Specialty writers of the small to mid-sized lawyers’ professional liability (LPL) market continued a pattern of strong financial results in 2021. The operating ratio was 70%—the lowest in over 20 years. Surplus reached an all-time high, having expanded nearly 7% over 2020. Insurers returned more than one-quarter of their net income to policyholders in the form of dividends, which in large part was due to reserve releases during the year. The industry is experiencing an extended period of reserve releases, which has been a driving force behind the near decade-long streak of combined ratios less than 100%. The magnitude of reserve releases has decreased in recent years, however, and the results of our analysis suggest this trend is likely to continue in the near term, calling into question: How much longer can the industry’s streak of profitability continue?
To further discern the state of the small to mid-sized LPL industry today, we have reviewed financial results from a composite of 16 specialty writers of LPL insurance primarily for sole practitioners and small firms. Most of these companies have been writing LPL insurance for decades, meaning that our analysis is of a mature marketplace. Our composite also includes four additional specialty companies who ceased providing coverage at various points within the past 25 years, allowing for more extensive commentary on long-term market trends. Missing from our composite are specialty insurers of relatively large LPL risks, as well as multi-line commercial writers with LPL products that may have different missions and profitability goals.
Our analysis is based upon statutory financial data and other information obtained from S&P Global Market Intelligence. We have compiled various financial metrics for the industry, categorized by:
- Written premium
- Claim frequency and severity
- Overall operating results
- Capitalization
Written premium
2021 direct written premium for our composite grew a modest 2% from 2020 (see Figure 1). From a long-term perspective, the specialty LPL industry was witness to a trifecta of catalysts 20 years ago—withdrawals from certain commercial carriers, planned expansion strategies, and rate level increases—that triggered the hard market from 2002 to 2004 and led to a 50% increase in direct written premium. In each of the 17 years since, the composite’s top-line revenue has remained at a remarkably steady level, notwithstanding some regional soft market conditions in the years leading into 2011.
Figure 1: Direct written premium ($millions)
Beneath the composite’s relatively consistent overall premium volume since 2004 lies significant divergence in premium level changes within individual state markets. We note that declining LPL premiums in a few jurisdictions, most notably California, have been offset by growth from other states in the forms of expanding footprints and rate increases.
Increased competition may have hindered growth in the composite’s direct written premiums over this time, especially if a competitor used an aggressive pricing strategy to enter new markets. Rate filings during the past few years, however, may provide early signs of a firming market. While there is still noise in the data, we have detected an upward trend in approved rate level changes from several specialty companies in many states—from an average of small rate decreases to, more recently, low to mid-single digit rate increases.
In the years since the premium surge of the early 2000s, the composite has consistently ceded about 25% of their business to reinsurers. Results from individual carriers in recent years, however, may suggest conflicting views on risk appetite. Some companies have elected to increase net retention in hopes of retaining additional layers of profitable coverage, while others have chosen to increase reinsurance protection (or otherwise absorb increases to reinsurance costs) out of concerns over emerging claim severity.
Claim frequency and severity
Although rising slightly from 2020, reported claim frequency remains near the lowest levels observed for the composite over the past three plus decades (see Figure 2). The recent reduction in frequency was most likely attributable to the COVID pandemic’s impact on the LPL industry. Temporary court closures in 2020 and other delays surrounding the litigation and discovery process produced fewer opportunities for liability claims to occur, most directly impacting the 2020 and 2021 coverage years.
Figure 2: Reported claim frequency, relative to 1988
While actuaries typically measure frequency as claim counts relative to the number of insured attorneys, ultimately it is premium dollars that must pay these claims. Thus it is relevant for insurers to consider frequency as claim counts relative to premium. Measured on this basis, we see that LPL frequency per $1 million of gross earned premium reached its lowest point for the composite in 2005 (see Figure 2). Reported frequency subsequently increased through 2008, driven in large part by an influx of real estate claims. Frequency since 2008 has fallen 20%, as real estate claims for most writers have declined to levels at or below the period preceding the financial crisis. A growing portion of claims in recent years stem from estate, probate, trust, and wills areas of practice. We suspect this trend will continue in the near term considering that underlying transactions are expected to increase due to the aging baby boomer generation.
Gross paid loss severity for the composite was noticeably higher in 2020 and 2021, resulting in an average annual severity trend rate of 8% since 2016, which has far outpaced the composite’s long-term trend of 3% (see Figure 3). While data can be thin and volatile when reviewing individual company results, rising claim costs do not appear to be driven by just a single carrier or state. More than half of the companies in our composite have experienced severity increases in at least four of the past five calendar years, mirroring the composite’s aggregate results.
Figure 3: Gross paid loss severity, relative to 1997
Overall operating results
The composite posted strong operating results in 2020 and 2021, which are among the strongest results going back two plus decades. However, a deeper dive found that reserve releases, a long-recurring source of profitability, appear to be weakening and could lead to reduced future underwriting gains or potentially to underwriting losses.
The story of reserve releases begins with initial perceptions of report year losses and loss adjustment expenses (LAE). Between 2015 and 2019, each report year’s initial net ultimate loss and LAE ratio was consistently pegged at approximately 80% (see Figure 4). The initial net loss and LAE ratio for the 2020 coverage year, however, improved significantly to 74% on a similar volume of premium. The ratio was not a byproduct of a larger writer’s influence on the composite, as three-quarters of the LPL specialty writers reported an initial coverage year net loss and LAE ratio for 2020 that was better than 2019. The initial net loss and LAE ratio for the 2021 coverage year improved yet another point to 73%.
We suspect the main driver behind the recent reductions in initial loss and LAE ratios is reduced claim frequency, which we largely attribute to COVID-related slowdowns as previously discussed. However, we find it interesting that the initial booked ratio for coverage year 2021 is lower than the corresponding measure for coverage year 2020, considering both frequency and severity measures have increased in 2021.
Figure 4: Net loss and LAE ratios by report year and calendar year
Figure 4 also displays the calendar year net loss and LAE ratio, which adjusts the initial report year ratio for reserve development on prior report years. The area between these two lines thus represents the composite’s reserve releases, which have shrunk from 25% of net earned premium in 2015 to 16% in 2021. The reduced reserve releases in recent years is likely attributable to higher-than-expected claim severity. Instability in reserve development is commonplace in long-tailed professional liability lines of business that are characterized by low frequency and high severity, especially when unexpected changes in claim frequency or severity occur. It is therefore important to recognize that a history of favorable calendar year reserve development does not necessarily imply that current reserves will run off favorably.
If starting the 2020 and 2021 coverage years at lower loss and LAE ratios is pandemic-influenced (with no material changes to the estimating principles and with COVID’s impact on these coverage years playing out as predicted), then these years may produce some measure of reserve run-off in the future. In any event, the composite’s lower initial loss and LAE ratios for 2020 and 2021 will put a ceiling on any potential future reserve releases stemming from these coverage years. Combined with declining reserve releases in recent years, we may soon see pressure on the composite’s future underwriting results.
The composite’s 2021 combined ratio of 95% is three-points higher than 2020, marking the ninth consecutive year below 100%. Decomposing the combined ratio into its loss and expense components, we note a calendar year loss and LAE ratio (see Figure 4) that also rose three points over 2020 to 57%. For much of the past decade, the calendar year loss and LAE ratio has remained under 60%, which is 20 points below the heights of the financial crash 10 to 15 years ago. LAE contributed two of the three points of deterioration in 2021, and over two-thirds of the LPL specialty writers have experienced mounting LAE ratios since 2015.
Underwriting expenses reached an all-time high in 2021. Relative to net written premium, the composite’s underwriting expense ratio rose one point from 2020 to 31% and has swiftly climbed from 24% in 2015. General expenses (specifically people costs) are the principal cause, even in the face of travel cutbacks during the past two years. About 7% of net earned premium was returned by the composite as policyholder dividends, which is one point below 2020 and remains in-line with the composite’s long-term average.
Figure 5 breaks down the combined ratio into its operating ratio and investment gain ratio elements. Investment gains were 25% in 2021, representing a 10-point gain from 2015 and remaining above results for any year since 2001. As expected, realized capital gains were the primary driver in 2021 since many assets in the capital markets sold for amounts greater than their carried values. 2021 produced a slight improvement in the operating ratio.
Figure 5: Combined, operating, and investment gain ratios
It is interesting to note the operating ratios for the composite were well below 100% during, and in the years directly following, the 2007-2008 financial crisis (i.e., subprime mortgage crisis). The real estate area of practice largely contributed to the poor underwriting results in these years, but even with the significant downturn in the markets at the time, the composite was able to post profitable results (i.e., operating ratios below 100%).
Capitalization
The composite’s profitable operating results in 2021 boosted surplus by 7% year over year. The higher tide lifted most boats, as more than 80% of the composite companies reported surplus growth for the year. While the overall 7% increase is consistent with the significant gains made in the years since the financial crash, it should be framed in a broader context. To do so, consider the risk-based capital (RBC) ratio. This metric compares a company’s surplus to the minimum amount needed from a regulatory perspective (i.e., authorized control level risk-based capital). From a practical perspective, companies typically hold capital well in excess of this regulatory minimum.
The aggregate RBC ratio for the composite was over 1,400% in 2021, which is unchanged from 2020 after having trended upward each year since 2008 (see Figure 6). While not all RBC inputs are publicly available, for the composite companies we estimated each risk component of the RBC calculation and noted the flattening of the ratio for 2021 was driven by a 21% increase in equity risk. This is likely attributable to the decreasing portion of the composite’s invested assets that are held as bonds. Our estimates suggest that three-quarters of companies in the composite reported increases in the equity risk portion of the RBC calculation.
Figure 6: Aggregate risk-based capital ratio
Looking ahead
It should be recognized that the small to mid-sized LPL industry has historically depended on reserve releases for its favorable operating results. Without favorable reserve development, operating results would have been roughly breakeven in most years. The potential for future reserve releases may be limited by the strong headwinds of lower booked ultimate loss and LAE ratios in recent coverage years and increased claim severities and expenses. Rising LAE costs may require comprehensive mitigation tactics like the medical professional liability industry has implemented in recent years. Rising underwriting expenses may prove to be more difficult to temper given current inflationary pressures on general expenses along with some amount of return in business travel.
At the same time, we continue to observe many of the small to mid-sized LPL specialty writers taking rate action even in the face of increased competition from carriers looking to expand their footprints outside of traditional target markets. In certain locales, the combination of aging/retiring lawyers and fewer law school graduates entering private practice is creating an additional burden on top-line results. Companies are paying increased attention to rating factors, with the estate, probate, trust, and wills areas of practice being a noteworthy example. These rate actions, combined with enhanced underwriting discipline, can be expected to offset, at least partially, the potential for adverse results from diminished future reserve releases.
So, while underwriting results may weaken in the near term, we suspect the small to mid-sized LPL industry will remain profitable, though likely to a lesser degree than experienced recently.