In this comprehensive analysis of the alternative markets, Mary Ann Godbout presents some interesting conclusions.
The US commercial insurance market has been very customer-friendly over the past few years. Prices have been low, and coverages have been readily available.
This is in marked contrast to the prior insurance climates that gave life to the alternative markets. Then, insurance prices increased sharply, and many coverages became unavailable at any price.
For our purposes, the alternative markets are defined as any mechanism outside traditional insurance that provides risk protection. Common alternative market vehicles include self-insurance, captives and risk retention groups.
In the past few years, these core alternatives have been joined by new and evolving techniques, such as capital market arrangements, program and association business and rent-a-captives.
Typically, we associate alternative markets with Fortune 1000-type companies. In reality, however, the use of alternative markets makes sense for many smaller companies as well. The only difference between different size companies is in the alternative mechanisms they may use. For example, it is unlikely that a small or midsized account would turn to capital markets or develop its own captive. However, such a company could turn to a rent-a-captive, participate in a risk retention group or retain risk as a participant in association business.
In general, the alternative markets represent business that has been taken away - in total or in part - from traditional insurers.
The size of the alternative markets
Conning has been studying and sizing the US alternative markets since 1980. Our recent analysis of the alternative markets determined that its overall size has not changed much throughout the mid-1990s. It has hovered at about one-third of the total risk protection market. With insurance prices so low, it is difficult to imagine that many businesses would want to leave traditional insurance and move into alternatives.
However, the fact that alternative markets have held firm during this period is quite an accomplishment. Obviously, businesses see value in these risk management alternatives and, despite low insurance prices, are unwilling to give them up. The value of a more global approach to risk management, more direct control over claim management and loss prevention and more overall stability in protecting against risk are some of the benefits. These strategic considerations, rather than tactical motives, explain why companies have stayed with alternative methods.
For the first time in our analysis, we also can explore different characteristics of the alternative markets in detail. Conning's market analysis tool - MarketStance(TM) - provides a comprehensive analysis of these markets by line of business, account size and industry group. In some cases, the data confirm long-held beliefs; in other cases, they shed new light on these markets. The result is one of the most thorough analyses of these markets to date, enabling insurers and brokers to develop targeted business and marketing strategies.
By line of business
We examined the alternative markets for workers' compensation, commercial auto, liability (comprised of other liability, products liability and the liability component of commercial multiperil) and property (comprised of fire, allied, boiler and machinery, inland marine and the property component of commercial multiperil). We found that alternative markets are most prominent in workers' compensation and least prominent in commercial property.
• Forty-two percent of the workers' compensation market is estimated to be in alternative markets. High retentions and self-insurance have dominated this line for some time, largely because it is the primary insurance cost for businesses and claim frequency makes it possible to estimate retained losses. State funds (quasi-governmental entities that provide workers' compensation insurance exclusively or in competition with private insurers) make up about 13% of the market, leaving traditional insurers with the remaining 45%.
• Commercial auto (both liability and property coverages) shows a 40/60 alternative/traditional split. The relatively predictable nature of this line may make companies willing to cover this risk through alternative methods.
• Liability lines are estimated to have a 30/70 split between alternative and traditional markets. The liability crisis of the 1980s was a key tactical driver back then. Once companies made the switch to alternatives, they have tended to stay with the decision, despite low insurance prices.
• The commercial property lines, at 21%, have the smallest percentage of risk in alternative markets. Despite two major catastrophes (Hurricane Andrew and the Northridge earthquake) in the early 1990s that caused some market disruptions (mostly in homeowners insurance), commercial property insurance availability and affordability - the main triggers for alternative markets use - have not been major issues. In addition, the generally lower cost for this insurance, compared to other coverages, provides little incentive to switch to alternatives.
By account size
We estimated alternative markets for large, midsized and small accounts. Account size definitions are based on number of employees, where large accounts are defined as establishments of 1,000 or more employees, middle accounts are businesses with 50 to 999 employees and small accounts represent companies of under 50 employees. We found that large accounts make significant use of the alternative markets, while small and midsized accounts have only a minimal percentage of risk in alternatives.
Use of the alternative markets has been concentrated in large accounts. More than three-fourths of national accounts are estimated to use alternative markets, while only about one-fifth of middle markets do. The next logical opportunity for alternative markets growth - especially if the commercial insurance market hardens - is in the middle market. Small accounts are most committed to traditional insurance. They are estimated to have just 10% in alternatives, which includes risks without insurance as well as those that are part of risk retention groups, in rent-a-captives or involved in program business.
By industry group
We explored how the alternative markets were used by different industries, where industry groups were defined by the US government's Standard Industry Classification (SIC) codes. This analysis concluded that the use of alternative markets varies widely among industry groupings, linked partly to the cost of insurance and the predominance of large accounts.
Generally, if a company's cost of insurance is low, it makes sense for that company to stay with traditional insurance. If it is high, alternative market choices are more attractive. In the accompanying graph, we show the relationship between below the cost of insurance (measured by the ratio of premium to sales) and the percentage of the market in alternative markets.
Industry groups like agriculture, mining and transportation have higher average insurance costs and, as expected, place higher percentages of risk in alternatives. In contrast, finance, insurance and real estate (F/I/RE) and wholesale trade have lower average insurance costs and, as expected, have lower-than-average concentrations in alternatives.
Not all industry groups follow this generalization, however. One reason is that account size can influence the use of alternative markets. For example, manufacturing has relatively average insurance costs, but has a high percentage of risk in alternatives, most likely because a large percentage of premium - about one-third - comes from large accounts. Construction is another industry that differs from this generalization. It has one of the lowest percentages in alternatives, yet a sizable cost of insurance. Partial explanations include the lack of large accounts, contractual requirements that often require insurance coverage and the potential for serious losses.
Market conditions and the alternative markets
This “beneath the surface” analysis of the alternative markets enriches the understanding of the total risk protection market. If prices begin to harden in the US commercial insurance market, this type of analysis will become even more important.
For the first time in a long time, we are observing very different conditions in the commercial insurance market. There is growing evidence that commercial rates may be bottoming and even increasing in selected coverages. Conning pricing survey data from agents and brokers also confirm a slowdown in pricing declines in most commercial lines. Further, losses appear to be on the rise, and reserves are more strained than in recent past. Conning's reserve analyses point to adverse development in workers' compensation and commercial auto for the 1997 accident year; reserves for commercial lines combined for accident year 1998 appear to be deficient.
Any hardening of the commercial market will bring renewed interest in alternative arrangements. Because we believe that price increases are likely to be gradual, the impact on alternative markets also should be somewhat gradual. Our forecasts for the alternative markets call for an increase to about 35% of the market by 2001 - only a slight increase over today's 34%.
However, much depends on the direction of commercial rates and the intensity of any rate changes. Our forecasts are based on expectations that rates will increase slightly and slowly. If rates head up sharply and quickly, more movement to the alternative markets is likely to occur. Even if rates edge up slowly (the likely scenario), interest in alternatives is likely to accelerate following years of ever-declining prices. After all, any price increase will come as a shock to customer expectations. Small and midsized accounts are likely to explore options beyond traditional insurance once prices start to climb. Because the small and middle segments make up 90% of the traditional market, any movement by these groups could be meaningful.
With the past success of the alternative markets, businesses now in traditional insurance should not be hesitant to move to alternatives in the future. The successful track record of large businesses using alternative markets will offer a supportive climate for smaller-sized risks wanting to enter alternatives. In the 1980s, despite high prices, it would have been difficult to envision small and midsized risks willing to consider noninsurance options, because the alternative markets concept was untested. But, after 20 years, use of alternative markets is a well established risk management practice. The result is that movement into alternatives by small and midsized accounts is a much more realistic scenario today than it was in the 1980s.
Once risks move to alternative markets, they are not likely to return to traditional insurance. A recent Conning broker survey indicates that only about 30% of the respondents have seen some movement of their clients out of alternatives due to low prices. The relative stability in the overall size of the alternative markets over the past few years confirms that such movement is not common.
Although the size of the alternative markets has not changed much over the 1990s, many other aspects have. We now have a better understanding of the characteristics of this market, and this understanding will help businesses and insurers better deal with future risk management needs.
Mary Ann Godbout is a vice president at Conning & Company, Hartford, Connecticut, where she specializes in analysis of the property/casualty industry. In addition to alternative markets, her areas of expertise are workers' compensation, banks in insurance, reinsurance and personal automobile.