Monday, October 08, 2012

Insurance coverage limit winners

Recently in the entertainment industry it seems like the major entertainment companies are requiring excess insurance policies of $9mil on top of base policies of $2mil aggregate and $1mil per occurrence.  For those not intimately acquainted with how insurance works, essentially this means that the excess policy brings your aggregate limit to $11mil and your per occurrence limit to $10mil -- lots of coverage, to say the least.

To get an idea of why coverage limits are climbing, consider this example for a typical general liability policy with $2mil in aggregate and $1mil per occurrence:

  • The first day of coverage there is a claim for $1mil -- that burns up 50% of the aggregate coverage and maxes out the per occurrence limit.
  • The second day of coverage there is a claim for $1mil -- that burns up the remaining 50% of the aggregate and maxes out the per occurrence limit.
  • The third day of coverage you no longer have any insurance left, even though you can continue to issue certificates showing proof of the coverage that you purchased.

Previous to the 2012 season, it seemed as though most large entertainment companies that were requesting insurance from entertainment service providers were happy with $3mil in aggregate coverage and $2mil-$3mil per occurrence; some of the higher volume providers carried excess policies of $3mil-$5mil bringing total coverage limits to $5mil and $7mil respectively.  Doing the quick math: for those that carried $3mil in aggregate, it's an $8mil (267%) increase; for those that carried $5mil in aggregate, it's a $6mil (120%) increase; for those that carried $7mil in aggregate, it's a $4mil (57%) increase.

Any way that you look at it, in real aggregate dollars of coverage or percentage increases of coverage dollars, the numbers are staggeringly large -- as you might expect, the corresponding jumps in the prices of coverage are staggeringly large as well.

The end result of these kinds of enforced jumps in order to continue doing business mean, generally, that prices of the services have to go up.  If buying up the insurance coverage costs a provider an extra percentage per billable unit, say 10%, then, correspondingly, the provider rates are likely to go up by 10% or the provider makes a business decision to absorb some of the additional insurance costs itself to keep your rates competitive, meaning that the provider receives lower net profit from the same work, which is not an ideal situation unless the provider can make up for lost net by increasing volume to make up for it.  In event-based entertainment in particular, due to the fact that it may be a particular tour or event requesting highly elevated coverage levels, vendors may choose to charge the entire increase effect to the entity requesting it -- either the insurance underwriter will sell an event- or tour-specific policy (unlikely) or the underwriter requires the entire policy limit for the term to be increased (most common).  The challenge in the case of the policy limit being increased for the term is that, although it is only one entity requesting the increase, all entities benefit from the increased limits.

Consider this example: Big Promo asks a ABC Janitorial for increased limits for a festival, which costs ABC Janitorial an extra $10K per year.  ABC charges Big Promo $10K as part of its expenses, so there is no additional out-of-pocket expense to ABC, Big Promo has the coverage the want, and ABC maintains its margins without increasing service costs.  One month later, Little Promo hires ABC for a different festival and requests the same limits.  In a ethical and fair situation, ABC would charge Little Promo $5K for the insurance and refund $5K to Big Promo since the cost of the additional coverage is now split between two events that are requesting them.  If, however, ABC were to be very unethical, they may decide to charge Little Promo the same $10K and actually turn the requested additional coverage costs into a profit center, and because Big Promo and Little Promo don't talk to each other, there is no central informational clearinghouse for those two entities to know that both have been charged the entire premium for the same insurance.

In the case of the example above, it would actually be better for everyone to whom ABC is providing services to simply pay a higher rate across the board with the insurance cost being drilled down to the hour or day or whatever the costing mechanism might look like.  Unfortunately for ABC, in the absence of being able to explain why their rates took such a massive jump, they may price themselves out of the market based on the standard pricing unit -- for example, if the previous hourly rate was $13.00 for services and the insurance costs represent a 10% increase per hour, then the new hourly cost becomes $14.30, which appears to be a massive jump without the benefit of explanation.

What changed?  It's really hard to get a straight answer.  However, moving into 2013, it seems like the higher limits are being adopted by more and more entertainment companies, driving the larger coverage limits towards being industry-standard.  The people inside these entertainment organizations that are demanding these changes tend to be in the risk management and legal side of the business that seem to rarely interact with the front-line accounting and operational sides of the business that are tasked with controlling costs.

Unfortunately, the gaps in what is being mandated by risk management and legal, and what is being budgeted by accounting and operational sides of the business are getting very wide, causing problems for providers and problems for all of the people working for the same entertainment companies.

Although everyone in entertainment going into 2013 will figure out ways to work through these issues and likely new industry standards for pricing and/or paying for additional coverage will emerge, one thing is for certain: the big winners in all of this are the insurance companies.

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