Aguilar Law Offices

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December 2012 - Aguilar Law Offices Newsletter

This lackluster year is finally ending. In order to expand your expertise in your business, many of you have added expensive employees notwithstanding the fact that their salary and overhead expenses would be stretching your company's reserves. I know that many of you have spent a lot of your time expanding your existing markets and looking for new ones. Most of you have met with limited success.

The undecided influence of an election year has heavily dampened the incentives for the insurance industry to expand. A number of companies have looked into utilizing technology to expand their infrastructure, but not very many have jumped into the technology with both feet. This has not helped you to recover or even maintain the cost of those specialized employees. In many cases, the added employees have not produced enough business to cover their costs and the burden on your surplus is growing. Since many agency owners are limiting or not taking any income from the agency, you will have to make some hard decisions. The implementation of the government's health care laws will soon release thousands of agents skilled in health insurance who will be looking for re-training and who have the basic production skills, which you are seeking. You now have the infrastructure and expertise, consider replacing or supplementing your staff with employees skilled in production and train them in your business techniques.

Surplus Lines Brokers, especially those Surplus Line Brokers acting as wholesalers, are finding that case law in California is starting to impose third-party liability for failure to provide coverage as requested by the client submitting the application for coverage. In other words, the Courts have found that a wholesaler has a duty of care to the client of the broker who submitted the business. Right now, the cases are "fact; however, the erosion of the protection requiring privities will have a long-term effect on the business. It will not be enough just to take an order submit it to the carrier and present the broker with the policy and its terms. The Surplus Line Broker will now be required to examine the request and be certain that the coverage is what the broker’s client requested.

Those of you have corporate licenses should remember that this is the time of year for you to conduct a review of your shareholder and directors meetings minutes. The corporate shield will not work well if you have not followed the corporate formalities. This is also a good time to reconcile your trust accounts and be certain that you will be entering the New Year in full compliance with the state regulatory requirements.

We have been working on a pamphlet on "HOW TO START AND OPERATE YOUR OWN INSURANCE AGENCY" which we felt would be useful to existing agencies and for those producers who want to take a chance in opening their own agency. The material that we have gathered, and will continue to gather, from many of you have become overwhelming and we are now considering converting this into a formal book on "HOW TO START AND OPERATE YOUR OWN AGENCY".

We have also been working on the definitive book on “THE FORMING AND LICENSING OF AN INSURANCE COMPANY.” The insurance Commissioner has made many of the forms required in an application for a certificate of authority or amended certificate of authority available on-line. The reasons for the form, what they do with the information and the intricacies of working the application through the Commissioner's Corporate Affairs Bureau and the Financial Analysis Division remain one of the vast mysteries of the universe. A number of straightforward considerations will eliminate months of delay in approval of an application and help those among you looking to enter the marketplace as an insurer. Our experience has shown that a number of large producers have substantial reserves and control a large enough book of business whose premium income would be sufficient to sustain a new insurance company. This book is intended for lawyers, but quite useful to the potential investor or shareholder.

I believe that the coming year will reflect a steady growth in the insurance market place. A way to monitor this growth would be to monitor the rates filing made with the insurance Commissioner. You will see a slow to increase over the last 6 months and I anticipate you will see filings that are more substantial in the coming months. This will signal opening markets and should alert you to start approaching existing markets and the company's identified as submitting the rate filings.

Your comments and emails are always welcome. Good hunting!

Note: A copy of this newsletter can be downloaded from http://aguilarlawoffices.com/blog/

PREVIOUS EDITIONS OF OUR NEWSLETTER OF SPECIAL INTEREST..........................................

We have been waiting for the casualty market to turn before commenting on the prospects for producers in the last quarter of 2011. As most of you have observed premiums are starting to firm up. This stems primarily from poor investment returns and the depletion of prior-year returns. As we mentioned earlier, companies have been focusing on underwriting profits rather than the company's abilities to earn investment income. This applies to insurers as well as their reinsurers who are starting to examine their premium pricing for 2012. Given the state of the economy today, it is going to be a while before investment income returns as a major factor in a company's profitability. What this means to the brokers in the trenches is a soft market slowly hardening.

A number of individual brokers and smaller brokerage firms have been quietly absorbed by larger firms seeking to generate sufficient volume to satisfy insurer demands. The unfortunate effect of this has been to slow the development of specialty products. There seems to be pressure to focus on those accounts which are dependable and avoid bringing specialty accounts forward which might fail and jeopardize the relationship between the brokers and the companies. This is unfortunate because in most instances specialty products are signs of evolving markets and the first ones taking advantage of those markets are the ones that usually profit the most. The uncertainty in the marketplace, in my opinion, is internally generated. The individual brokers and smaller brokerage firms do not have a large overhead to overcome and as a result of their lack of optimism have decided to retain earnings for that rainy day rather than pursue developing specialty products.

A number of experienced brokers have banded together to start new agencies and take advantage of the absence of competition and a perceived increase of the markets available to them. Notwithstanding the fact that the number of applications for new certificates of authority to transact insurance business in California have remained at the lowest level in years, I believe that the first quarter of 2012 will see a reversal in this trend. The capital and surplus requirements are at a level which will provide more than adequate financial stability to their operations. While, in most instances, these new companies will pursue a particular line or risk, the capital and surplus requirements will provide sufficient reserves to extend their business plans to some of the developing specialty markets.

If you are approached as the subject of an acquisition, be certain that your books and records are in order and before deciding to give up your independence for the confort of a perceived business stability, re-examine the marketplace and your client list. There is a reason that they are looking at you. And that reason usually means that you have a good reputation, a solid client base and a good market (your products are competitively priced). This also could be an indication that your market may be ready to expand. If you do not use an attorney to review your contract, then read it carefully and know what you are getting into.

You have all heard the economists argue that the majority of jobs are created by small business. That is undoubtedly true. In the insurance industry it is also true that it is the broker that is the creative engine behind expanding existing markets and developing new specialty markets. Many years ago, an attorney who I respected for his insight into risk analysis and for his understanding of the insurance industry gave up his law practice and became an insurance broker. He successfully developed a number of niche specialty markets which provided him with an income beyond that of his successful law practice. As is always the case, as insurance company underwriters and actuaries focused upon those specialty markets, the full force of the industry stepped in and made them standard fare. However, for a couple of years he owned those markets and retired quite comfortably.

There are a dozens of extremely profitable specialty markets which are not being exploited by knowledgeable brokers. For reasons which are inexplicable, no one wants to take the initiative or maybe the time and energy to present those niche or specialty markets to insurance company underwriters. Perhaps insurance companies have gotten so large that insurance company presidents or senior executives no longer have contacts with the front-line broker or underwriters have become so conservative that they will not pass on niche or specialty markets within the company. Perhaps it is simply a question of company policy to limit expansion to existing markets and allow someone else to package a niche or specialty product before expending its resources. It is certainly not the regulatory environment. Any reasonable product aggressively priced can be justified to the regulator. All that is required is a knowledgeable advocate who understands the product and the market to secure any necessary regulatory approvals.

In the absence of any evidence of innovation by front-line brokers, perhaps it is time for a few savvy insurance attorneys to consider and weigh commission income against legal fees. An intelligent insightful person should be able to take advantage of these niche or specialty insurance market opportunities. The opportunities for innovative brokers in the current marketplace are amazingly open. Yes, it does require you to sit down and isolate the risk, define the scope of the product and identify the boundaries of the market, but the first broker to develop a product will be unchallenged and hold that market for a period of 2 to 5 years. If you do the underwriters homework, the more likely he is to present it within the insurance company infrastructure and open up the opportunities for you exclusively. In the meantime, do not be too surprised if you find some your former legal advisers giving you competition where you least expect it. Who else knows more about insurance risk and the insurance marketplace than you do. Think about it. Look around you, I think you will agree.

Beware of Strangers Bearing Gifts

The current state of the economy has impacted every segment of the insurance industry in California. The impact is uniformly spread among insurance producers although its impact on the medium to small clients has been much greater due to the fact that a small increase in the premium will have a substantial impact on a poorly performing market segment, for example California’s diverse artisan contractor industry. When business is lean, most medium to small businesses start by exploring options to lower insurance costs. The scope of the impact in California has been such as to draw the Insurance Commissioner’s express concerns that consumers would go so far as to cancel their automobile insurance coverage to save money.

The current economic conditions have created an environment whereby clients are seeking coverage in name only and not coverage which provides substantive protection for their individual risk. In these situations, insurance clients begin to buy coverage based on price and not benefit. Most of us will remember that over 10 years ago, a similar crisis nurtured an environment which led to a proliferation of offshore insurance companies, some legitimate, others labeled Pirates of the Caribbean with no substance or organization, offering cheap affordable insurance coverage. It took substantial efforts by the California Insurance Commissioner and the legislature to curb these excesses, primarily for the protection of the medium to small insurance clients.

As the broker agent, you are the first line of defense in advising your small to medium clients who are shopping on the basis of price rather than on the basis of coverage. It will be up to you to explore alternatives and one of the ones that I believe you will encounter will take the form of inexpensive alternatives for liability insurance coverage through Association group coverage. This will take a number of forms. Although there are others, the most common can be expected to be a risk retention group.

If the premium offered to cover your small to medium client’s liability risk sounds too good to be true, it may not be to your client’s benefit. Shopping on the basis of price has its pitfalls and you may be held responsible by the California Insurance Commissioner for failure to counsel your client appropriately. To that end, you should at least verify that the entity offering the inexpensive coverage in fact meets the minimum standards for a risk retention group.

A Risk Retention Group has been defined as a corporation or other limited liability association, acting as a captive insurance company and organized for the primary purpose of assuming and spreading the liability risk exposure of its group members. A Risk Retention Group is a unique creature of federal genesis which must be incorporated and licensed as a liability insurance company in one of a number of states which provide special state captive laws such as Vermont, Delaware, Colorado, Illinois, etc.

The corporate form of a Risk Retention Group can be a stock or mutual company, or even a reciprocal exchange. All of the owners of the risk purchasing group must be both members of and insured by the group and must be engaged in businesses or activities which give rise to the liability exposures which is subject to the insurance risk and which is created by virtue of common business or trade practices, products, or services.

A Risk Retention Group cannot write coverage which is prohibited by state statute; however, the states do have broad discretionary powers in deciding whether coverage from a Risk Retention Group is acceptable. Only the state of domicile of the risk purchasing group has approval authority over rates, coverages, forms, insurance-related services, management, operation, investment activities, or loss control and claims administration. For example, California would have no authority to regulate rates are coverage over a non-California domiciled risk purchasing group, but would have authority to regulate the amount coverage where proof of financial responsibility is needed to obtain a license to operate a motor vehicle.

A little effort in the exercise of the duty to your client to explore alternatives as a broker agent, notwithstanding your clients need for coverage on the basis of price, will protect your client’s interests as well as your own. Clearly, the importance of knowing the bearer of cheap inexpensive programs in this time of unprecedented economic turmoil will protect you and your client. As always, if you run into situations which are unclear or which sound too good to be true, please take the time to ask for a second opinion. These are difficult and complex issues which should not be ventured without expert assistance.

Surplus Of Capacity

It is hard to believe that, given the conservative regulatory controls established for insurance company premium funds investments, the problems which banks are having with derivatives and mortgage backed securities would impact insurance companies day-to-day operations. AIG’s problem operations do not stem from their insurance activities but rather from the special branch designed to dabble in securities which were quickly rendered worthless. Unfortunately, there have been a number of companies, primarily life companies, which have been impacted by the credit issues and investments in entities whose value contained derivatives and mortgage-backed securities. A number of these companies have quietly approached their home state insurance commissioners and secured concessions regarding re-characterization of assets for the purpose of preserving their public paid in capital and surplus. Some actually approached the NAIC and, not surprisingly, were rebuffed in their efforts. After all, the NAIC is not one to take bold steps without the leadership of the individual state regulators.

The reason I find all this activity interesting is that it appears that insurance companies, other than life companies, have sustained a sufficient devaluation of their assets to a point where it has impact their paid in capital and surplus. There is a movement afoot to approach the regulators to relax their standards permitting them to re-characterize certain assets which would make up for the impact that the economic downturn has had on their bottom line. It appears that consumer friendly regulators have accepted some of these arguments. The impact of this is that most property and casualty companies will be in excellent condition to take advantage of the market when the economy turns around. Given the trillions of dollars are being pumped into the system by the federal government, this is going to happen sooner rather than later. Those of you with existing markets should be positioning yourselves to take advantage of the situation. There will be a suplus of capacity sooner rather than later.

Unfortunately, the economy has been hit hard enough that a number of medium to large brokers with existing markets are struggling to meet their company commitments. A word of caution, tighten your belt and make sure that you have no shortages in your premium trust accounts. More importantly, be certain that your system will allow you to accurately monitor your trust accounts for compliance. Too many good well-meaning producers have been caught with trust account shortages which they honestly believed did not exist. Unfortunately, accounting mistakes in trust accounts are rarely an excuse to fend off the regulator. Do not scrimp of this accounting. The Department’s insurance investigators are very bright people and have a tendency to dig in for a long stay at your office if they find anything out of place as it relates to trust accounts.

Notwithstanding the current issues with the economy, I believe that in the coming year the sluggish insurance marketplace in California will come to life and will result in the expansion of many existing programs. The current Insurance Commissioner reflects a constructive change in the insurance regulatory philosophy of California and has and will continue to foster an insurance friendly regulatory environment for the next few years.

Properly underwritten, most insurance programs can be highly profitable. During the period of high returns from investment income, underwriting standards were relaxed as long as the overall result losses were manageable and so long as the company could make a reasonable profit.

In California there were a number of general agents whose careful underwriting consistently resulted in abnormal profits due to tight underwriting resulting in unreasonably low claims levels. For those company presidents or executive officers who were able to identify these general agents, profits were consistent from year to year in addition to the returns from investment income. Unfortunately, with success comes arrogance. Large profits were always attributed to premium volume and not the quality of the writings. The statistical averages created by the laws of physics and mathematics came into play and by the time anyone noticed, the lack of proper underwriting resulted in unacceptable losses. Coupled with the sharp economic downturn over the years after the dot-com bubble, like the Titanic attempting to avoid the iceberg , many companies had too much momentum to be able to reduce the overall volume and implement strong underwriting guidelines in time to avoid the adverse results which their actuaries knew would occur.

Today, in the 2009 marketplace, insurance companies are poised to make fantastic profits by utilizing and controlling their general agency field force. Smaller volume, tighter underwriting standards will mean millions of dollars of profits. There will always be other markets who will absorb risks which fall within the standard limits of the statistical probability curves. For those insurance companies willing to make the investment in a startup company in California, success is almost assured. Those non-admitted insurance companies, who have always looked to becoming admitted to California and penetrating the California insurance marketplace, are facing the most friendly insurance regulatory environment in recent memory. As with most opportunities, the window available will not last more than a few years, if that long. The smart ones will move rapidly to secure admission to California or to acquire struggling California admitted insurance Companies.

Brokers in the 2009 marketplace who are willing to tighten up their underwriting standards and negotiate profit-sharing arrangements with insurance companies are poised to take advantage of the existing marketplace. This may be difficult in the beginning simply because competition is looking solely for volume and not quality underwriting. Volume means immediate income, quality underwriting is a longer-term process.

The insurance companies balancing of volume and quality business is unfortunately often tempered by necessity rather than by a conscious business decision. Brokers have to provide volume and negotiate quality business. The process is not difficult, but it does require a conscious decision to implement the specific business plan and to convince the insurance company that its long-term benefits outweigh volume.

Brokers should concentrate in developing alliances which will allow them as a group to develop the premium volume necessary to meet the insurance companies premium volume threshold requirements and allow them, as a group, to negotiate a business plan which, through proper underwriting, will result in a profit-sharing arrangement which will benefit both the brokers and the insurance company.

Those few Large Brokers who have developed resources and sufficient premium volume to enter into negotiations with insurance companies will clearly have an advantage. Unfortunately, the larger the broker the less inclined they will be to change its tried and true business plan or its existing relationship with the insurance company. Those few who recognize the current state of the insurance business in California will be the first to take advantage of the situation.

With respect to the Small Brokers, now is the time to start developing alliances and implementing a business plan which can be marketed to insurance companies. Clearly, these opportunities will not last forever. As soon as the marketplace starts to pick up, it will be business as usual for everyone except those that have already positioned themselves to take advantage of this outstanding business opportunity.

I recently overheard a heated argument between two insurance brokers regarding the distinction between an insurance agent and an insurance broker and the impact on a 1994 decision, Krumme v Mercury Insurance Company, 20 Cal.Rptr.3d 885. What impressed me was how knowledgeable these two brokers appeared to be about recent legislation (September, 2008) which both sides believed codified the standard of review to which the Insurance Commissioner would be required to apply in making a determination as to whether certain activities were being handled as an agent or as a broker. The phrase "The Totality of circumstances test" versus "the single act test"were prominent in the discussion.

I was aware of Assembly Bill 2956 and generally the court's decision in the Krumme v Mercury case, but I didn't really think it had much impact on the distinctions which clearly define the relationships between a broker and a company's agent. It certainly didn't have any impact or impose any limitations on the Insurance Commissioner's analysis or evaluation of a particular complaint before it. At best, the legislation has codified what has been the state of the law for many years. Notwithstanding the appellate court's analysis of the impact of Proposition 13 on the distinction between a broker, agent or broker-agent, its ruling was consistent with the basic principles applicable since the Insurance Commissioner was given the power to regulate.

The Insurance Commissioner's investigators have always looked at the totality of the circumstances. Some of the Commissioner's staff attorneys decided to make it easier for the investigators to apply the rules and gave them a number of examples which they could utilize as they reviewed complaints or various other violations which they perceived breach the distinction between an agent and broker. This lead to many more visits from investigator and unconfortable discussions with brokers and agents as to the propriety of their operations.

With the advent of the so-called "clarifications", the only thing that has been accomplished is to provide attorneys with a basis to argue that the actions of their clients must be examined in their totality to justify the position or client has taken either as a broker or agent. For lawyers this is a good thing. It has provided a basis for giving seminars and presentations explaining what the legislation means. Common sence should be your guide, be warned, if you wonder if the activity is improper, applying simple definitions of agent and broker will give you the answer. The overconfident licensee, looking for a way to get fees as an agent or broker, will still find himself having to justify his actions to the Insurance Commissioner. Keep it simple and you will stay out of trouble. The insurance companies will ask their in-house lawyers and they may share their findings with you.

The current economic forecast will continue to put abnormal pressure on insurance companies’ earnings. Since investment income has long disappeared as a buffer to keeping rates low across the board, you can be certain that insurance companies will be reexamining their portfolios with a view to maximizing premium production. This will manifest itself by pressure on you to increase the volume of your production in view of the insurance companies’ anticipation that your production volume will outperform claims.

The marketplace has gotten tighter for everyone across the board and many, if not all of you, already know that the insurance companies’ problems will become your problems very soon. Cutting overhead will certainly streamline operations but will not necessarily increase your production. The dilemma which faces many of you is not isolated to the small producer. I don’t need to tell you that the larger your operation, the more that is expected of your company.

Some of you will remember the solution which served as a lifeline to many small producers 10 or so years ago. The cluster concept allowed the individual producer to retain its own identity and permitted the group production by the cluster to grow to the point where it would meet the insurance companies’ threshold production requirements. The concept would apply equally well to middle to large operations where volume is essential for survival. It is something to seriously consider in these harsh economic times.

The legal structure to create these clusters is not particularly difficult. One of the agents associations, many years ago provided guidelines and general advice on how to set up a cluster. I haven’t seen anything like that recently; however, if you get a copy of the old handout, be cautious and make certain that the legal formalities are followed.

The cluster concept applies to both the admitted and non-admitted marketplace. Although, different considerations regarding the structuring of the cluster come into play and you should consider carefully an exit strategy when the crisis has abated and you want to go your own way again.

Don’t forget to keep your books and records up to date. If you decide to adopt a cluster program, the status of your and your associates, corporate books and records must be absolutely pristine. Take the time to review the status of the corporate trust accounts and your ability to respond to a Department of Insurance audit. Steps of prevention now will save you thousands of dollars in legal fees later to preserve your license.

Imagine coming to work on a bright crisp sunny Monday morning to learn that your most trusted associate has decided to leave. Your associate will not tell you where he is going because of his new employers has requested privacy. Your years of investment in time and training, the bonuses, the trips, the authority, the trust and loyalty that you'd showered upon your associate were not enough. You give your trusted associate a great party, wish your loyal associate the best of fortune and start looking for another young associate to train.

You soon learn that your loyal and trusted employee has gone to work with your competition.

A few weeks later you start getting calls from some of your friends and clients and learn that your loyal trusted associate has started to solicit their business. At first you wish him well, knowing that without your closely guarded client policy bordereau and database, your former associate will achieve only limited success. A few more weeks go by and you discover that your loyal and trusted former associate is soliciting all of your clients. Since you allowed your trusted associate over the years to handle the accounts directly, your loyal trusted former associate has developed enough of a rapport with your clients and, armed with your company client bordereau, client database, and other trade secrets your loyal and trusted associate has started to convince them that you're going out of business and he is in a better position to take care of their future needs.

As a result of technology, months before he announced his leaving, your former loyal and trusted employee was able to copy all of your electronic files onto a flash memory card smaller than a cigarette lighter. There has been an increase in the ability of employees with access to company confidential data, trade secrets and other customer databases, to copy your trade secrets and go to work for your competition. Yes, there is the 1984 Uniform Trade Secrets Act (UTSA) which provides a legal remedy for the misappropriation of trade secrets for California employers.

I do not need to remind you how valuable your customer lists, contact persons, policy renewal dates, claims history, premium payments history are to your business nor the ability of a competitor with the same information to severely attack and damage your business. Yes, you can sue your former loyal and trusted employee and your competitor. After a long, expensive and protracted litigation you may recover some portion of your losses; however, during that time you will be struggling to rebuild your business and pay your attorneys in an effort to survive.

All this of course can be avoided by taking reasonable steps to protect your customer lists, customer databases, confidential data, customer premium and claims bordereau, and other trade secrets. If your employees are loyal and trustworthy they will understand the steps that you must take in order to protect the integrity of your trade secrets and the ability of your company to continue growing its business.

We strongly recommend that you contact your insurance lawyers and discuss what steps you need to take in order to protect your company. A cursory search of the internet will reflect an alarming trend of trade secret theft. Unchecked and unprepared, the theft of your trade secrets could ultimately destroy your company and give your competitors the ultimate advantage of your years of hard work and effort.

A reminder that the Insurance Commissioner continues to monitor the payment of brokerage fees. For you wholesalers, be alert to the activities of your retail brokers insofar as they relate to the charging and payment of brokerage fees.