2003 Canadian Insurance Congress: Finding Direction

The future stability and prosperity of the Canadian property and casualty insurance industry can only lie in the direction of substantial improvements in underwriting and getting the pricing of covers right, says Paul Kovacs, chief economist of the Insurance Bureau of Canada (IBC). Although insurers’ financial returns for 2002 show a modest improvement in the combined ratio, the decline in investment returns saw an overall 22% drop in total investment performance, resulting in the industry posting its worst ever year in return on equity of 1.6%, he adds.

Kovacs was joined by Jeff Rubin, chief economist of CIBC World Markets, in providing an economic and investment outlook on what insurers can expect in the year ahead. The investment environment is unlikely to improve on either interest-bearing or equity instruments through the remainder of this year into 2004, comments Rubin. Although, in measuring the two mainstream avenues of investment, economic circumstances will likely favor bonds, he adds.

Listed companies were producing higher profits and therefore higher shareholder returns in 1997 than compared with corporate profitability of today, Rubin says. And, he notes, if the energy-based companies are stripped out from the financial performance of stocks, then the core earnings growth of listed companies over the past year has been about 7% – vastly inadequate of the 15% ROE target of shareholders. And, looking at the broad economic landscape, corporate earnings growth is likely to remain weak to flat into next year, he predicts.

The biggest influence on the performance of equities and interest-bearing investments in Canada is economic developments in the U.S., Rubin observes. This, he notes, is due to the high level of trade and commerce between the two countries. Notably, consumer spending in the U.S. today is about 10% less than in 2001, while the country has lost around 1.5 million jobs since the end of the last recession, he notes. “By this time next year, we can expect the U.S. jobless rate to almost double to about 6%-7%.” As such, the current economic downturn is turning into the most protracted downward economic cycle to date, Rubin says.

Coupled with the above factors, the interest investment environment faces a unique difficulty in that the U.S. is currently in its first “deflationary cycle” outside of a post-war era. As a result, interest rates in the U.S. will likely continue to trend downward, Rubin predicts, which will place pressure on the Bank of Canada to follow in line. Already, economic growth in Canada has slowed to about 2% in annual gross domestic product, and this is not likely to improve for the next couple of quarters, he notes.

Kovacs confirms that the deterioration in interest returns has had a greater negative impact on insurers’ investment returns than the decline in equity prices. In fact, he points out that the industry’s investment income performance is currently on par with that of the 1960s. Interest rates have been declining for years, he notes, and insurers have not been able to get their underwriting in line with the drop in rates. “There’s no sense that we’re [as an industry] are going to see higher [investment] returns [in the near future]. Which means that we have to get our underwriting performance back to where it was in the 1960s.”

And, while a general reduction in interest rates would boost the capital value of bonds held by insurers, Kovacs notes that the industry’s biggest problem is lack of income. “The industry has a small capital problem, and a very big income problem.” Although, he did express concern over the significant jump in adverse reserve developments during 2002, which saw insurers collectively make reserve adjustments of about $750 million. Much of the problem remains with auto, Kovacs says, and getting reserving right in this area of the business is proving to be one of the biggest challenges facing the industry. This is clearly draining both capital and income from the industry, he adds. “Interest rates are going down, and the combined ratio remains up – we simply cannot sustain this.”

CAPITAL DIRECTION

“The hard market will last until we can attract capital, and this is only going to happen once [industry] earnings start growing,” says Claude Dussault, president of ING Canada. Dussault partook in an industry CEO panel that examined business challenges facing insurers. And, he adds, “this time, we really are facing challenging times. We’re being squeezed from both sides, shareholders and consumers. The capital shortage is a new issue for the industry, and it’s unlikely that fresh capital will come into this market.”

Notably, Dussault says it will be interesting to note investment interest in the upcoming initial paper offering (IPO) of the Fairfax group’s plans to list its Canadian insurance operations under a new entity, Northbridge Financial Corp. “This will be interesting to watch in terms of whether there is [investor] interest to put new capital in the [insurance] industry.”

Rick Evans, the CEO of Liberty Mutual Group, notes that attracting new capital into the primary insurance industry will require more than just a temporary recovery – investors will be looking for predictability in earnings. Consistent returns on par with investor expectations will see a return of capital to the industry which in turn will signal the end of the hard market, predicts.

The current capital and earnings pressures on primary insurers will likely see two trends occur, says Dussault. “I think companies will begin to focus resources in areas where they can make money – in other words, there will be a shift of business.” Secondly, the industry is likely to experience consolidation due to capital pressures. The future is going to be about “intelligent capital use”, he notes. Those companies that apply capital in a way that generates returns will attract capital enabling future growth. As such, Dussault expects a higher concentration of business being held by fewer companies in the various markets, “which will create a more rationale marketplace”.

From a reinsurance perspective, one of the greater concerns facing the industry is “recoverability”, comments Gerry Wolfe, chief agent for Canada at GeneralCologne Re. “There’s no question that [reinsurer] company downgrades by rating agencies [over the past year] has increased the question of recoverability. If you’re writing short-tail business [as a primary insurer], then there is less emphasis [on whether reinsurance can be recovered]. But, the question is, how do you place business where a loss may emerge 10 to 15 years from now – which [reinsurance] companies will still be around?”

In addition, Wolfe points out that recoverability in terms of whether a reinsurer can pay or not is not the only concern – there is also the issue of increased reluctance by reinsurance companies to pick up the bill as they in turn come under earnings pressure. And, in looking to developments in the U.S., reserve adequacy in the reinsurance ranks has also become a “red flag”. “None of these issues have yet become a problem in Canada, but I think they are on the ‘radar screen’. The question is, what is happening in Canada?”

Looking at market conditions in the Canadian reinsurance sector, Wolfe believes that the property market has stabilized in terms of pricing. The greatest concern lies on the liability side of the business, he adds, with auto loss exposure being at the top of the list. “I think Ontario auto will continue to be a [loss] problem despite product reform.”

Also, he notes that, while the reinsurance sector managed to reduce its combined ratio to 110% for 2002, which fell from 2001’s 119% ratio, reinsurers are still running at unacceptable underwriting losses, which for last year totaled $226 million (2001: $302 million loss). “There’s a new commitment [among reinsurers] to address the profitability issue. I think there has to be a lot more resolve on our target margins, which we should be looking at a combined ratio of about 95%.”

Bruce Perry, senior vice president at Partner Re Canada, who was an attendee at the congress, concurs that getting the reinsurance combined ratio to below a 100% is critical. “I think this is a realistic goal [getting the combined ratio down], 2003 should go well for reinsurers – unless there is a major catastrophe loss.” While the reduction in market capacity as a result of company exits, such as Gerling Re and most recently the announcement by Hart Re of its global withdrawal, does not bode well for the healthy state of the reinsurance sector, Perry does not believe that there is a capacity shortage on the reinsurance end in Canada. “Hart Re had been downsizing [its book of business] for about a year, so the impact will be minor.” Perry does, however, expect to see the current capital growth restraints on companies resulting in greater concentration of business with the top five reinsurance companies. Another factor influencing the placement of business is the financial ratings of companies, he notes. “The marketshare of the top five reinsurers has been increasing over recent years. I don’t see this [trend] reversing.”

AUTO CRISIS

“From my perspective, I think we have as an industry our own SARS problem, being ‘severe auto reserve syndrome,” comments Bob Cooke, senior vice president at State Farm Insurance Co. and chairman of the IBC. The Pilot Insurance Co. situation, which recently saw senior management members axed due to the discovery of a reserve deficiency totaling about $195 million, is a “situation that surprised everyone”, Cooke says. In this respect, he points out that “getting a handle on” accident benefit (AB) and specifically bodily injury (BI) claims within the auto line is proving to be extremely difficult for insurers. “I think that there are companies that are going to have to make reserve adjustments [for auto business],” he predicts.

Referring to the various legislative auto product reform initiatives underway among many of the provinces, Evans notes that the future direction of auto will depend on “continual stages of reform”. The price increases introduced by insurers on auto over the past year have made politicians nervous, he adds, and additional actions have to be taken to avert public confrontation.

Cooke also points out that the current actions of insurers to shun auto in the standard marketplace, which has resulted in an unprecedented growth rate in the Facility Association’s (FA) business over the past year, is costing in the industry in capital. “We all need to recognize that it’s the industry’s capital in the FA – there is a capital cost. The last eight months has seen an increase in the FA’s volume of about four to five times.”

As a result, Cooke believes that the only solution to the auto cost crises is for the industry to convince regulators to allow for a more basic product in terms of benefits. “We’re in an era where we are going to have to move to a more basic personal lines [auto] product.” This view was supported by Dussault, who points out that regulators need to look at what are the minimum benefits of coverage expected from the auto product, and then allow insurers to compete on offering optional features. “This is what competition is all about.”

With regard to the Ontario auto marketplace, Dussault notes that exiting the business is not optional for the major players – due to the market’s sheer size in premiums and committed capital. “Ontario is not an ‘in and out’ possibility.” Re-entry is extremely difficult after having exited the marketplace, he adds.

Evans, however, shares a more upbeat perspective of the future of the auto market in general, noting that much of the pricing problems relate to the 2000 and 2001 accident years. Subsequent pricing adjustments have made the marketplace more stable, he suggests, while most companies have made the necessary reserving adjustments for the years in question. “I don’t think there are going to be any huge surprises coming through adverse reserving because the results are improving.”

B.C. COMPETITION

Gary Collins, the minister of finance at the British Columbia government, says legislation will soon be enacted that will “lift the barriers” on competition within the province’s optional auto insurance market. In line with its election promise to boost competition in auto insurance, the new Liberal Party government will also eventually look at shifting some of the basic auto components (crown insurer, the Insurance Corp. of British Columbia (ICBC) currently holds a monopoly over mandatory, basic auto insurance) into the optional market, he adds.

While the B.C. government’s reforms are yet to be made official, there are some definite changes in the offing, comments Lindsay Olson, vice president of the Pacific Region at the IBC. The first initiative is the establishment of an independent regulator to monitor ICBC’s activities on the basic auto side, which should eliminate any potential for cross-subsidization on business through the optional marketplace, she notes. This should ensure for a more level playing-field between the crown insurer and private insurers competing in the optional market.

The IBC is also pushing the government to gain access to motor vehicle records, the data of which is currently collected by ICBC. “Insurers need to have access to the data that is at the core of our ability to accurately determine appropriate pricing levels.” Another issue which the IBC is pushing for is to have ICBC issue policyholder documents, and to have the crown insurer regulated similarly to other insurers under the same legislation. At present, ICBC operates mainly under the province’s Insurance Motor Vehicle Act, while private insurers operate under the much outdated Insurance Act. “Revamping the legal framework around auto insurance must be a critical component of auto insurance reform…We [private insurers] would like to see a clear declaration from this government. What is their ultimate vision for auto insurance in B.C.?” Olson says.

There are indeed positive signs that the B.C. government wants to increase competition in the auto line, observes Cooke. A recent private meeting held between insurers and the government suggests that the latter is interested in encouraging open competition in steps, with the optional auto market being the initial offering, he adds. “But, there is still the problem that ICBC is not required to meet the same capital regulatory requirements [as private insurers]. The cost to insurers in setting up an auto operation is expensive from a capital perspective.”