In 1975, it was standard procedure for claims to be investigated by insurance companies. That was not yet mandated by what later became the Fair Claims Practice Regulations created by the National Association of Insurance Commissioners (NAIC) and adopted by most (if not all) states, as that came several years later. It was a boots‑on‑the‑ground investigation. That was important so as to quickly develop the facts of any claim, even first‑party claims that served two purposes.
Insurance companies statutorily are required to post reserves; although in most states, they must post liability or ultimate net payout reserves, not necessarily inclusive of any expense. Claims expense is an important aspect of any potential claim, so insurers universally do set reserves for claim expenses such as for defense costs and outside investigators.
By investigating a case aggressively at the outset, it was often possible to have a developed factual matter for analysis within 90 days, maybe as long as 6 months, depending on the cooperation of any third‑party claimant and other sources of information. By having that development, one could set accurate reserves earlier. The insurer would know where it stood, and actuaries could also have access to that data and reassess a particular book of business or a particular program to see how profitable it may be over time and make adjustments, rather than canceling a program as unprofitable, should development and accurate reserve setting take longer, such as years versus months.
Another important function was the interaction between claims handlers and underwriters. The two go hand in hand. Underwriters have a certain view of the world and ways they want to approach coverage, but it's the claims people who must handle the result and keep up to date with the latest case law affecting liability and/or coverage. Such teamwork results in tighter and more successful programs including decisions as to whether or not policy language needs to be changed or the need to add additional exclusions based on developing appellate decisions that might create new perils. That level of communication was important, especially for innovative insurance companies. Where the intent is to cover something as communicated to the applicant, the claim department might not be aware of it, resulting in a claim denial.
Many insurance companies have internal claim departments run by their own claim supervisors, examiners, and field adjusters. Depending on the size of the insurance company, they may do this nationally with physical offices in all 50 states or be based in 1 state but writing nationally or in many states.
That model gets shifted a little bit because now they may have to use independent adjusters and investigators. Another model is to delegate claims (such as extra expertise in a particular line) to a third‑party claim administrator (TPA). There, it gets interesting because what's the fee going to be? How is it going to be negotiated? Is it a flat rate per claim or by the hour with a cap? Is the fee sufficient to do the work required?
Obviously, there may need to be local boots‑on‑the‑ground investigators. The TPA might have the authority to hire those companies in the locale where the loss occurred as well as working out an arrangement on how to pay them. They may even be the same boots‑on‑the‑ground adjusting companies that the insurance company itself may have used. That also adds to the equation.
However, the third model is more interesting, and is one usually used in more sophisticated types of claims like professional liability and directors and officers (D&O) liability or cases with large exposures. That is where counsel is used to monitor the claims—an expensive proposition.
Monitoring counsel is often a situation where a law firm is hired to act as a claims TPA. That may sound like a great idea, especially on more sophisticated types of claims. But consider this: Who is doing the work? Is it going to be the relationship partner that makes a lot of money and is basically entertaining and promoting the claims department at the insurance company? Or is it the second-, third-, or fourth‑year associate who is doing the day‑to‑day work? Who are they working with? After appointing defense counsel in a particular state where, again, a second- or third‑year associate will be assigned to do the workup for the trial partner, what do they hear? What are they talking about?
However, they may say: "We have to file a demurrer. We have to file a motion to strike. We've got to get rid of the punitive damage allegations. Then we've got to do discovery. We need these interrogatories and requests for admissions."
How are those people trained to close the file? What is the end result, and how long is it going to take? What's the goal? Is it well‑defined? This model is much more expensive than a TPA.
The bottom line is that each model has its pluses and minuses. However, the focus is to investigate, develop, adequately reserve, and have a plan to close the file. That's the ultimate goal—closing the file without throwing money out the window.
The profit center of any insurance company is not the marketing or the underwriting department. The profit center of the insurance company is the claim department, which is the exact opposite of what many people would expect, but that's how the insurance industry actually functions. It's the opposite of what most other businesses experience. Unfortunately, over time what has developed is that the claim department is seen as a cost center. There's not a lot of investment in it. That occurs because management is always trying to cut costs and overhead to maximize profit.
But, unlike most other businesses, claims expense is really an investment that, if properly utilized, can result in a positive return on investment. By spending up front, claims can be rapidly developed, accurately reserved, and settled earlier, thus reducing defense and litigation costs. The total expense incurred is thus lower. This has been qualitatively proven.
Qualitative claim audits can identify problems that loss runs cannot identify. There are many functions to review. First, adequate staffing with experienced people is a must. Reasonably managed caseloads are equally a must, lest only cases "on fire" get handled while others "mosey along" on their own until they too become a fire, and often are underreserved as well.
Equally important is having accurate reserve and exposure levels set (exposure being the current demand despite whether it is reasonable or not). It's one thing to have a sudden fall where somebody will bang their knee. It's another thing to have a compound fracture that could be serious. Since the 1990s, there have been claims that computer systems set up that tracked this data. Corporate Systems was one of the first. Its powerful system used cause‑of‑loss and severity codes as a means to monitor the injury and reserve adequacy.
Using structured query language (SQL), management could review many types of useful claims information. This included claims involving compound fractures, claims involving a death, and the current reserve. Claims that are potentially underreserved can be quickly identified. This data can and should be used during an audit.
Auditors should look at additional useful standards that include specific activities from day one of a claim report. What is the date of loss? When was the claim report received? What was the date of the first attempt to contact the insured? When was it finally accomplished?
Sometimes, insureds are not as cooperative as hoped. Yet, a lot of the responsibility lies on the claims person. Was the first attempt to contact the insured within 48 hours of the claim report date? Did the TPA attempt to contact the claimant or the claimant's representative as soon as possible? Were all the witnesses contacted? Were statements obtained? Were they evaluated? Were the reserves adjusted timely? Were all other documents obtained? These are all investigatory issues that also affect reserving.
It's not uncommon to set an initial reserve of a thousand dollars, a dollar, or whatever, and this amount must be adjusted based on developing information. If it's in suit, how fast was defense counsel notified or retained? Are they panel counsel? Are there coverage issues? If there are coverage issues, is a reservation of rights needed? More importantly, was the reserve increased shortly before the offer that was accepted (i.e., commonly referred to as "stair stepping"—an undesirable practice)?
One needs to worry about whether the insured will be allowed to hire its own counsel at the insurance company's expense under what's commonly called the Cumis decision or a Cumis statute. Those are items to look at.
Finally, how's defense counsel handling the matter? Is the attorney being properly supervised? Is there communication going on between the examiners and the defense counsel with the ultimate goal in mind, closing the file? Is the case going to go through trial because of an unrealistic demand? Such may affect a ratio that needs to addressed—that is the ratio between expense and indemnity.
Slip-and-fall cases may generally have an expense-to-loss ratio of $0.25 to every $1 spent on indemnity. With more sophisticated types of claims like attorney malpractice or D&O liability, it could approach 1:1.
A good example of what doesn't show up in a loss run, yet affects the ratio, is the exposure. The exposure in that context is the plaintiff's demand (i.e., the amount in controversy). Consider a situation where there's $750,000 in defense costs, a closed file, and zero indemnity. The claimant demanded the $5 million limit on the policy as well as the same from two other defendants. Yet the case was one of no liability. The plaintiff attorney never asked for anything less than policy limits. A defense verdict was obtained by all three defendants. The claims person spent $750,000 to save $4.25 million. That's a good result. What never shows up in a loss run is the exposure, the last demand, and how much the plaintiff attorney was demanding; these are not tracked. The loss runs don't show there was a standing $5 million demand. What mattered was only the expense-to-loss ratio, which artificially looked awful, but in reality was a great result, determined only by reviewing the file rather than looking at a line item on a loss run.
One disturbing trend nowadays is the lack of field investigation and factual development. More insurance companies are moving toward a trend to evaluate claims, which basically means they're putting the burden on either their policyholder or a third‑party claimant to provide the claim department with enough information to justify a payment. Such passivity may satisfy "cost cutters," but the result is longer development and more referrals to lawyers.
That's not what the Fair Claim Practice Regulations require. Fair Claim Practice Regulations require that insurers investigate claims. That means you've got to do something affirmative, not remain passive. Evaluating means you're waiting for something to happen, land on your desk, you'll read it and evaluate it, and make decisions.
This is a trend that is not good for anybody because it means that you're probably underreserved. The other trend is to use lawyers more often. The lawyers are the ones developing the claim, either through legal discovery or otherwise. In one matter recently, defense counsel was getting information from the claim bureaus as to what comparable claims had been settled for. The claim department couldn't do that? This means the insurer is paying a lawyer $300 an hour or more to perform this type of research.
The more you delegate to law firms, then the higher your claim expense will be. That's going to be an actuarial factor to increase pricing unnecessarily.
There are several private equity models. The model that I think is bad for the industry is the acquire, grow profitably, and flip in less than 3 years model.
That places a lot of pressure to increase profitability, which can be done in one of two ways. You can grow organically and be highly profitable or you can cut internally. Cutting internally can be done in several ways with an insurance company. Staff can be cut, along with claims expenses, which is self-defeating in the long term. Basically, one is inclined to be underreserved. That's going to artificially increase profitability, but after flipping, it becomes someone else's problem.
At some point, whoever buys that insurance company later will wake up and discover they're grossly underreserved. That has happened many times, especially with smaller insurance companies. The NAIC has gotten very concerned about private equity companies coming into the industry for that very reason.
Following a short-term model, private equity companies tend to look at how to make a quick profit; they don't care how it's obtained. If it means they must be tight on claim payments and on claim reserves, they will do it. Unfortunately, too many departments of insurance are understaffed or underfunded and can't do the departmental audits they used to make, and a lot of companies are getting away with this.
Overall, we are seeing that trend not just in the insurance industry; we are seeing it everywhere.
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