What A.M. Best Says
Report Examines the Legal Professional Liability Market
Best's Market Segment Report (Excerpt): LPL Insurers Address Changing Claim Trends, Emerging Risks (July 18, 2018).
- A.M. Best Company
- September 2018
Law firms of all sizes and across various specialties face challenges that threaten their bottom lines. Small law firms, defined here as solo practitioners and those with fewer than 30 attorneys, account for about a quarter of the market, according to a 2017 study by the Thomson Reuters Legal Executive Institute.
While it is not easy to make accurate, general assertions about the small law firm market without a lot of caveats, it does appear that there are some common challenges that many small firms face. Factors considered by these firms to be most critical to their success include acquiring new business, addressing client demands for lower rates, maintaining cost/expense control, and reducing time spent on administrative tasks. The legal professional liability (LPL) insurance companies underwriting small law firms must understand these factors in order to develop adequate risk management advice and coverage solutions for their clients.
A.M. Best provides ratings coverage in the form of an LPL composite for a small group of specialty LPL insurers. These companies are primarily mutual insurance organizations or specialty, single-state insurers that only serve attorneys that are members of state bar associations with the principal practice in the state of domicile. The exceptions would be ALPS Property &Casualty Insurance Company and Minnesota Lawyers Mutual, which operate in multiple states. All of these companies, with the exception of ALPS Property &Casualty, are members of the National Association of Bar Related Insurance Companies (NABRICO) and generally compete with national carriers, while only competing with other NABRICO companies on a few occasions.
LPL Operating Results Generally Favorable
Operating performance for the specialty LPL composite overall has been favorable for the past several years. The specialty niche orientation of the companies serving the solo practitioner and small law firm market has aided in understanding the issues faced by insured clients. The results have shown in the LPL composite's net combined ratio, which has improved noticeably over the past few years, trending downward from a high of 108.3 in 2009. The higher loss ratios for the 2008-2011 time frame reflected, in part, the hardships on the legal profession wrought by the financial crisis that led to the burst of the housing bubble and the associated credit crisis, both of which helped devastate the real estate market. The economic downturn produced a sharp uptick in lawsuits brought by disgruntled clients as lawyers often served as convenient targets for the frustration people felt and the hardships businesses dealt with.
The LPL composite has posted more favorable results since 2010 compared to the performance of the entire commercial casualty composite, of which the companies comprising the specialty LPL composite are members, in terms of both underwriting and operating profitability.
Although the recession affected the entire property casualty market, the elevation in the annual net combined ratio for the LPL composite was a little starker than for the commercial casualty composite. In the ensuing years, after the rise of claim activity against lawyers began to moderate in terms of frequency, results for the LPL composite improved notably. The small law firm focus of the LPL composite's insurers likely played a significant part. Larger law firms, with larger corporate clients that have deeper pockets, probably faced both a frequency and severity of lawsuits that lingered longer than the cases brought against the clients of smaller firms. The more favorable result for the composite was evident in not only lower loss and loss adjustment expense (LAE) ratios, but lower net operating ratios as well, after taking into account the benefit of net investment income earned.
As a component of underwriting profitability, the LPL composite has produced total underwriting expense ratios that are favorable when compared to those of the commercial casualty composite. This difference is driven by significantly lower comparative brokerage and commission expenses for the LPL composite, resulting from the distribution/production sources for the composite members. Several of the companies operate as direct writers, and thus save on the competitive commission fees commercial casualty composite insurers generally need to pay to the agents or brokers producing the business that they write. The LPL composite insurers largely generate their written premium from insurance agencies that are sister companies, again benefiting from acquisition cost savings.
Despite enjoying an overall underwriting expense ratio advantage one component of those total underwriting expenses, average general incurred expenses, are higher for the LPL composite relative to the commercial casualty composite, resulting in a much higher general incurred expense ratio. These general expenses include not only important expense categories such as salaries, payroll taxes, director's fees, and advertising, but also daily operational expenses such as rent, equipment, the cost to depreciate older computer equipment and software, and both legal and auditing fees. The fact that the general incurred expense ratio has consistently been significantly higher for LPL insurers than for commercial casualty insurers demonstrates a distinct need for smaller LPL insurers to be more efficient. Enhancing operational efficiency is an issue that, coincidentally, also plagues the smaller law firms that are insured by the LPL composite, in comparison to medium and larger law firms.
Although there was some variability in the performance of the LPL composite as a whole, exhibited in the median combined ratios for the member companies of the composite over the last five years, the group nonetheless produced strong pretax operating profits during that period. While the pretax profits were primarily driven by underwriting gains, investment income also contributed. There was only one LPL composite company that generated a pretax loss during the period from 2013 to 2017, and that company actually suffered a pretax loss in two different years.
The aforementioned claim severity associated with the 2008-2009 real estate and broader financial crises led to a deterioration in operating profitability and low net income generation in those years for the LPL composite. Since 2010, however, net income has trended favorably, driven largely by underwriting profitability. The solid trend of net income and overall favorable operating performance has been achieved despite LPL composite members, the majority of which are mutual insurance companies, using dividends to return capital to their policyholder/owners and, in doing so, lowering their income.
Prior accident year loss reserve releases likely helped fund the policyholder dividends to some degree, in addition to augmenting calendar year net loss and LAE and combined ratios for the LPL composite. As a percentage of net premiums earned, reserve releases have decreased consistently since a 10-year high of 27.1% in 2013. The decline comes at a time when claim severity for insurers of law firms is increasing both in potential damages and in the expenses incurred for claim defense. Recent industry studies indicate a rise in the number of claims ultimately yielding payments greater than $1.0 million.
This Best's Market Segment Report is available at www.ambest.com.