 lobbyists registered for the industry in Illinois, but only a fraction of them are active in Springfield at any one time.)

The Illinois Senate, House and the state's Insurance Department have all held hearings on liability insurance. The executive agency has concentrated on the availability of coverage, while legislators have also examined rate hikes and calls for tort law reform and increased regulation of the industry.

"The mood of the legislature is rather punitive toward the insurance industry," according to Dart of the ICIC. That mood was expressed in a new law passed and signed in October that forbids mid-term cancellation of insurance policies unless specific conditions, like nonpayment of premiums, exist. Insurance Department spokesman Robert Heisler said, "It was the fastest I've ever seen a bill passed." Dart warns that new regulations should be tempered. "If the mood is too punitive, it will merely dry up the insurance market."

The Department of Insurance has been working closely with the industry on the availability problems of certain commercial consumers. On December 2, the department launched a market assistance program in cooperation with the major industry associations. The program is designed to locate underwriters for any commercial line of insurance that has become difficult to obtain. Heisler said he expects the service will be needed for some time. "I'd say it'll be a year or year-and-a-half before this thing settles down."

In the meantime, the department has also been pressured by the insurance industry to approve a new formula for property-casualty coverage, called the "claims-made policy." Lloyd's has threatened to pull out of the U.S. liability market entirely unless every state accepts this new proposal.

To understand "claims-made" you must understand what insurers call "the long tail." "Essentially it means that we must cover things that might go back 20 or 30 years," says Brad Kading, Midwest regional director for the Alliance of American Insurers (AAI). Pollution liability is perhaps the best example of the long-tail concept.

If a chemical company had a policy covering pollution liability in 1975, it might have had no claims filed against the policy until 1985 because damaging effects of a pollution incident that occurred in 1975 may take that long to become apparent. Under the current practice the 1975 policy underwriter is expected to cover damages arising from that year even if the effects show up years later. During that time (1975-1985), inflation rose dramatically and the premium dollars collected by the underwriter in 1975 have shrunk considerably by the time of the 1985 claim. The insurance industry says this "long tail" makes it difficult to predict what their losses might be, and thus, it becomes impossible to spread their risks reasonably or to set realistic prices.

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The "claims-made" formula is meant to correct this situation. Under the proposal, a claim made in 1985 would be covered by the insurer of record in 1985, the year in which the claim is made, rather than by the insurer during the year in which the polluting event occurred. Twenty-seven states have already approved a claims-made form as presented to them by the insurance lobby. But in Illinois, the director of the Department of Insurance found the proposal to be "atrocious," according to Robert Heisler. Illinois drew together a group of states that had not yet approved it and attempted to reach a compromise with the industry. Heisler says, "We've made a lot of changes which will now be beneficial to the insureds, but there are still more adjustments needed before we sign on to that claims-made form."

Looming tort reform

The biggest battles over the liability insurance issue will come to the legislature this spring, as the insurance industry and the ICIC begin their push for state tort law reform. What the insurance industry wants, and the ICIC supports to some extent, are changes that will hold down the costs of civil cases. Suggestions include ceilings on liability awards, the elimination of punitive damages, limits on contingency fees for plaintiffs' lawyers, the elimination of joint and several liability, and a modification of comparative negligence.

In Illinois, the ICIC is working with insurance associations in drafting legislative proposals that will be ready in late January. "We're hoping to build this coalition and really go out for real reform," says ICIC founder Dart. Last year's changes in medical malpractice laws are serving as an inspiration and model for the emerging proposals, which will cover the liability area for all types of businesses and governmental units.

One of the goals of those drafting the proposals is to close up what insurers call the "deep pockets." According to AAI press material, "Deep Pocket is a term for the person, government or corporate defendant with the money to pay a judgment, regardless of proportion of fault." As Blue Island's mayor Don Peloquin puts it, "This city could have no more than 5 percent fault for an accident, and yet we've got to pay 95 percent of the damages." Current laws favoring joint and several liability and pure comparative negligence encourage juries and judges to award high damages to an injured party, according to AAI. The damages are assessed against whatever party has substantial insurance coverage.

Consumer advocates like NICO's Robert Hunter are staunchly opposed to these efforts to change tort law. "They'd like to take away some victims' rights," says Hunter. "I'm not against tort law reform if it's justified," Hunter adds, pointing to his support for no-fault auto insurance. "But there's no need for overarching tort reform throughout the 50 states." He urges legislators to weigh the pros and cons of each specific proposal carefully, and he warns that the insurance industry is trying to take advantage of its 1984 crisis to force sweeping changes in the law.

... he warns that the insurance
industry is trying to take
advantage of its 1984
crisis to force sweeping
changes in the law

Some lawyers also view current laws as a system of hard-won victims' rights. Chicago attorney Eugene Pavalon says, "This isn't a lawyer versus insurance industry battle. The issue is: Do people want their rights taken away?" According to lawyer Jeffrey Martin, the Illinois Trial Lawyers' Association operates under the philosophy that "persons who are injured have a right to be compensated." Martin argues that lawyers and legislators "should look at all legislation in terms of justice or fairness." He maintains that current liability insurance problems stem not from the civil justice system, but from the failure of state regulators to adequately monitor insurance company practices.

In making its case the insurance lobby cites the rise in million and multi-million dollar jury awards judgments. Forbes magazine has reported that the average product liability award in the U.S. increased from $345,000 in 1974 to $1.07 million in 1984. In testimony given before the U.S. House of Representatives, AAI President Franklin Nutter said that the average award against U.S. cities jumped from $230,000 in 1982 to $2 million in 1985. Nutter added that "the number of lawsuits filed against public officials doubled since 1982."

NICO's Hunter warns that such data should be carefully scrutinized. "It's a myth that every injury ends up multimillion dollar verdicts. Only 2 percent of all cases actually go to the verdict at all." Hunter also argues that the real problem with insurance rests with inadequate, understaffed regulatory agencies in the states. While he doesn't support federal regulation, he thinks there's a need for federal guidelines for the states.

But ICIC's Dart says, "Regulation is the problem, not the answer. Anytime you put restrictions on a business, all you're going to do is increase the cost of the product or service it provides." Dart insists that market forces will take care of the poorly managed insurance firms that have handled their affairs poorly during the past five years.

Attorney Pavalon says he and the Trial Lawyers' Association have the ear of House Speaker Madigan. House Minority Leader Lee A. Daniels seems to be swayed more by the commercial consumer lobby. Sen. Jones says only, "The issue is so complex, we will not rush to judgment."

At this point, with the 1986 campaign underway, no one anticipates any significant legislative action on the issue until after the March primary. By then, many mechanisms may already be in place to help business and government cope with the availability of liability insurance, and the "crisis" may be over. But it's a fairly safe bet that no matter what the legislature does, insurance bills in 1986 will be higher for consumers — including government whose higher insurance bills will mean higher taxes.

Linda M. Wagner is a reporter for WBEZ Public Radio in Chicago and a free-lance writer for various publications.

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