An annual review of commercial insurance coverage is critical to the small business risk management program. A careful review yields insights that allow small businesses to optimize their resources as market conditions evolve. The current insurance market poses difficult challenges to consider.

The first is that the events of 2008--2010 have completely upended the traditional insurance cycle of rising and falling premiums. In the past, insurers typically experienced a “soft” cycle of low premium costs which “turned” when a large catastrophic loss, such as a major hurricane, caused premiums to rise and the “hard” cycle to begin. For small businesses, this meant that post-catastrophic rate increases would eventually fall to lower, sustainable levels.

But that has changed. Moody’s Weekly Credit Report demonstrates that while there has not been a severe natural catastrophe in 2009 and 2010 to date, “the underwriting margins of many industry players, particularly those with property coverage concentrations, have suffered significant aggregate losses because of a sharp upswing in the frequency of low-severity perils including tornados, winter storms, hail and covered floods. …In the past, losses from non-hurricane weather-related events were less volatile, allowing insurers to charge sufficient premium to offset exposure to these perils. But this recent uptick in volatility is problematic for insurers given the thin underwriting margins in what is largely a commodity business.”  

As the cumulative effect of these low-severity events is catching up with insurers, it is not surprising that they should respond by filing for rate increases on their homeowner insurance line. Expect them to follow suit on commercial lines. If you can renew your coverage before rates increase, you would be wise to do so.

In the first edition of Prepare for the Worst, Plan for the Best: Disaster Preparedness and Recovery for Small Businesses (Wiley, second edition paperback, 2009), titled Contingency Planning and Disaster Recovery: a Small Business Guide (Wiley, 2002), I explained how, in the aftermath of a major disaster, insurance premiums rise. However, large corporations eventually reach their threshold for pain and adopt self-insurance, captive and other programs to reduce their costs (p. 171):

“Large corporations will become increasingly unwilling to pay such steep insurance premiums and will develop innovative means of insuring their risks. We have seen this phenomenon before, beginning in the 1980’s with the development of the so-called alternative risk transfer market (ART). ART offered a portfolio of tools by which corporations could transfer their risks by means other than standard commercial insurance programs. One such tool is a captive insurance program whereby large corporations insure their own risks through wholly owned insurance companies. They were typically domiciled offshore, in places such as Bermuda and the Cayman Islands, to benefit from the favorable tax treatment and fewer regulations. Captives allow corporations the benefit of tax-deductible premiums to cover their risks while ensuring that profits on the program remain in-house.”

Vermont is the leading jurisdiction for captive formation in the U.S. with a favorable legal environment. This year, Vermont has seen an unusual volume of captive formation with new licenses issues to captives across industry sectors, particularly hospital groups seeking coverage for their professional medical liabilities and financial services companies that face premium increases for their directors and officers liability coverage.

This suggests that savvy players anticipate further premium increases in the traditional market. To reduce their exposure to rising costs, they form captives to self-insure. If this assessment is correct, the insurance market, where small businesses have relatively little bargaining power, is about to get tougher for us. Captive formation and other means of self-insurance are not feasible for smaller businesses, so we should examine other alternatives to cope with expected rate increases. Consider such measures as raising deductibles and possibly exiting high-premium, risky lines of business entirely.

A careful review of your insurance program will allow you to reduce the risk of being surprised by rising rates in 2011 and manage your expenses with that outlook in mind.