By David J. DePaolo
The following article is the second in a series on national trends in workers' compensation. Part 1 reviewed the "The Social Contract."
The basis of this article series is a presentation that was given to the California Association of Rehabilitation and Reemployment Professionals at their annual conference in San Diego October 15, 2005. The presentation has also been adapted as a professional continuing education course at WorkCompSchool.com in a multi-media format including video, audio and supplementary reading materials, and has been approved for, or is pending approval for (depending on the accrediting agency) 2 hours of CE units.
DON'T JUST READ THIS ARTICLE, GET CONTINUING EDUCATION UNITS BY TAKING THE COURSE AT WORKCOMPSCHOOL.COM. Unicover - Financial Principles
In the business of trading risks around, insurers use a peculiar kind of bookkeeping that will be familiar to anyone who has played the lottery. In the lottery business a $25,000-a-year payout lasting 40 years is called a $1 million prize, even though in economic terms it's worth only a fraction of that due to the time value of money. In similar fashion, a $1 million disability payout expected to be spread over the next 40 years is called a $1 million claim. Take in $600,000 of premiums to cover that future liability, and you have a $400,000 underwriting "loss," even though you may be ahead of the game when you invest premium dollars in the bond market at 6%. Remember this principal because it governs overall workers' compensation finance and pricing and comes in to play when understanding the Unicover Scandal, how both reinsurers and primary carriers got caught up in it, and how Unicover converged with other financial phenomenon occurring concurrently to produce "the perfect workers' compensation financial storm."
Unicover - What it Was
Unicover goes back to a basic financial reality in insurance - work comp insurance is a cash flow business - historically "written" at a "loss," the cash from the sale of policies permits investments over time adequate to cover the future losses and produce a profit.
Life insurance companies like the medical portion of workers' compensation as an investment vehicle because of the long tail nature of the claims - thus they can put (or "buy") their risk in to work comp via reinsurance, but since it doesn't pay out for some time, they produce a greater return on investment over time.
Typically reinsurers become responsible for these type of "carve-out" losses at $500,000 to $1 million strike point. What this means is that the reinsurer is not on the hook until the primary insurance expends $500K to $1M in medical payments, which is a rare work comp claim, but nevertheless could be catastrophic for the primary carrier if not protected against.
Unicover was started in 1995 by John Pallat. Pallat was looking at the upper end of the work comp reinsurance stratosphere, the area where it was difficult to get reinsurance on 175% loss ratios because of the thin profit margins. In addition, brokers could get only 7.5% commission writing work comp reinsurance. But Pallat realized that if he could put together a series of transactions at this level he could make upwards of $250 million.
So he formed the Unicover Pools.
Unicover focused initially on California risks, primarily because of the size of the market. Unicover started with a group of mostly small carriers in California whose policies were priced to create an underwriting "loss." For every dollar they collected in premiums, they anticipated an eventual $1.25 of claims and expenses. Trash? Probably not at this point because comp is a cash flow business, not a net underwriting business.
Pallat arranged through various brokers for three reinsurance vehicles to insure those primary carriers. One was Reliance, another Lincoln National and the third a pool of companies that included Cigna.
But here the pricing was not so favorable to the companies absorbing risks. Companies at this layer could expect $1.75 in eventual costs and payouts for every dollar of premium. Profit is almost impossible at this level--unless the reinsurer can get rid of most of the exposure while retaining a disproportionate share of the premium. That's what Pallat was able to convince his reinsurance companies that he was able to do.
Next he and his brokers got a trio of companies--Cologne Life Re, a subsidiary of General Re (now part of Berkshire Hathaway), Phoenix Home Life and Sun Life--to take on most of the exposure under the policies. Pallat got these reinsurers to take on $2.6 billion of reinsurance on $8 billion of work comp policies in 14 months.
This meant they were taking on nearly $4 of loss and expenses for every $1 of premium. They underestimated the future payouts largely because the thick treaties that covered these risks contained language that had these carriers assuming total claim losses, not just the traditional medical only portion of the claims.
For the primaries, under the Unicover arrangement, attachment points were generally around $25,000 and some as low as $10,000, instead of the traditional reinsurance strike points of $500,000 to $1 million. Some observers said that due to the overcapacity in the market, members of the life insurance industry invested in a scheme they didn't investigate very fully - greed. Life insurers thought they were reinsuring accident-health coverage, but the medical only coverage for workers compensation involves a totally different loss experience.
As you can imagine, the primary carriers thought they had stumbled in to a huge stroke of unbelievable good luck - basically free money! When you can buck the long standing rules and free up money off the books and invest that money to produce extraordinary gains, everyone wins: shareholders, employers, executives, etc. This scheme fueled the greed that began making its way through the industry, and we'll see how other events added to that greed to the point where carriers got drunk with unchecked financial thrills - what the rating agencies call "undisciplined financial management."
Unicover - Blows Up
In the late 90s, the reinsurers began to see claims coming in a lot faster than they had anticipated, and started to closely review their reinsurance treaties. They soon realized that they had taken on a lot more risk than the previously anticipated.
These treaties were all written "off shore" because they involved largely Bermuda entities, and all contained arbitration clauses. The reinsurers decided they were not going to pay because the risks they bought were misrepresented. One case got to the New York Supreme Courts, AIU Insurance, etc et al vs. Unicover Managers, which challenged the validity of the contracts in an attempt to void them and get out of arbitration. Motion for summary judgment was rendered in favor of Unicover and after that, everything went off shore in to private arbitration and out of media attention.
The Unicover mess erased over $2 billion in capital from the work comp system, leading Alice Schroeder, a PaineWebber analyst, in January, 2000; Forbes Magazine, "Passing the Trash," to exclaim: "This is shaping up to be one of the worst scandals in the history of the [insurance] industry." But this was only part of the picture. Unicover unraveled at the worst possible moment. The next installment will review how Unicover led carriers to take extraordinary risks when California deregulated premium price controls.
Next: California Deregulation
Article be David DePaolo. This article series is an adaptation of a continuing education course that starts with the hypothesis that the reform movement in California was the product of a national workers' compensation crisis, and that California was not alone in its reform agenda. This course also takes the hypothesis that the workers' compensation crisis that spawned reform had less to do with medical costs and utilization, and more to do with the confluence of a dubious reinsurance scheme, stock market losses, and blatant high end financial cheating. This course is pending 2.5 hours of continuing education units from various administrative agencies, and has been approved for 3 hours of CLER, 2 of which are approved for Certification. This course is available as an on line multi-media presentation at WorkCompSchool.com
The views and opinions expressed by the author are not necessarily those of workcompcentral.com, its editors or management.
The following was received in response to this article from Mr. John Pallat and is republished here verbatim:
On 1/10/07 8:38 AM, "John Pallat" wrote:
Mr. DePaolo, I recently came across an article that you wrote in November of 2005. As you are probably well aware, a great deal of misinformation surrounds the business underwritten by Unicover. These inaccuracies seem to have a way of repeating themselves. By way of example:
Unicover was not started in 1995. It was formed in 1994.
Unicover was not formed by me. I was minority shareholder with less than a 25% stake in the company. I did not become CEO until late 1998 when the current CEO decided to retire for health reasons. I became CEO for the specific purpose of selling the company, which was sold in 1998 to a publicly-traded company and subsequently repurchased in 1999 after the company ceased writing business.
I did not form any pools, nor did I affect formation of the same by the executing any agreements with any pool members.
The pools were formed to write quota share and working-layer excess reinsurance, not the upper end of the stratosphere. The maximum limit that could be offered by the Unicover Pool was $500k.
The coverage specifically authorized by the pool management agreement included all carve-out components of workers compensation, not just medical coverage.
The company did not at any time focus on California risks.
I did not arrange for the purchase of any reinsurance. The pool members specified from whom reinsurance (retrocessional coverage) was to be purchased and at what terms (including the price and the attachment point) through reinsurance brokers who represented the Pool member insurers.
I did not get any reinsurers, including the trio you reference, to take on any reinsurance exposure.
The amount of premium you indicate was taken on by the trio of companies is off by an order of magnitude.
The pool members and retrocessionaires all knew they were reinsuring the medical, disability and death coverages of occupational accidents (including cumulative trauma and disease) that were insured by workers compensation policies complete carve-out, including LAE, subject to a seven year sunset / commutation clause.
Moreover, not only was summary judgment granted in our favor against AIU, the arbitration between the retrocessionaires and the pool members, which included numerous actions against Unicover Managers, resulted in a complete victory for Unicover all charges against us were denied. We moved to confirm the award and confirmation was granted.
Unicover Managers and the coverage it wrote on behalf of its risk-bearing principals are greatly misunderstood by the trade press; it does not surprise me that your article contains factual inaccuracies. If you elect to write concerning Unicover in the future, I am sure you will endeavor to get the facts as accurate as you can.
If you choose to mention me by name, please verify your information or email me for verification. Thanks.