The U.S. Senate failed to pass legislation Feb 28 that would avert devastating cuts to the federal spending budget, which are almost certain to affect insurers writing coverage for government contractors. Competing bills proposed by Senate Democrats and Republicans did not gain enough traction to head off more than $85 billion in across-the-board cuts to government spending.
Barring a last-minute deal, the cuts will be spread across the entire federal government, putting contractors of all stripes in line for a significant drop in revenue. The hit could force many to impose layoffs and furloughs, raising the risk that they will see an uptick in bogus workers' compensation claims and efforts by employees to steal trade information or hard assets as they are forced out of their jobs, said Michal Gnatek, who leads Lockton Cos.' aerospace and defence practice.
The increased risk could be passed along to insurers writing policies for contractors that cover workers' compensation, directors and officers liability and employment practices liabilities claims, Gnatek said.
Gnatek, who recently published a white paper on the potential effects of the sequester on the insurance industry, said for months, government contractors remained confident congressional Republicans would strike a deal with the White House and Democrats to avoid the sequester. That's no longer the case, he said.
"Government contractors don't like to be surprised, and they have known for months this was a possibility," Gnatek said. "Many have built the increased risk into their budgets. But we have been working with them to ensure they were taking the right steps to minimize the potential impact in case Congress didn't reach a deal."
The Republican proposal would have left the cuts in place but would have given President Obama the more flexibility to decide how they were implemented. The GOP bill fell on a 62-38 vote, with all but two Democrats rejecting the proposal.
Likewise, lawmakers also rejected the proposal from Democrats to replace across-the-board cuts with a combination of cuts and tax increases. The Democrats' bill lost on a 51-49 vote that saw some Democrats up for re-election in 2014 side with Republicans to block it. Under Senate rules, a bill needs 60 votes to ensure it will not be held up by a filibuster.
With Congress set to leave Washington for the weekend after the March 1 session, it is unlikely lawmakers will reach a deal to avert, or at least soften the impact of, the sequester. The sequester, which goes into effect on March 1, is a legislative term for the intentionally painful automatic spending cuts Congress imposed on itself after a bipartisan "Supercommittee" failed to reach a deficit reduction deal during the 2011 fight over raising the federal debt ceiling. In January, Congress delayed the sequester by two months as part of a deal to avoid going over the so-called fiscal cliff.
Lockton and other insurance brokers have advised government contractor clients to approach the sequester as a massive layoff. Gnatek said that has meant ensuring the proper notices are ready to send out to comply with federal and state labor laws and bolstering security systems to ward off crimes committed by employees. Anytime you have a large number of employees who are losing their jobs, the potential for employee fraud goes up, Gnatek said.
"Contractors need to manage their risk by keeping an eye on their employees, watching for fraudulent or misleading workers' comp claims before they are furloughed or laid off," Gnatek said. Employers need to watch for employees stealing hard assets like cash or equipment on their way out. Contractors also need to be wary of employees taking "soft assets" like trade secrets from the company that could be of interest to competitors, he said.
There is also the possibility that contractors will face a new onslaught of cyber attacks from outside the United States as foreign competitors watch U.S. contractors hand pink slips to security personnel.
"Foreign hackers may recognize that there will be fewer people watching security systems and see that as an opportunity to get at trade secrets. The people who are watching the systems may not have the experience necessary to keep hackers out," Gnatek said. "We're strong proponents of cyber protection at Lockton."
Gnatek said he has been working under the assumption that contractors will suffer a 6% and 10% reduction in revenue stemming from the sequester. The drop in revenue combined with massive layoffs could spark a wave of lawsuits filed by former employees and shareholders, Gnatek said.
"Shareholder litigation would drive an increase in [directors and officers] claims," he said. "I'd almost guarantee that will happen with the plaintiffs bar. They will say companies failed to properly plan for something they knew was coming."
Employment practices liability insurers may also see an increase an increase in class-action lawsuits arguing that layoffs could have been avoided.
Gnatek said it may take months for contractors and insurers to gauge the impact of these risks. "It's going to be a slow-burn situation." The sequester could also affect insurance brokers themselves, he added.
The federal government began pressing contractors to cut costs prior to the sequester. Many contractors have targeted arrangements with brokers for reduced spending as they work to submit "lowest price that is technically acceptable" bids for government work, Gnatek said, He said Lockton "was not sure" what the sequester may mean for its business.
The sequester is not the only fiscal challenge facing Congress in March, he added. Outgoing Treasury Secretary Timothy Geithner has said publically the country will run into the cap on federal borrowing authority around the middle of the month. At the same time, Congress still has not passed a budget. Without a budget or continuing resolution, the federal government may shut down this month, Gnatek said.
"A government shutdown would mean lost revenue that contractors could never recoup," Gnatek said.