Cutting to the fat

For those who felt the market conditions of 1999 were worth a good cry over a beer, the year ahead is likely to be a very sober occasion, analysts warn.

Results for property and casualty insurers for the final quarter of 1999 are expected to mirror the poor performance delivered for the first half of the year. “The writing is definitely on the wall,” comments one analyst with reference to what probably lies ahead for 2000. Even if the industry manages to pull a broad market rate increase from its hat at this late stage (an unlikely event), the impact would not be felt until the early returns of 2001 due to the annual cycle of the business. And, with the investment side of operations producing little support to underwriting, with this trend likely continuing into 2000, management of companies are going to have to deal with the ticklish issue of cost reduction, the analysts predict.

The Canadian industry has slipped into a ROE trough of 6% to 7%, which based on current and expected business conditions, will remain unchanged in 2000. Unfortunately, shareholders and global head-offices are likely to take a peevish view of this prospect having already endured a sickly 1999 return on their Canadian investments. As such, company CEOs will have to adopt pragmatic actions next year to stave off impatient demands. And, the analysts note, the only room to really maneuver is on the expense ratio.

With the combined ratio for the first six months of this year at 105% (which is lower than for the same period for 1998, but does not reflect the cost of the ice storm), the industry has seen a general rise in both underwriting losses as well as its operating expenses. While there may be moderate room for correction on claim costs (which Paul Kovacs of the IBC expects will happen on a selective basis), the area more likely to yield a significant improvement lies with overhead. According to A.M. Best Canada statistics, less than a third of companies are currently operating on expense ratios of 27% or lower (which includes brokerage commission), a ballpark figure which the rating agency believes Canadian insurers should be targeting. Most companies, however, are operating at expense ratios of around 33%, of which brokerage commissions comprise on average for 14.5%.

As such, getting to the bottom of the expense issue will mean some serious negotiating by insurers with brokers to reduce the commission portion of costs, observes Joel Baker, general manager of A.M. Best Canada. “Companies will have to rein in expenses next year, which will mean putting pressure on brokers to renegotiate commission rates lower,” he says. The problem, however, is that brokers are not expected to react to such requests with hearty enthusiasm and, with the present “supply/demand” nature of the company/ broker relationship favoring brokers, it is highly unlikely that any insurer will seriously attempt to reduce commission schedules any time soon.

In addition to which, when it comes to addressing expenses, insurers have a natural tendency to point a finger at the broker, observes one company CEO. The reality is that this portion of operating costs has remained constant for several years while the expense ratio has trended upward — with 1999’s ratio likely to be the highest of the 1990s while underwriting results and profits will be among the poorest. “Laying everything at the door of the broker isn’t going to solve the cost issue or enhance operating efficiency,” he adds. What companies really need to do is cut away the layers of fat within their own organizations and apply/invest in modern technology based processing. This view is supported by Ted Belton of the Belton Report, who expects the expense ratio will become a critical competitive issue next year, with technology forming center stage. And, he notes, as the call center operators begin achieving critical market mass, the competitive target on the expense ratio will move to the lower 20% range, rather than the current high twenty-end.

The technology side is perhaps the one positive aspect of the overall cost debate, both Baker and Kovacs agree. Their point being that the heftyY2K upgrade costs incurred over the past two years will have washed through the system by next year. “With Y2K having been dealt with, technology won’t be a big cost concern during 2000. Although Internet investment will eventually become a necessity of doing business, it’s unlikely to gain serious momentum next year,” says Baker. That said, companies and brokers alike still have to face up to the issue of enhancing efficiency, and the little breathing space gained from getting past the Y2K hurdle should be used to focus operations rather than sitting back.