< Previous18BEST’S REVIEW • JANUARY 2023 By Rob Tugander In coverage litigation over the opioid suits, the issue is whether the damages the governmental entities seek to recoup are “because of” bodily injury. Two Words Play a Key Role in Opioid Litigation B ig insurance claims can sometimes turn on interpreting a single word or two. The phrase “because of” wouldn’t seem to stir much debate, but those two words have proven key to whether insurers owe a defense to drug companies sued by state and local governments over the opioid epidemic. Governmental entities across the nation have sued pharmaceutical companies and others for their improper distribution of opioids, which the governments claim led to opioid overuse and addiction and caused a public health crisis. The governments allege economic losses, such as the costs of increased law enforcement, judicial expenditures, emergency medical care and substance abuse treatment programs. Commercial general liability policies typically pay “sums the insured becomes legally obligated to pay as damages because of bodily injury or property damage.” In coverage litigation over the opioid suits, the issue is whether the damages the governmental entities seek to recoup are “because of” bodily injury. Yes, opioid victims sustained bodily injuries. And the governments may have incurred costs in responding to emergencies and treating those victims. But the governmental entities themselves did not sustain bodily injury. So, for insurance purposes, the question is: What connection must there be between the damages sought and the injury to satisfy the “because of” test? State supreme courts in Ohio and Delaware have recently taken up this issue and both have found that there must be more than just a tenuous connection between the damages and the injury. In Acuity v. Masters Pharmaceutical Inc., the Ohio Supreme Court looked to the common meaning of the phrase “because of” and found that it means “by reason of” or “on account of.” Applying this meaning, it determined that an adequate connection would exist when the damages sought are for losses asserted by: (1) Best’s Review contributor Rob Tugander is a partner with Rivkin Radler. He can be reached at robert.tugander@rivkin.com. Regulatory/Law Photo by Andrew Lichtenstein/Corbis via Getty Images19BEST’S REVIEW • JANUARY 2023 the person injured; (2) a person recovering on behalf of the injured person; or (3) a person or organization that directly suffered harm because of another person’s injury—in which case, the existence and cause of the injury must be proved. The court found that all these conditions were absent. The governments didn’t seek damages for bodily injury they sustained themselves or derivatively. Nor did they seek damages for any particular opioid-related injury to a citizen. Instead, the governments tied their claimed losses to the aggregate economic injuries they experienced as a result of the opioid epidemic and not to any particular bodily injury. The court found the governments’ claimed damages were not “because of” bodily injury. Thus, the insurer had no duty to defend the drug company against the governments’ suits. In Ace American Insurance Co. et al. v. Rite Aid Corp. et al., the Delaware Supreme Court also found that the policy required more than some linkage between the bodily injury and the damages sought. To satisfy the “because of” test, the claim must arise from a bodily injury and the damages sought must be tied to that specific injury. The court found that the government’s claims were tied not to an individual injury but to a public health crisis; the success of these claims didn’t depend on proving bodily injuries. In fact, the court noted, the government plaintiffs expressly disclaimed any bodily injury damages. The insurers thus had no duty to defend. Not all courts have held this way. But these two decisions provide a logical approach to the issue that other courts might find persuasive. BR20BEST’S REVIEW • JANUARY 2023 Life Insurance Lincoln Financial Sees Lapse Rates Plummet for Over-75s After years of venturing into areas that put some of their products in direct competition with investment vehicles, insurers are hard-pressed to predict policyholder lapses and surrenders, thanks to interest rate hikes and a looming recession. by Terrence Dopp C onventional wisdom has it that rising interest rates coupled with a potential recession on the horizon could mean life insurers see an increase in lapses and surrenders. Yet, for an industry giant, the opposite proved true in the third quarter of 2022. Lincoln Financial, the eighth largest U.S. life insurer by admitted assets as of September 2022 Best’s Rankings, was forced to take a $1.8 billion charge in the quarter as customers over the age of 75 actually held on to guaranteed universal life policies at a higher clip than the company anticipated. As a result, it was forced to increase its reserves to cover the cost of paying out more death benefits than it had built into its budget. Ellen Cooper, Lincoln’s president and chief executive officer, said the charge was brought on when the company reconciled its own GUL experience for late-duration policies—i.e., older policyholders—with industry research. The company posted a $2.6 billion net loss in the quarter, attributed largely to the reserving change and another $634 million goodwill loss. Terrence Dopp is a senior associate editor. He can be reached at terry.dopp@ambest.com.21BEST’S REVIEW • JANUARY 2023 The GUL products are permanent life policies with guarantees they will stay in-force if the insured continues paying a certain minimum premium, Cooper said in a recent earnings presentation. “Because of this guarantee, GUL is subject to long-term assumption risk,” she said. AM Best downgraded the financial strength ratings it assigns to A (Excellent) from A+ (Superior) for The Lincoln National Life Insurance Co. and subsidiary Lincoln Life & Annuity Company of New York in light of the charge. The shift reflected a reduction in its enterprise risk management assessment to appropriate from very strong due to the capital volatility. Josh Stirling, founder of the Insurance Collaboration to Save Lives and a former insurance equities analyst, attributes such charges to a simple factor: COVID-19 changed everything from financial decisions to basic health assumptions that lead people to shift traditional patterns in some cases. His view is that higher retention is likely to be the result of people becoming aware of health problems and reflect a growing desire to retain protection products. “Morbidity leads mortality and lapse rates suggest morbidity,” Stirling said. “A person with a morbidity is less likely to let their policy lapse.” In the case of Lincoln Financial, the $1.8 billion change in their GUL lapsation assumptions was the prime driver of a total impact of $2.2 billion for the segment. In a set of slides distributed in its most recent earnings report, the company said lapse rates declined during the COVID-19 pandemic and have remained lower than historical experience. The issue is whether, in the post-COVID world of life insurance, persistency takes a hit now that the most acute health fears begin to subside in a population that rushed to secure protection against the unknown. As 2023 remains an open book, the question of whether lapses and surrenders fall or rise in the near future is top of mind for those who track the industry. Going Up Consultancy Forrester Research Inc., in an outlook for the coming year, predicted 2023 might prove to be the choppiest year for the overall insurance industry since the financial crisis of 2008. Consumers and small businesses could face cash flow issues during the course of the year, leading them to either shrink cover or forgo insurance where possible. The outfit projected as much as a 20% increase in lapses as inflation and rising interest rates drive a hardening market at the same time consumers face a cash squeeze. “It’s across the industry, not just for life but life in some ways may be more acute,” Ellen Carney, a principal analyst with Forrester, said. “Do you eat? Do you heat your house? Do you fill your car with gas? Or do you pay the premiums Key Points Falling: Lincoln Financial Group was forced to take a $1.8 billion charge in the third quarter of 2022 as lapse rates fell below anticipated levels in its guaranteed universal life segment. Rising: The industry is expected to see lapses increase as inflation and a possible recession in 2023 force some consumers to look for places to tighten the belt. At the same time, rising interest rates make other investments prime candidates to entice policyholders to take their money somewhere else. Fragmentation: Expect the numbers to rise and fall unevenly among insured populations and product types.Life Insurance 22BEST’S REVIEW • JANUARY 2023 on your life insurance now that we’ve gotten beyond the end of the world that 2020 was and COVID just seems like the forever flu,” Carney said. “Life insurance is more discretionary.” Lincoln’s case may prove to be a canary-in-the- coal-mine for the industry heading into 2023, as the Federal Reserve hints that the spate of increases seen the prior year could slow down but are not set to cease outright. After four consecutive increases of three-quarters of a percentage point each in 2022, the Federal Open Market Committee has signaled future increases are likely to be a half percentage point and will follow a review of economic conditions. Sebastian Kohls, an associate partner with McKinsey & Co., said lapse rates for life insurance products tend to maintain a “tight relationship” with larger economic conditions. In some cases, particularly with annuities, that’s already beginning to creep into view though unemployment remains low and the U.S. hasn’t tipped into recession, he said. “Over the last, say, 10 years it didn’t move as much as we’re now expecting it to move,” he said. “You usually see, of course, a lot of relation with interest rates. Of course, that varies a bit by product and by segment, but as interest rates go up, you see more people lapse or surrender as you find better alternatives elsewhere.” AM Best maintained its stable outlook for the U.S. life insurance industry in a November Market Segment Report: Market Segment Outlook: US Life/Annuity. Among the strong points the report cited were high levels of risk-based capital, product de-risking and regular stress-testing as part of risk management practices. However, the report noted ongoing concerns of market volatility including rapid interest rate increases and legacy liabilities in “risky” products such as long-term care, universal life with secondary guarantees and variable annuities. “Although higher interest rates create an economic benefit owing to improved investment yields, other dynamics in the industry should continue to be monitored,” the report said. “These include market-sensitive lapse rates, asset credit risk, and the ongoing need to attract talent.” Diverging Lapses As the economy shifts, and if consumers feel pressured, the industry could see lapses and surrenders become more fragmented or break down among products and demographic groups rather than a uniform result. Translation: For a younger policyholder, it might make financial sense to pull out of a universal life policy to take their money elsewhere. Yet the same impetus might have no impact on a 75-year-old policyholder, who likely has a shorter investment horizon and sees a moribund equities market. Investment Competition Jason Ralph, a McKinsey partner, said insurers’ shift to so-called capital-light products without guarantees in recent years has put them directly into competition with investment products rather than the traditional insurance world. At the same time, the industry is seeing the business cycle change after the COVID-19 pandemic sparked interest in life insurance and some products saw significant sales increases and first-time buyers. The question is whether rising interest rates and higher levels of financial stress prompt the “Do you eat? Do you heat your house? Do you fill your car with gas? Or do you pay the premiums on your life insurance now that we’ve gotten beyond the end of the world that 2020 was and COVID just seems like the forever flu. Life insurance is more discretionary.” Ellen Carney Forrester Research Inc.23BEST’S REVIEW • JANUARY 2023 same reactions among all policyholders. The results could break down differently for people who hold shorter, term products compared to a GUL policy or anything with a savings or investment component. “You’ve seen a significant interest in insurance products with COVID and as a result you basically have to think of new customers untrained in the market and we don’t know their behaviors because they wouldn’t have bought without this exogenous event,” he said. “ So as a result, we don’t know how sticky they are.” Ralph said the shift to products that are less capital intensive has removed some long-term exposures on the books. Yet, by limiting guarantees in some cases it has also removed one of those aspects that tend to make products “stickier,” or raise retention rates. “You’re incentivized to maintain this for the long term,” he said. “If you think about some of the more RILA-type products, they’re investment products and now you’re competing with other investment products. So as rates start to go up you see more competition from other equivalent-type investment products. Bond yields are higher than insurance products, so I might be more likely to move my money away from an insurance product into a bond—particularly if I purchased it recently or during COVID.” He and Carney both said volatility in stocks is also a wild card that may deter some consumers from lapsing or withdrawing the money. A guarantee may not appear sky high, but it also isn’t exposed to the wild swings that can be seen with traditional stock investing. Carney said the industry can take a lesson from investment banking titan JPMorgan Chase. Early in the pandemic, as fears of an economic rout were rampant, the company turned to collections experience teams, which poured over client books to ascertain details such as its customers’ life stages, employment histories and asset levels. The goal was to be able to identify those who were most stressed and build a bond to ensure that when the turmoil passed they were first in line. In the cases of insurers, that will mean predicting which customers may be most at-risk of lapsing and which ones carriers most want to retain, as well as finding a way to” take care of them.” That will require an investment in data sciences and a visionary leader, she said. “What the smart insurance carriers are going to do is they’ll use their predictive analytics and they’re going to look at the customers who are most likely to lapse or non-perpetuate a policy that might be coming up at this time,” she said. “They’re going to give them extra TLC and they’re going to change that relationship around. That’s what the smart ones are going to do. That not only will help them navigate this kind of situation we’re in right now but also build loyalty and build evangelism.” “You’ve seen a significant interest in insurance products with COVID and as a result you basically have to think of new customers untrained in the market and we don’t know their behaviors because they wouldn’t have bought without this exogenous event. So as a result we don’t know how sticky they are.” Jason Ralph McKinsey & Co.24BEST’S REVIEW • JANUARY 2023 Innovation I nnovation is becoming increasingly critical to the long-term success of all insurers. With innovation, companies can develop sustainable competitive advantages and better respond to external challenges such as evolving consumer preferences, growing business complexity, shifting market dynamics, and ever-expanding technological advancements. Companies need innovation to outpace competitors, fend off potential external disruptors, and promote organizational longevity. Insurers can gain a competitive advantage by improving efficiencies through innovation. Technological developments tend to be the innovations that receive the most fanfare. However, while technology plays an important role in providing tools for innovation, innovation is not all about technology. Many insurers have historically found nimble ways to adapt to an ever-changing market environment without having to become sophisticated technology players. To keep up with current innovation developments, insurance innovators rely on diverse sources, including employees, customers, and consultants. When innovators are faced with challenges requiring innovations outside of their core competencies, many have demonstrated their willingness to make investments and form partnerships. AM Best’s Innovation Criteria AM Best formally adopted its criteria procedure, “Scoring and Assessing Innovation,” in March 2020. The criteria procedure, along with the update to Best’s Credit Rating Methodology, outlines how AM Best explicitly considers an insurance company’s innovation efforts in its rating process.25BEST’S REVIEW • JANUARY 2023 Given the accelerating pace of innovation and magnitude of change, insurance companies that fail to innovate may find it difficult to sustain long-term success/profitability and may ultimately be subject to anti-selection and loss of relevance. Those insurers that successfully incorporate innovation will likely strengthen their organizations, increase their customer base, and improve their efficiency, supporting their financial strength. AM Best’s innovation initiative is two-pronged: (1) all rated companies are scored and then given an innovation capability assessment; and (2) as outlined in Best’s Credit Rating Methodology, AM Best explicitly considers whether a company’s innovation efforts, or lack thereof, have had a demonstrable impact (positive or negative) on its long-term financial strength in its business profile building block. Defining Innovation AM Best defines innovation as a multi-stage process whereby an organization transforms ideas into new or significantly improved products, processes, services, or business models that have a measurable positive impact over time and enable the organization to remain relevant and successful. These products, processes, services, or business models can be created organically or adopted from external sources. There are several key aspects to AM Best’s definition of innovation. First, innovation can take many forms—it is not limited to a particular type of innovation or technological development. The definition also allows for flexibility regarding the source of innovation; for some organizations, innovation through adoption may prove to be the most appropriate path, as there may be inherent barriers to innovation in the organization. Second, AM Best expects the output of the innovation process—those new or significantly improved products, process, services, or business models—to have a measurable impact. Some level of risk-taking and possible project “failure” is an expected part of any innovation program, but companies receiving the highest innovation scores will have a demonstrable success in innovating. Without productive results, the resources consumed by the innovation process will be a financial drain rather than an aid. Third, innovation is a dynamic and ongoing process, as well as a long-term commitment. Companies receiving high scores will be those that treat innovation as part of a continuous cycle of organizational growth and development, and that successfully integrate their “new-stream” innovations with their mainstream legacy operations. Business Profile Building Block Historically, AM Best has captured innovation indirectly through the various building blocks of its Credit Rating (rating) process. The revised BCRM incorporates innovation as the ninth subcomponent of the business profile building block. Innovation always has been important for the success of an insurance company, but with the increased pace of change in society, climate and technology, it is becoming increasingly critical to the long-term success of all insurers. As part of the criteria, insurers are placed into an innovation assessment category: leader, prominent, significant, moderate or minimal. Companies assessed as being more innovative (i.e., leader and prominent) differentiate themselves by credibly quantifying the results of their innovation efforts. Leaders further distinguish themselves by pushing the innovation ceiling of the industry and responding to market pressures by offering new products to solve emerging needs. Those companies assessed as significant recognize the need to innovate but may not have yet developed deep connections between their investments, resources and behaviors that are necessary to drive results and tangible outputs. Innovation may not be a priority for insurers that receive an innovation capability assessment of moderate, owing to limited resources. Moderately innovative companies are not necessarily behind the curve. For these companies, there may be early signs of innovation outputs, but a track record is needed to determine their commitment to innovation, said Edin Imsirovic, associate director, AM Best Rating Services. The least innovative insurers, or those that receive an innovation capability score of minimal, frequently operate in heavily regulated lines of business or have fewer competitive pressures, which may provide little incentive to innovate. 26BEST’S REVIEW • JANUARY 2023 Shell Companies A Shell of Their Future Selves: How Insurer Acquisitions Spur Faster Growth Insurers and potential insurers purchase shell companies to expedite the process of expanding their businesses and becoming full-stack insurers, rather than starting from the ground up in each state. by Anthony Bellano J ohn Swigart and Dax Craig founded Pie Insurance as a managing general agent in 2017, but they always had their sights set on the MGA becoming a full-stack insurance company. They made their move in 2021, acquiring Western Select Insurance Co. to obtain the shell company’s license and expand into new states while taking on risk. “It’s not the same as buying an actual business,” said Swigart, who serves as the company’s chief executive officer. “If you’re buying an ongoing business, you would take on that business’s liabilities. This is literally, ‘I just want the licenses and the different lines of business that this company can write, and I don’t want any surprises coming up from the balance sheet.’” The practice is not uncommon. Within the last year, pay-per-mile insurance agent Metromile bought Mosaic Insurance and transitioned most customers over to what is now Metromile Insurance Co. Insurtech Kin acquired a shell carrier with 43 state licenses, rebranding it as Kin Interinsurance Nexus. Insurtech Openly acquired a shell with licensing in 17 states and rebranded it as Openly Insurance Co. Insurers are purchasing shells as an opportunity to expand their businesses, with insurtechs using them as a means to becoming full-stack carriers. Those interested in acquiring shells can find them through consultants, reinsurance brokers, auditors and actuarial firms and companies that specialize in mergers and acquisitions. Aaron Prisco, president and chief executive officer of Propel Advisory Group, said there can be anywhere between five and 20 “shell deals” that close in a given year. The deals can take from Anthony Bellano is an associate editor. He can be reached at anthony.bellano@ambest.com. Key Points Faster Pace: Insurers find that the practice of acquiring shell companies helps them grow more rapidly than awaiting approvals to get started state by state. Insurtech Rush: Pie Insurance is among the personal lines insurtechs that have acquired shell companies to help grow their business and become full-stack carriers. Looking Down the Road: The trend of buying shells will continue as companies want to quickly enter a market, insurers say.27BEST’S REVIEW • JANUARY 2023 three and four months to well over a year to complete, he said. They often can take as much time and resources as other merger and acquisition insurance company deals. And as Swigart said, acquiring a shell isn’t the same as purchasing other businesses, mainly because shells are companies that exist only on paper, with no offices and no employees. The term tends to have a negative connotation because they usually make news when used for a tax evasion or money laundering scheme, but that’s not why most exist. Acquisition Process AM Best Managing Director John Andre said that shells frequently come from two sources: companies that were once thriving but fell on hard times and ended up becoming inactive, and those that were acquired as part of a larger deal, but their license ended up outliving its usefulness to the acquirer. He said in the United States, the process for approval varies widely by state and by the lines licensed. Andre said an acquirer can save a significant amount of time acquiring a shell because it doesn’t have to go through different processes multiple times. “If you were to start one from scratch without having any insurance company that you control, you would have to apply for a license in your state of domicile in particular,” said Swigart. “In many cases, other states have seasoning requirements, where they require you to be writing business for two, three, sometimes five years before they grant you a license for that line of business in their state. The build-out process can take quite a while.” Swigart said the first step is for the insurer to let it be known it is interested in acquiring a shell company. There won’t be a lot of responses because there isn’t a large market for shell acquisitions. Prisco’s company, Propel, is among the largest brokers that deal with shell acquisitions and, in fact, it deals in all aspects of insurance M&A. Another major broker is Merger and Acquisition Services. Both companies keep data on available shells. Prisco said it is important for insurers to remember that when they purchase a shell, they are purchasing the stock of the whole company. This includes not only all the licenses for that company, but also that company’s assets and liabilities. However, what are known as “clean shells” can be purchased without liability and without any chance for liability. Pie acquired Western Select as a “clean shell.” Prisco said everyone has their own definition of what a clean shell is. “Most targets have written direct premium at one point so there will usually be some open case reserves or potential liabilities that may arise regardless of the different types of reinsurance contracts and/or indemnification agreed upon. There are several methods to reduce such exposure; however, the ultimate decision becomes the willingness of a purchaser to take on the credit risk that a seller will be solvent to indemnify such liabilities in the future.” He said if an insurer possesses multiple licenses in the same state via multiple entities after an acquisition, the owner can merge the entities, keep them separate, or even voluntarily surrender a certificate of authority, “but there’s not an option to sell off an individual or multiple license(s), unless you’re selling the whole company with all of the licenses.” “I frequently get the question from companies “When there’s a need for a new company or an opportunity in a new market, anytime there’s a new trend in startups, that probably would drive the desire for shells.” John Andre AM BestNext >