Adverse Developments

Last year saw the highest number of U.S. property and casualty insurers go into liquidation or placed under regulatory supervision in the last three years, according to a report recently released by rating agency A.M. Best. Several rating agency and investment analyst reports indicate that the capital base of the U.S. insurance industry showed marked deterioration over the course of the year, mostly resulting from plummeting investment returns (the biggest decline being in realized capital gains), but also due to adverse reserve developments. Overall, insurers in the U.S. made reserve “top ups” equal to about US$20 billion during 2002, according to estimates by one analyst.

The Canadian p&c insurance industry’s financial performance during 2002, including pressure on capital, reflected many of the same ailments suffered by its southern brethren. However, the most significant difference is that the Canadian insurance industry showed modest capital growth last year, observes the Insurance Bureau of Canada’s (IBC) chief economist Paul Kovacs. “About $400 million in capital came into the [Canadian] market last year through retained earnings and capital injections. In other words, there [the industry’s capital base] was not a decline, but then it didn’t really grow either. The most significant issue is that the U.S. and European markets have shrunk [in capital over 2002].”

Kovacs points out that, compared with the last eight years that the IBC has collected industry reserve/capital data, 2002 was an “unprecedented year” in terms of adverse reserve development. Canadian insurers lost approximately $650 million to auto reserve adjustments last year, with a further $125 million absorbed by liability-related business. Most other lines of business produced a favorable reserve development last year, Kovacs notes. The net result was an overall adverse reserve development of around $750 million for 2002 (equal to nearly 10% of net written premiums/revenue) – nearly double the reserve shoring made in 2001 and a long stretch from the favorable reserve windfall exceeding $300 million for 2000.

With the vast majority of company reserving adjustments made toward the end of the calendar year, which coincides with most insurers’ financial yearends, the latest industry quarterly financial data collected by the IBC highlights the extent of the reserve adjustments made. Although the fourth quarter of 2002 points to a dramatic improvement in the industry’s underwriting performance, with the underwriting loss cut by more than half to $404 million versus the $859 million loss reported for the same period the year prior, the latest three month results also show a $2 billion year-on-year rise (21% increase) in claims costs which amounted to $5.7 billion. Notably, claims incurred in the final quarter of 2002 were $720 million higher than the third quarter’s cost of $4.9 billion. Kovacs confirms that most insurers make reserve adjustments at the end of the financial year.

In terms of the “bigger picture”, the Canadian insurance industry remains adequately capitalized, Kovacs says, with total assets of around $45 billion – although when liabilities are taken into account, the net capital base is about $20 billion. However, an alarming trend having emerged from last year’s performance is that nearly all of the 200 companies tracked by the IBC are at what Kovacs describes as “very close to the line” relative to the minimum asset test (MAT) applied by the federal regulator (MAT was replaced at the beginning of this year by the more flexible minimum capital test (MCT).

In this respect, the vast majority of the large national insurers are currently “at the line”, Kovacs notes. In contrast, insurers writing approximately 75% of all premiums in 1997 were above the “15 score level” on the MAT test (in a very healthy capital position), he adds. While the switch from MAT to MCT may provide some insurers with greater flexibility (depending on their business mix) relative to the regulatory restraint of surplus to premium, the overall impact on the industry’s capital requirements, and therefore capital adequacy, is negligible, he notes. So too, is the new discount claims reporting requirement, he adds, which in simplistic terms allows for “inflationary adjusted” reserving for future claims costs. Discounting may provide a little relief on company reserves in the year ahead, Kovacs says, “but there’s not going to be much impact on the overall loss reserving of the industry”.

There are several implications resulting from the current capital strain on the industry, Kovacs says. The first being that, when insurers see market opportunities, many now have to think of “what they can drop” in order to take on new business. Another negative factor to the industry’s current weakened capital position is the potential of unexpected catastrophe losses. “We’re [the industry] less able to take a surprise [large loss].” On a more positive note, Kovacs points out the capital abundance of 2000 and before had led to some “irregular market activities”, resulting in the broad erosion of pricing witnessed across all lines of business. “Companies weren’t very efficient in capital management, now we’re [the industry] better using what we have.”

With the industry having delivered a return on equity (ROE) of 1.6% for 2002 compared with the 3.1% reported for the year prior, the latest financial returns paint a stark picture of the damage caused by the years of the “soft market”. The numbers also highlight the challenges facing insurers, from both an income and capital standpoint, in getting their operations back on course. Ultimately, the bottom-line is not whether 2003 will be a “good year”, but rather which players will still be in the game – by choice or otherwise.