When thinking about loss costs, the focus is often on discussing the larger picture loss cost trends, their severity, and what has changed over time in what segment. What is less discussed are the defense and cost containment (DCC) expenses for insurance companies.
In general, losses and expenses are subtracted from earned premium when calculating the underwriting profit or loss. The “loss” portion includes incurred losses, which is the most significant piece, and what we usually focus on.
The second piece is the loss adjustment expense, which includes allocated loss adjustment expense (ALAE) and unallocated loss adjustment expense (ULAE). DCC is the revised terminology for ALAE under the NAIC’s initiative to update the categorization of certain items.
DCC expenses include items related to defense, settlement, or reduction of claims and typically include legal/lawyer fees, litigation expenses, expert witness testimony costs, and cost containment expenses such as mediation and arbitration costs.
Over time, DCC will reflect the impact of inflation (wage and admin), role of technology, uptick in severe convective storms, societal trends, litigation and regulatory environment shifts, and a change in litigious behavior.
Besides the focus on loss reserve setting, loss management and claim management have become core deliverables at insurance companies. Several past notes have focused on the shifting reserving trends in the casualty lines. Given that DCC is an important part of any industry or company’s risk management, we took a deep dive into the DCC trends by segment and state over time.
First, our analysis shows that a few long-tail lines’ DCC trend lines are beginning to go up for problematic lines such as other liability-occurrence, commercial auto, and medmal. This could be a cyclical trend or the beginning of a new trend line.
Second, these lines make up large parts of the overall insurance business mix and will weigh on industry profitability if they continue going up.
Third, a state-level analysis shows that it is not always the case that higher population equates to a higher cost ratio, and trends do move around over time.
Firstly, DCC ratios are ticking up in a few long-tail lines
The chart below shows DCC ratios over time (note that these are direct ratios and not net DCC ratios). Direct is before cessions; hence, the trend line will likely be higher for these numbers. Nonetheless, the chart below demonstrates that many lines had declined slightly into Covid but are now inverting.
We can see this in the other-liability occurrence side, which continues to be a hot-spot for the industry and recently seen in Travelers’ reserves adjustments. Commercial auto, which continues to pose industry challenges, has also modestly ticked up based on the latest data.
Secondly, these lines make up a large portion of industry premiums
The chart below also shows the same trend line but with a view on the premiums associated with these lines. We have also added personal auto and homeowners for contrast.
In recent years, much has been made about rising defense costs in the personal lines space, but as one can see, these are still a materially lower ratio, even when making up half of the industry premiums.
However, switching to the commercial lines, one can see that other liability makes up 12% of industry premium, commercial auto makes up 7%, and CMP makes up 6%. Approximately 25% or one quarter of the industry premium is showing modest reversals in DCC ratios.
Thirdly, new hot spots might be emerging
As expected, there is a correlation between the size of a state’s population and its DCC incurred ratio trends, as shown below. In 2023, only one of the 5 most populous states (Texas) had a DCC incurred ratio below the overall industry ratio of 4%.
However, what is interesting is states that rank slightly above or below the national average are witnessing reversals and have decent market shares. Two such examples are shown below in Michigan and Connecticut. At the same time, some offsetting impacts from the relevant states show a decline (shown in green below).
Taking a step back, this shift translates into portfolio management for the insurance companies to watch their growth in states where trends might be reversing over time.
In summary, trend reversal in long-tail lines such as other liability and commercial auto gives us cause for concern, as this could start a new trend line. A combination of pressures on DCC costs and a worsening reserving scenario for the soft-market years and even recent years could pressure the profitability of the long-tail lines sooner than anticipated by the market.
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