The casualty side of the insurance industry is being hit by rising levels of claims and losses. In this episode of William Blair Thinking Presents, Adam Klauber, CFA, partner, group head of the financial services and technology sector, provides a framework for understanding the depth of the issue and delves into the underlying nature and causes.

Podcast Transcript

00:21
Chris T

This episode was recorded on Tuesday, July 23, 2024.

Hi everybody. On today's episode of William Blair Thinking Presents we welcome Adam Klauber, CFA, partner and group head of the financial services and technology sector. Adam and his team, in collaboration with Paradigm Actuaries, published a report in June with the intention of providing a framework for understanding the reasons why the casualty side of the insurance industry is being hit by rising levels of claims and losses. I’ll let Adam obviously get into it, but ultimately, while the industry is known for, its ups and downs, the consensus of the report is that significant forces are driving structural change. So, with that, Adam, thanks for being here. I figure we can jump in. Do you mind just giving us a high-level overview of what inspired you to write the report in the first place, and then maybe just a broad overview of the report and then from there we can go into the key findings.

1:12
Adam K
Thanks, Chris. So, in essence, what motivate us to really dig in, and we put a lot of time and effort, you know, across my team to try and get to the bottom. The bottom line here is the insurance industry and particularly the commercial insurance industry, which means insurance for businesses is facing an onslaught of litigation type claims.

So, in layman's terms, that means legal lawsuits, litigation is just jumping up to much, much higher levels than we've seen in the past. And that's a concern for the industry, a concern for investors who focus on the industry, but it's also concern for customers because what's going to impact insurance companies will also impact their customers who need and who buy insurance.

So that that's really why we dove into what we see as an escalating issue. And in summary, again, you're seeing building litigation. And just to give you a backdrop for the industry, the property casualty business is roughly half commercial, half personal lines, so half business staff individuals. The commercial side, it is a very significant $450 billion a year market.

So that's a very sizable market. Roughly half that is known as casualty insurance. So roughly 200 to 250 billion revenues/premium goes to pay for what's known as a liability insurance. But again, in normal terms that means lawsuit. So, when you’re a business, you buy casualty insurance or liability insurance for the main reason to protect you that someone can sue you. Some party, some person, some business can sue you, that's what's known as casualty insurance. And so the insurance industry, particularly, again, that's part of the insurance industry, has been in the business of providing backstop against lawsuits for a long, long time. So, this is nothing new. You know, the fact that lawsuits are increasing, and claim payments related aren’t really new.

But what we saw and it's not just us, if you talk with a lot of people in the insurance business or investors who focused on it, it's sort of a well-known fact that litigation, you know, legal issues are climbing and that is an issue. But what we try and do in this report is really to drill down to, you know, what's the extent of the issue? How bad is it really getting? What are some of the impacts? Clearly, because that's what we're what we and our investors are focused on. And you know, what are the ramifications of long term, whether from an investment or industry standpoint. And, you know, what we really try to do is develop sort of an analytical framework to allow people from the outside to begin to metric and understand this change that's going on.

My team, we put in a good couple of months, really dug in and did a fair amount of analysis. We brought in an actuarial firm, Paradigm Actuaries, to actually help us also benchmark metric. And maybe we'll go into some of the data later, but clearly you're saying, you know, a big jump up in the amount of lawsuits. And it's not just really the amount of lawsuits and this is one of the aha’s or conclusions that it's the amount of large lawsuits.

So, the industry again, they get sued all the time. And that's normal course of business. And most of the lawsuits are either go away or settle for a lower amount. And every once in a while the industry gets hit with a bad judgment or needs to settle for a large amount. It's really that last part, those larger judgments or the large settlements. That's the part that's going up very significantly, and that's relatively dangerous for the industry because the industry isn't really set up for that. So, the essence or the conclusion is that it's not just purely, oh, there's more litigation. It's there's a lot more what we'll call deep severity or large litigation. And that is and will continue to cause a whole host of issues for the industry.

5:15
Chris T
So, another question I have is, you know, what is it exactly that's causing this litigation? I mean, do you have a sense, you know, what are these big pieces of litigation that are more severe than usual?

05:25
Adam K
That's exactly what we dug into what's causing or what's different now that is really driving these big leads up or the big jumps up in litigation. The normal industry response, and we've heard this for five, six, seven years is social inflation. And people have different definitions for social inflation. But generally, the thought there is that the mentality of the juries is against big businesses and against insurance companies, therefore, if a claim, or if a lawsuit gets in front of a jury that it's going to go against insurance companies and against businesses, and it's going to go very badly. And I'm not saying that there isn't an element there. But, you know, we really tried to dig under the covers and saw, you know, a number of other core factors and to summarize it: One is the legal industry itself is getting more sophisticated and more aggressive and I'll dig into that. And two, the structure of the client base itself is actually much different today than it was ten, 15 years ago, which is really creating much more exposure to these very large lawsuits.

So, well, let me start with the legal industry, the legal industry, the plaintiff lawyers, the ones who bring the lawsuits. One fact is they're much better funded today. And this is the big, big difference that the large, mid and large size plate of firms are actually getting outside funding, in good part from private equity funds that are allowing them to pursue cases to a greater degree and for much longer. And that has a lot of ripple effects. So, PE firms are looking at literally on a case by case basis and saying, we think this case has more merits or more potential to drive a larger insurance payment.

So, they're actually funding the law firms to go and pursue those claims much longer. And that really, what I'll say smacks up against insurance strategy or claims strategy 101. Insurance claims strategy is really a war of attrition. So, the insurance companies in general, and it's not always the case, but in general, their thought is that if they can drag out the litigation as long as they can, that the claimant will lose money, will lose steam, and will eventually settle and probably settle for a lesser amount.

On the flip side, the longer a claim goes, or a lawsuit goes and the closer comes to a jury, then the insurance companies are, I'll say, forced or push to be much larger claim payments because the thought of actually taking an insurance claim to jury is a very scary thing for insurance companies. They don't want to do it. So, if they can settle on year one, you know they'll settle for a small amount, make sure the lawyers get paid some fee and they're done. But as it gets closer to that, that lawsuit or sorry, to a jury trial, the payments go up, up, up. So, the increased funding mechanism has really provided much more of a long-term duration to these claims where the result is exponential. So, I think that that's probably one of the biggest factors.

Another factor is the lawyers are getting more sophisticated. Their use of the analytics is up, a survey I saw says it’s up like 95% in the last couple of years. As far as finding, targeting the right potential claims, the right people who are going to sue businesses and the insurance companies. So, whereas I'm sure we've all seen, you see lawyers advertise on billboards, if you drive, you know, drive around highways, you know, more and more you're seeing on TV. It used to be more blanket just “Hey, let's see who we can draw in.” And now that is a very sophisticated effort using analytics and actually, you know, digital capabilities to try and target and find more lucrative potential claims. So, you put those two together, they've got more staying power from a funding standpoint. They're much more sophisticated. And you know, they're going not after the $100,000 settlement. They're looking for the five, ten, $50 million settlement. They have just much better capabilities. And when I say they again, I mean the plaintiff lawyers have much better capabilities than they did five, ten, 15 years ago.

That's half. The other half is there's been a change in the client base. So commercial insurance is insuring businesses - small, small, midsize and large. When you're insuring small businesses, the insurance limits are relatively small. Usually, it's $1 million policy. So, the max loss for an insurance company is typically a million dollars. And that's not a small amount, but for insurance companies, million-dollar losses don't break the bank. What's happened is in the last ten, 15 years, because you've seen a lot more consolidation of what I'll call fragmented sometimes mom and pop businesses, what we're small businesses are now are much bigger amalgamations, roll ups, consolidated entities. So, if you look at, and we have this in the report, you look at the amount of doctors who are part of physician groups versus individual doctors. It was like maybe seven years ago, the amount of doctors and physician groups went over 50% seven to eight years ago and continues to go up. So in that case, insurance companies getting sued over doctors close to $1 million limit, those limits or the amount they can pay out a lawsuit again, can go up to five, ten, 15, 20 above. And that's happening to a lot of the industries. The trucking industry is being consolidated. A bunch of retail industries are being consolidated. You name it and you see a tremendous amount of mom and pop business consolidated. And for the plaintiffs, that's just a goldmine.

I mean, the difference between a potential $1 million settlement and a $20 million settlement, you know, it's just a night and day difference. So, it's really that confluence of legal getting more aggressive and the targets getting bigger is adding up to these much larger settlements and lawsuits. And that's where the real pain is coming from for the insurance industry.

11:43
Chris T
There’s a part of the report where you talk about how losses are putting pressure on what you say is an ill prepared industry. Why is the industry ill prepared?

11:51
Adam K
You know, that's where it gets really interesting. Really on the go forward part that, you know, really goes down in the structure of the industry, that the insurance industry is then rightly so, based on diversification. If you go back to where insurance was sort of found back in London in the 1500’s and 1600’s in the shipping business. The individuals, you know, this was really the foundation of Lloyd's of London, the individuals who were insuring the ship and ship cargo, they went out to sea with a chance of being lost, the basic principle, if you put all your money, all your back into one ship, that was very risky. So, they said much better if we can, you know, back ten ships, 20 ships, 50 ships as a way to diversify. So, you know, diversification has always been the key underlying principle.

And I'm not saying diversification is out the window, but the idea the law of large numbers is being challenged because the way commercial insurance is run is that again, you assume that you're going to have probably out of every ten claims, maybe one claim or two claims will become a larger claim. Now we're in a situation where it's not 1 or 2 in any given area or product or sector group, and there are dozens of those.

It can be three per ten, four per ten, probably not as much as five per ten. And the way the insurance industry prices, again and based on that 1 in 10, doesn't really line up with the three per ten or four per ten. And it's the variability or increasing variability and uncertainty that the industry is really challenged by the traditional underwriting methodology doesn't really capture that in an adequate way.

And that's part of it. The other part of it is the way the insurance industry solves its problem is increasing prices. And prices are going up, but they're not going up by a tremendous amount in casualty insurance. Today they're going up by five, six, 7%. And that's partially because it's a very competitive market. There are hundreds of companies providing that casualty insurance, and not every one of those companies is getting tagged with loss after loss. Some are, some aren't. So, you're not having a big pullback from market. But it's going back to the other part. I think the industry is struggling with how to price for this phenomenon. So, in the near term, we think that the commercial industry is going to struggle, and struggle meaning that returns will be probably less going forward than they have been. And I would say one of, I guess, axioms or, you know, or way I think about it, nothing happens in insurance overnight. It's a very slow-moving train. So, it's not like the industry trying to say roughly right now for ‘23, ‘24 is by running around 12-13%. It's not like by the end of ‘24 it's going to go down to 6%, but it's probably going to be more of a slow erosion. So by ‘25- ‘26, the margins, and when we think about combined ratios, you should see some moderate upward pressure and the returns begin to come down because it's going to take the industry a good couple of years to probably, you know, figure out how to deal with these issues.

15:11
Chris T
And that's great. Very helpful information. There's some data, further down in the report that helps illustrate how these losses are putting pressure on the industry. And you know, that these trends are sending up a big red flag. What are the trends that really stuck out to you, or I should say, data that really stuck out to you in this regard? And what is it about these, these trends or this data that you deem a red flag?

15:32
Adam K
Sure. You know, just to give you a couple of data points, severity increases, or you know, the amount per claim and other liability, which is generally lawsuit insurance and one type of lawsuit insurance on average for the last couple of years are running a range of 35 all the way up to 80% more for different time periods. So that's huge jumps. When you look at the actual claim dollar per lawsuit that alone in the last five years is up by 40%. And when you look at the amount of large verdicts, I think in the last 5 or 6 years, that's up by, say, 50%. Actually, the number of verdicts – I can give you an exact detailed number of verdicts above 10 million – if you want pre-COVID, you know, roughly you had maybe 50-60 of those a year. Now you're running more 90-100 of those a year. So again, a big, big jump in these large verdicts.

16:30
Chris T
What would you say are the implications of all this.

16:33
Adam K
So, the implications again are several fold. You know again the near term, as we mentioned, that the commercial insurers, particularly the ones that deal more in these larger liability lines, the insurers that deal with middle and larger middle market of Fortune 200, the returns you know this year are beginning to flatten out. And they've been going up in the last couple of years. And by ‘25 and ‘26 begin to go down. So less of a less an attractive investment environment or the, you know, for those larger ones. But on the flip side, you know, from a structural standpoint, 2 or 3 things probably are going to happen to help solve this issue. There are parts of the industry are shifting to what I call more bespoke or tailored coverage.

So, insurance policies can be crafted and sculpted for very specific risk. And that's known as more of the E&S or excess and surplus market. So, I think you have more business shift over to that market. So that's going to be a benefit for companies in the E&S, or excess and surplus. And the insurance companies that are very good at sculpting and more targeting matching the risk, which again is a lot more flexibility on the E&S, or excess and surplus market, are probably going to be the winners.

And the other when we think about winners, are the industry needs, you know, they have to match the plight of attorneys. The plaintiff attorneys are using better analytics and data. The insurance company needs to do that. So, the technology companies and vendors who provide that or analytics around the nature of risk and how to target the right risk and the insurance companies that adapt or have the insurance platforms to use that advanced analytics are, you know, getting much, much better position because, again, it's not the one in ten anymore. It's really, you know, on a granular basis trying to figure out which are the 3 or 4, 4 or 5 bad risks and that that's a much different proposition. And ultimately, you know, tech and analytics are not the only but that is going to be a big part of the answer.

18:44
Chris T
All right. Well, Adam, this has been great. for those interested, the report is called Property and Casualty Insurance: P&C Industry Facing Structural Change in Casualty Severity. You can request a copy by reaching out to us at WilliamBlair.com/Contact-us or your William Blair representative. Thanks again for taking the time to be with us today, Adam. Really appreciate it. Let's do it again soon.

19:05
Adam K
Yep. Thanks, Chris.