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Insurance buyers' growing interest in managing the total cost of risk is leading to more customized, hybrid risk management programs and is gradually transforming the traditional insurance marketplace, Johnson & Higgins says.

Though standard insurance remains the most cost-effective way to protect certain risks, sophisticated buyers are more frequently seeking alternatives, the New York-based broker asserts in its "1996 Insurance Market Review and Forecast."

Despite the persistent soft market, alternative markets have been growing substantially, J&H points out in its annual report, which is to be released tomorrow. Captives, self-insurance and finite risk coverage are all gaining prominence as risk financing tools and large companies will continue to use them to fill shortfalls in capacity in the traditional market, J&H predicts.

Taking what the report calls a "holistic" approach, more and more risk managers are realizing that "a $100 million loss from a wrong bet on interest rates is just as painful as a $100 million loss from a plant fire," the report said.

Even the way risk managers buy traditional insurance is changing. Buyers and insurers today are not always negotiating on a risk-by-risk basis every year but are discussing multiline, multiyear programs with single aggregate limits, J&H says.

As risk financing options expand, the relationship between large clients and brokers is becoming increasingly complex, and for brokers to add value to their clients' operations, they must fully understand each client's business, the report said.

For property insurance, J&H expects catastrophe rates to level off this year after two years of severe price escalation, while there also will be several other major changes over the next two to five years.

"Capacity is improving, but it's not up 50%. It's still a tough market," said Norman Barham, an executive vp at J&H in New York.

Meanwhile, over the next two years, rates for non-catastrophe property coverage will be "notably lower as the result of heated competition and additional capacity." Large retentions will become more common on property risks, and retention levels will more frequently be tied directly to company financial performance.

J&H also forecasts the proliferation of multiyear and multiline products that blend property and casualty coverages for a broad scope of policyholders, as well as the decline of blanket limits in favor of per loss limits.

Over the next five years, J&H anticipates that the first financial derivative products tied to property losses will be traded at the retail level, while virtually all large companies will protect catastrophic exposures through some combination of alternative risk financing products.

By the year 2000, multiline insurance products that include property will be commonplace, J&H said, and banks and other financial institutions may very well enter the field of insuring property risks.

On the casualty side of the fence, historical market cycles have vanished because underwriters have access to far more data on loss development than before. In the past, underwriters were often unaware of deteriorating results until well after those results were beyond repair. Thus, when insurers became aware that a change was needed, they would overreact, according to J&H.

But the casualty market of today and the future is different. Large-deductible programs on scaled-back insurance products are now the norm. These programs have become more popular than self-insurance because commercially insured companies can more readily obtain aggregate stop-loss protection and can negotiate letter of credit and surety requirements with underwriters rather than having to meet state standards.

For casualty accounts, J&H reports that insurers today are locking in more multiyear programs at fixed premiums and are allowing policyholders to pay up front or throughout the contract period.

While these programs have become very popular, J&H still warns buyers against getting too comfortable with these contracts. "Underwriters have budgets to meet, so they may not adjust prices unless they feel competitively threatened. Thus, to get the best price possible, it is often necessary to market programs periodically."

In the next five to 10 years, J&H anticipates that ample capacity and the lack of substantial losses will keep the casualty market soft. But as insurers locked in a competitive market attempt to distinguish themselves from one another, they will be forced to bring new products to the market. Those might include derivative-based products that tie a policyholder's retentions, limits and premiums to profitability, or coverages that are activated only when the policyholder is having an off year, letting the buyer absorb the loss in strong years or when investment income is up, such as 1995.

For excess liability, J&H recommends that companies balance out programs by utilizing a blend of capacity from the United States, London and elsewhere in Europe and Bermuda, rather than relying on one or two markets. Furthermore, buyers should seek to combine professional liability and excess coverage into multiline programs, and develop multiyear plans as a means of achieving further cost savings.

In the future, J&H expects that more consolidation among insurers will result in a smaller number of "mega-insurers" capable of offering large blocks of excess capacity and coverages that transcend current definitions of insurable risks.

In addition, the role of Lloyd's of London in the excess liability market will continue to erode, according to J&H, especially for long-tail risks, regardless of what happens with proposed runoff reinsurer Equitas Ltd.

With insurers concerned about what might become the new asbestos or pollution-related liability, environmental impairment liability coverage will continue to be written on a stand-alone basis, although a few insurers may choose to offer combined general liability and pollution liability policies.

J&H assessed the directors and officers liability market as "generally positive." Future D&O coverage will be issued not only for directors and officers, but also for the corporate entities, the broker predicts.

In the D&O liability markets and the insurance market overall, everything could be thrown out of sync if brokers and buyers ever "crack the code" of accessing the capital markets for risk financing needs.

With the total surplus of the U.S. property and casualty market at about $200 billion, J&H asks, "Is it any wonder, then, why many in the industry are investing millions of dollars to find a way of directly accessing the capital markets? Unfortunately, no one yet has figured out how to crack the code....The race to access the capital markets is on, and even if it does not produce the Big Solution, it will undoubtedly spin off a whole new series of products and services that will enable companies to identify, analyze, and price risk in ways never before contemplated."