The current marketplace for medical

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1 MEDICAL MALPRACTICE INSURANCE: A MARKET IN TRANSITION By Chad C. Karls, FCAS, MAAA and Kevin J. Atinsky, ACAS, MAAA Milliman USA The current marketplace for medical malpractice coverage in the United States is going through its third crisis in the last thirty years, characterized by: Deteriorating underwriting results, driven largely by trends in claim severity; Withdrawal of major players, either voluntarily or otherwise, leading to availability issues in certain jurisdictions; Large rate increases implemented by those carriers remaining in the market, leading to affordability issues in most jurisdictions; Physicians marching on state capitals to protest the current market conditions; and State legislatures responding with some combination of tort reform and/or alternative market mechanisms. The current crisis was not born by one overriding factor, but is rather the result of a variety of circumstances compounded together, which have manifested into the recent financial results of the medical malpractice industry. In our view, a fundamental change in the industry s underwriting discipline must occur as one of the primary steps for transitioning through the current crisis. Medical Malpractice Underwriting Results: A Historical Perspective The history of the medical malpractice market shows that its underwriting results tend to be highly volatile and cyclical in nature. In fact, the current market characteristics are, in some respects, remarkably similar to the previous crisis in the mid 1980s. The crisis of the mid 1980s was followed by a decade of relatively stable underwriting results for the industry (although there were signs of some deterioration in the late 1990s). Given the relatively stable underwriting results in the 1990s, it is not surprising that this decade saw very modest overall premium level activity. This can be seen in the graph Originally published in The Physician Insurer, Third Quarter, The authors can be reached at (262) or via at and

2 - 2 - below, which shows that during this period, the countrywide direct premiums increased from $4.9 billion in 1990 to $6.0 billion in 1999 for an annual average increase of approximately 2.2%. Over this same time period, data from the American Medical Association suggests that the number of professionally active physicians grew at an average annual rate of 2.8%, thus exceeding the rate of growth in the industry s total direct written premium. $10 $9 $8 $7 $6 $5 $4 $3 $2 $1 $0 Growth in Direct Written Premium Direct Written Premium (Billions) 6.7% (3.0)% 3.9% 9.7% 3.2% (1.5)% (0.9)% 3. (0.4)% As a note, the premium figures displayed above only include the premium written by entities that file statutory annual statements, and therefore exclude the funding associated with alternative risk transfer mechanisms (e.g., captives and trusts). The estimated 5 growth in direct written premium since 2000 was almost entirely driven by manual rate increases and 4.9% 15.6% 29.6% reductions in schedule credits. This premium growth has occurred in spite of the fact that the coverage being provided has, in many cases, actually decreased (e.g., higher deductibles or self-insured retentions, lower policy limits, restrictions on certain tangential coverages that were introduced in the mid 1990s, etc.). Further, the rate increases and coverage restrictions in 2001 and 2002 have driven more risks to explore alternative risk transfer mechanisms (captives, trusts, etc.), which would tend to reduce the premium reported and compiled in statutory annual statements. The traditional measure of underwriting profitability in the insurance industry is the combined ratio, which compares an insurer s claim costs, administrative expenses and policyholder dividends to the net premiums collected from insureds within a given calendar year. A ratio below 10 indicates an underwriting profit was made. The following graph provides a long-term perspective on the underwriting profitability of the medical malpractice insurance industry since 1978, including a decomposition into the underlying components. As an aside, one of the results from the first medical malpractice crisis of the 1970s was that the National Association of Insurance Commissioners (NAIC) modified the statutory annual statement to track medical malpractice separately (it had previously been included with other liability).

3 Historical Combined Ratio incorporate investment results (discussed further below) Loss LAE Expense Dividend Regarding the first item, the history of the medical malpractice market shows that its underwriting results and reserve positions tend to be volatile, yet highly correlated. The graph below shows the relationship between the industry s one-year loss reserve development (expressed as a percent of prior year loss reserves; whereby a negative result indicates reserve strengthening) and the published calendar year combined ratio: As displayed in the graph above, the most recent industry underwriting results are at nearly the highest (i.e., worst) levels since the previous crisis of the mid 1980s. As a note, A.M. Best has estimated a break-even combined ratio for medical malpractice of 114.5%, assuming a 4. investment yield. Thus, it is clear that the industry has been operating at unprofitable levels during the last several years. Combined Ratio Combined Ratio & Impact of One-Year Reserve Development Combined Ratio One-Year Reserve Development One-Year Reserve Development on Prior Year Reserves There are two important items to recognize when interpreting the combined ratio results displayed above. First, the combined ratio is measured using calendar year results (versus coverage year), and as such, is subject to loss reserve adjustments related to prior coverage years. Second, as the combined ratio is intended to measure underwriting performance, it is calculated on an undiscounted basis with regard to the time value of money and therefore does not As can be seen in the graph above, the stable underwriting results for most of the 1990s were bolstered to some degree by reductions in prior year loss reserves; and conversely, the deterioration in the most recent couple years has been exacerbated by increases in prior year loss reserves.

4 - 4 - In order to facilitate comparisons within the individual components, the following set of graphs isolates each component of the combined ratio (note that the ratios are measured on a calendar year basis): % 3 25% 2 15% LAE Ratio 1 5% % 2 15% Decomposition of Historical Combined Ratio Loss Ratio publications and reports, the recent increases in claim severity (average cost per claim) has been the catalyst for the deteriorating loss ratios and underwriting results. Jackpot justice is the term that has been used to characterize the increased frequency of the big verdicts and settlements in medical malpractice lawsuits, and the mentality behind them. Based on data compiled by Jury Verdict Research, by more than half of medical malpractice verdict awards were at least $1 million, and onequarter of all awards exceeded $2.7 million. As evidence for this emerging issue, the following graph summarizes the results of the PIAA data-sharing project, which represents a global view of trends in claim severity across the country: 1 5% Expense Ratio PIAA Claim Trend Analysis Historical Close Year Paid Indemnity Severities 5% 350,000 4% 3% 2% 1% Dividend Ratio Indemnity Severity 300, , , , ,000 50, Close Year Loss Ratio In comparing the patterns between the combined ratios and the loss ratios, it is apparent that the loss ratio results are the driving factor behind underwriting profitability (i.e., combined ratio). As such, the recent loss ratios are also at nearly the highest levels since the last crisis. As has been extensively chronicled in various Source: 2002 PIAA Claim Trend Analysis. As additional information related to this issue, the following graph summarizes calendar year paid loss severity information (normalized relative to a base period of 1993) based on medical malpractice claims

5 - 5 - data we have collected from major insurers in various markets around the country: Severity Index (Relative to 1993) Source: Proprietary client information (included with permission). It can be seen that while the broad market has seen a steady climb in claim severity over the last several years, the experience has varied substantially across different markets. The following table draws comparisons between the results of the PIAA data-sharing project with the information we have summarized in five different markets: Data Source Historical Average Calendar Year Paid Loss Severities Market A Market B Market C Market D Market E Average Annual Increase in Paid Loss Severities Based On: and Prior and Subsequent Market A % Market B 3.3% 14.8% Market C 4.8% 4.7% Market D 2.2% 5.5% Market E (0.1)% 3.7% Avg of A-E 2.8% 9.1% PIAA 4.1% 8.5% LAE Ratio While the loss adjustment expense (LAE) ratio, primarily legal defense costs and expert witness fees, has historically been fairly volatile, it has generally hovered in the vicinity of roughly 3. Over the last several years, the industry LAE ratio has been running close to or above 35%; and 2002 was near an all-time high level. Thus, while not the driving factor in the deterioration of underwriting results, this component has contributed approximately 5% towards the recent upswing in the combined ratio results. In our view, one of the reasons for the increase in the LAE ratio is that with the spike in average indemnity payments discussed above, the stakes are higher and it may cost more to successfully defend claims (i.e., some carriers may be more insistent on using seasoned, experienced counsel). Further, as the plaintiff s bar becomes more selective in terms of which cases to pursue, the average cost to defend these claims has increased. Expense Ratio The historical underwriting expense ratio has generally been in the 15% range; however, this ratio has been trending upwards over the past few years and is currently in the 2 range. Thus, like the LAE ratio, the expense ratio is not the primary factor in the recent industry results; however, it has also contributed approximately 5% towards the underwriting deterioration.

6 - 6 - Dividend Ratio The historical dividend ratio has typically displayed an inverse relationship to the underwriting results (i.e., it tends to decrease when the combined ratio results increase). This component has served to modestly offset the deterioration in the other components of the combined ratio, and is currently at the lowest levels since the last crisis of the mid 1980s. Medical Malpractice Operating Results: A Historical Perspective As noted earlier, the combined ratio strictly measures underwriting results and does not recognize investment income. The traditional measure of overall profitability in the insurance industry is the operating ratio, which measures both underwriting results (via the combined ratio) as well as investment performance. Investment Income As can be seen in the graph below, the investment gain ratio (as defined by A.M. Best 1 ) has historically provided a significant offset to underwriting losses in the medical malpractice industry, historically ranging from 2 to 5 of net earned premium: Historical Investment Gain Results As evidenced by the graph above, the profitability of the medical malpractice industry has been adversely impacted by the recent decline in investment performance. There is a public perception that malpractice premiums are increasing to cover losses that insurance carriers have suffered in the stock market. However, the overwhelming majority of invested assets for the medical malpractice industry are in fixed income securities, not the equity markets. Thus the reality is that, while investment returns are down, this is primarily driven by a decline in interest rates, and only in part by the stock market. The graph below demonstrates the recent sharp decline in interest rates (threeyear U.S. treasury bonds displayed for illustrative purposes), which largely underlies the trend in investment gain ratios presented above: 1 Ratio of investment gain on funds attributable to insurance transactions and other income less other expenses to net earned premium.

7 % Yield on 3-Year Treasury Bonds At Successive Year Ends 6.3% 5.1% 3.7% Source: The Wall Street Journal. 1.9% Operating Ratio Combining the underwriting results with investment performance to derive the operating ratio 2 (above 10 represents an operating loss), it is clear that the medical malpractice industry s financial results have deteriorated significantly, to the point where the most recent couple years represent the poorest results the industry has seen in more than twenty-five years: Conclusion The current medical malpractice crisis has resulted from a variety of factors discussed above; including the deterioration in underwriting results, poor investment returns and increases in prior year loss reserves. As the medical malpractice insurance industry copes with its recent financial results, we believe the industry needs to re-examine its operating objectives and critically review its underwriting process. With challenges come opportunities, and in our view, the successful companies will be those that are able to integrate the expertise from all functions within the insurance operation in order to objectively evaluate each risk and take the appropriate action. Historical Operating Ratio Operating Loss Operating Profit As defined by A.M. Best; combined ratio less investment gain ratio.

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