Risk Management: Navigating the Fiscal Cliff

December 2012 • Lockton Companies

L O C K T O N C O M P A N I E S

NadiNe MooreProducerChicago

1.312.669.6701nmoore@lockton.com

Our elected leaders in Washington, D.C., continue to

debate how to avoid the “Fiscal Cliff,” the expirations of tax

incentives and implementation of budgetary cuts known as

sequestration. No matter the outcome of this situation, the

themes of this paper will be relevant issues for the coming

year.

For most Americans, the fiscal cliff is a sound byte that may show up in our tax bills in form of an increase in federal taxes of a few thousand dollars per year. You can turn on any news channel and hear either party’s spin on how this will impact our country, but what does falling off the cliff mean for insurance risk managers and your company?

The economic recovery in the U.S. is measured on three fundamental economic indicators: gross domestic product (GDP), job growth (via unemployment metrics) and the recovery in housing. Any solution implemented by our government may or may not solve the issues posed by all three. In fact, it is likely that each indicator will be impacted differently, and our strategies as managers in business must reflect the nuances of each item.

What does falling off the cliff

mean for insurance risk managers

and your company?

2

Gross Domestic Product (GDP)

The fi scal cliff will cause an immediate contraction in GDP via the shrinkage of output from sequestration (government spending cuts). Companies that serve the federal government will feel the most direct and immediate impact. Most people think about defense and related industries, but you need to look further to see the potential impacts. If sequestration takes effect, several broader industries will be impacted adversely. These industries include healthcare, technology (electronics and communications), chemicals, automotive, aviation and construction.

Contraction in one sector of business will impact another in the form of margin pressure and cost pressure. Margin pressure impacts infl ation; cost pressure causes job loss at worst and no hiring at best. Additionally, these pressures impact companies’ abilities to sell products globally. Finally, access to credit and the cost of credit are tied to an organization’s ability to generate a healthy profi t. It is a vicious circle that takes time to break.

For risk managers, a probable recession with deep impacts in certain sectors means cuts in spending on insurance where possible. The changes could mean higher retentions, shifts in casualty and workers’ compensation programs due to shifts in payroll and staffi ng, pressures on collateral from carriers and rate hikes for those impacted by Sandy. The

picture is not pretty, we have seen that movie before and know the ending. The problem this time is the programs are already lean. What is left to cut or improve upon? Indicator number one, GDP, will be key to follow as we move into the coming year’s renewal discussions.

Job Growth

Indicator number two is job growth; the economy has consistently shown slight job growth over the past several months. The growth in the U.S., in spite of the global economic issues in Europe, Asia and Latin America, is good news. While the American job market is absolutely inexorably tied to the global economy, we are working our way out of the last recession with jobs in new areas. This change is promising, but it will be derailed if our government does not address the cliff.

Jobs must continue to develop in all industries, including defense and technology. Many of the innovations that are leading the resurgence of American products were fi rst developed in the defense and high technology sectors serving the U.S. government. It is critical that our economy continues to grow in high-margin, high-value products for our country to continue to evolve our workforce, and provide rewarding and meaningful employment to Americans. Even if we look beyond this philosophical argument of America as innovator, we cannot ignore the

December 2012 • Lockton Companies

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numbers. Falling off the cliff will do two things to jobs. First, it will immediately increase unemployment, as many workers will be laid off. Second, it will destroy business and consumer confidence, reducing hiring, investment and spending, which will cause GDP to contract and bring on all of the issues associated with it.

As a risk manager, increases in unemployment inevitably result in increases in workers’ compensation costs because claims increase. As you try to balance the issues of GDP contraction in your program costs, you will be faced with counter pressures with increasing claims activity. These factors create a difficult balance for risk managers to strike with carriers that are more than aware of the situation.

Housing Market

The third indicator of the U.S. economy is the housing market. Growth in the housing market is the single largest driver of job growth and domestic GDP growth in our country. It takes jobs to build houses and all of the materials that comprise a home. It takes products made in the U.S. and elsewhere to fill our homes. Finally, it takes credit to make housing grow.

Part of the fiscal cliff discussions is the removal of the mortgage interest tax deduction. If this deduction is removed, housing will certainly decline. Most Americans count on that deduction when determining the size of the home (mortgage) they would like to buy. The incentive to be a society of homeowners versus home renters will be gone. If housing begins to slow again, credit will once again tighten, and we will be veering into a recession once more. It is very popular these days to decry banks and their role in the financial crisis. It is absolutely vital to have a banking sector that is healthy and profitable to support housing

growth and credit for companies and consumers. Without a prosperous financial services system, the economy grinds to a halt.

As a risk manager, pay attention to the growth and impact in housing, as it is a sound barometer for planning. Also, watch the health of our financial institutions, as it indicates their willingness to grant credit to not just organizations with perfect credit, but to the ones who really need it to grow.

As we head into 2013, keep track of this trifecta of economic indicators: GDP, job growth and housing. The options for solving the fiscal cliff impact each of these indicators in different ways. Extending the deadlines relieves the pressure now but merely delays the pain. Changing the size of our government is tricky business; it will either impact our GDP or the government’s income statement and balance sheet, or both. These indicators are all closely tied together as is the health of our financial system. As a risk manger, initiate

dialogue with your leadership today to understand your organization’s plans for these potential changes. Additionally,

it is important to engage with your professional team at Lockton to develop strategies for potential outcomes to ensure you have the right program going forward.

Happy New Year! The immediate welfare of our nation lies in the hands of our electorate; they will indeed impact how happy the coming New Year will be for America.

Growth in the housing market is the single largest driver of

job growth and domestic GDP growth in our country.

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