9 OPINIONS: A Crash Course In Investment

In July 2008, Canadian Underwriter canvassed a number of reinsurers and asked for their opinions about what differentiated the soft market occurring now in Canada with soft markets in previous times. The answers noted pricing decreases in the country’s reinsurance market tended not to be as sharp as rate decreases in the primary side. There was some discussion about how Canadian reinsurers were being more careful than in the past because they were not achieving the same favourable investment returns in today’s soft market as they had in the past.

One financial quarter after that article, the United States economy is in a state of collapse, the globe’s largest insurer is now primarily owned by the U. S. government, and nobody’s investments seem safe because of their potential links to subprime mortgage investment losses.

And so it’s hardly surprising that Canadian reinsurance CEOs in November have their eyes fixed on the future — and their investments — in light of the volatile financial markets.

All bets are off as to how the turmoil will affect reinsurers’ capital. But in the meantime, losses are piling high in the auto insurance market, and the market meltdown seems destined to magnify reinsurers’ long-tail auto losses going forward. The need to address the issues in the auto product is paramount, reinsurers say.

These reflections and observations are based on our annual survey of reinsurance company executives. This year, reinsurers were asked to choose their single most important issue facing Canada’s reinsurance industry today. We have reproduced the answers of nine senior executives here in alphabetical order.

1 Francis Blumberg, Head of Canadian Operations, Chief Agent, PartnerRe

In the casualty business, both the incidence and severity of claims vary significantly. It often takes a long time for the true extent of claims to emerge. For this reason, Canadian insurers have been seeking and finding protection in the reinsurance market for many years.

Today’s financial market turmoil creates additional implications for long-tail lines of business such as casualty. Indeed, even a small increase in inflationcan generate a significant increase in the cost of an excess of loss reinsurance program. Inflation creates a compounding effect, disproportionately increasing the cost of the reinsured part of a claim. Taken together with increasing legal costs and the rise in motor casualty awards, the price of casualty covers quickly spiral.

Although predictions are tricky these days, financially strong reinsurers seem to be weathering the current storm; they should continue to have capital to respond to an increasing demand for casualty reinsurance. That said, I would expect them to have less tolerance for under-priced business than in previous years.

2 Christophe Colle, Branch Director, Chief Agent, XL Re America Inc. Canada Branch

The Canadian insurance market that reinsurers service is experiencing a sharp reduction in profitability due to increases in loss frequency and severity, increases in expenses and a decrease in investment income coupled with increases in property and casualty exposures. We are seeing significant increases in recent years in property values and construction costs. Also we are witnessing larger casualty claims, due in part to recent benchmark court decisions related to future care costs and increased frequency of large automobile claims. For the reinsurer, these loss and exposure increases are magnified because of the reinsurer’s role as the risk carrier of peak losses.

The recent financial market disruptions have not only reduced investment incomes. It has also shrunk the liquidity available in the marketplace, leading to both less capital flexibility as well as a higher cost of capital.

Underlying all of these dynamics is the reinsurance buyers’ overriding concern about reinsurance security and the increased value for Canadian licensed reinsurance paper. It is becoming more relevant across all lines of business, across all the programs — especially on top catastrophic layers, where the capacity purchased is a significant portion of the buyers’ equity and surplus.

The Canadian licensed capacity remains more than sufficient to meet the demand. Yet the risk-adjusted cost of exposures ceded to reinsurance has continued to increase, as has the cost of the capital allocated to cover them.

3 Carol Desbiens, Chief Operating Officer, Chief Agent, Paris Re

There are currently several deficiencies in the Ontario’s automobile insurance system; together, they represent a serious threat to market affordability and stability. In particular, the underlying inflationary pressures affecting Accident Benefits have caused a dramatic deterioration in results as indicated in Table 1, on page 38.

While from the perspective of the customer and insurance companies, the current situation is worrisome, the excess of loss reinsurer might find it financially unbearable.

The problem reinsurers face is the leveraged effect of inflation. For losses reinsured over a fixed retention, inflation will increase both the severity of losses that already exceed the retention and the frequency of claims, by actually creating new excess of losses that were previously below the retention. As such, the expected excess of loss payment increases proportionally much more than indicated by the general rate of inflation, thereby eroding the excess carrier’s position.

As the retention increases, the effect on losses exceeding the retention will increase without limit. This phenomenon is without any doubt one of the most serious problems facing any carrier writing long tail business over fixed retentions.

We all look forward to a series of major reforms aiming at improving the auto-mobile insurance system in Ontario. In the meantime, we need to find a fair balance between the insurers and reinsurers by either adjusting upward the reinsurance premiums or increasing the retention level to reflect the additional burden on reinsurers’ shoulders.

Because of the weight Ontario automobiles carry in most casualty programs, we would anticipate a moderate rate increase for the 2009 renewals.

4 Andre Fredette, Senior Vice President, General Manager, CCR Canada

Given the current upheaval in financial markets, it is hard to see what new surprises will hit us in the near future. However, if I had to identify two persistent challenges, the following would be my choice. Looking at Table 2 below, you will see what probably is the most significant challenge for Canadian-based reinsurers.

For the past five years, local reinsurers’ net written premiums in Canada have been dropping due to a number of reasons. Market consolidation has reduced the number of insurance companies. This happens because, after mergers and acquisitions, the resultant company is bigger and requires less reinsurance. Also, following four good years, companies’ capital bases are healthy. Consequently, they have decided to retain more of the risks themselves through reductions or cancellations of proportional treaties and retention of lower-layer excess treaties. Unless there is a paradigm shift or tremendous erosion of companies’ capital bases, this trend is unlikely to reverse itself in the near future.

A second challenge that faces reinsurers is the performance of auto excess treaties. This class stubbornly continues to be unprofitable for most reinsurers. The issue that surrounds this class is that companies are still too slow to recognize the size of their ultimate accident benefit (AB) claims in serious losses. This leads to inaccurate presentations on reinsurance submissions and ultimately losses for the reinsurers that relied on the submitted data. This has led to a greater reluctance among reinsurers to write this class of business. Since auto represents close to 50% of Canadian property and casualty insur ance premium, a solution to the AB claims issue remains a major challenge for everyone.

5 Jean-Jacques Henchoz, President and CEO, Swiss Reinsurance Company Canada

The Canadian reinsurance marketplace will clearly be affected by the global financial market turmoil, since the industry will face higher cost of capital and see the withdrawal of leveraged capital. This year’s relatively active catastrophe season will also act as a reminder that natural disasters continue to rise in frequency and severity.

Due to competitive pressure, as well as higher windstorm and water- related losses, primary property and casualty insurers experienced a deterioration of underwriting margins in 2008. Combined ratios worsened towards the high nineties and return on equity (ROE) values fell significantly. Balance sheets remain strong, but costs are managed carefully and reinsurance budgets have probably not increased.

In this market environment, there will likely be little pressure to further reduce reinsurance rates as we enter 2009. A continuous focus on disciplined underwriting and effective capital management remains the most appropriate approach to support the long-term sustainability and future viability of the Canadian reinsurance marketplace.

6 Caroline Kane, Senior Vice President, Chief Agent in Canada, The Toa Reinsurance Company of America

The most important issues facing Canadian reinsurers in 2009 are to maintain underwriting discipline and preserve capital.

Most auto reinsurance is placed on an excess of loss basis; although reinsurers are removed from the frequency of smaller losses, we have witnessed a general deterioration of larger catastrophic claims. This, combined with inflation, will continue to affect reinsurers’ experience negatively.

Primary commercial property and some casualty lines are also deteriorating as soft pricing continues and claims activity increases. Again, since most reinsurance is placed on an excess of loss basis, reinsurers suffer a double whammy vis-a-vis pricing for the exposure, since reduced reinsurance rates are applied to a lower subject premium base.

Despite excess capital in the Canadian market, the need for reinsurers to maintain underwriting discipline is further reinforced by the current turmoil in the financial sector from which Canada is not immune. Capital needs have increased and will continue to do so with respect to underwriting and investment risk.

In general, reinsurers have exercised more underwriting discipline than the primary market over the last few years. Having said this, we cannot ignore mistakes of the past — i. e. the period during 1999 to 2001, when reinsurers offered two-to three-year treaty contracts at the bottom of the cycle. It is true we have seen available reinsurance premiums in the Canadian market shrink dramatically, perhaps temporarily. But if we repeat the sins of the past, then perhaps maintaining underwriting discipline on Canadian reinsurance business and the preservation of capital in Canada will be decisions made elsewhere in the future.

7 Cam MacDonald, Regional Vice President, Transatlantic Reinsurance Company

Recent economic and financial market turmoil, coupled with an abundance of available capacity and competitive trading conditions, has led to a drop in premium for the Canadian reinsurance market. This trend will likely continue into 2009.

In an effort to maintain top line premium and reduce expenses, some primary companies are again rationalizing their reinsurance requirements. Changes in buying patterns and the ongoing consolidation of the primary market have meant less business for reinsurers.

As we move toward the treaty renewal season, the combination of achieving significant growth while maintaining adequate profit margins will be difficult for reinsurers.

However, despite these turbulent times, the reinsurance market has made a concerted effort to maintain underwriting integrity and rate adequacy; as net income and return on equity continue to fall, these disciplines will be in even greater demand.

8 G. S. (Steve) Smith, President and CEO, Farmers Mutual Reinsurance Plan Inc.

When asked to give my “top issues” facing Canadian reinsurers, two issues immediately come to mind.

In the wake of the current financial and investment chaos happening south of the border, the impact of the fallout will certainly be felt throughout the insurance and reinsurance sectors, affecting both income and capacity. The extent and full effect is still yet to fully realized.

The second issue is the Ontario auto loss trends during the past 12 to 18 months. This dramatic change in loss severity represents direct exposure to reinsurers, since losses are escalating well in excess of primary retentions.

The issues here are multi-fold. They include:

• Historically inadequate primary rating in this continuous soft market;

• significant decision from the courts that have increased exposure not only on new claims, but, more importantly, on many existing claims that will be subject to significant reserve adjustments.

Pricing consideration at both the primary and reinsurance level will be critical over the next year to offset these developments.

9 Matt Spensieri, Chief Agent for Canada, General Reinsurance Corporation

If anyone in our industry has not heard of the “global credit crisis,” they must just be awakening from a very long slumber. The extent to which it will affect our economy, industry or each one of us as individual consumers is a big unknown.

Some insurers and reinsurers have declared and/or identified exposure to — or losses from — risks or investments they have on their books. It is uncertain whether all of this has been fully captured, or whether more exists within our industry. Financial markets are in jeopardy around the globe. Investors, hedge funds, pension plans have all lost millions/billions of dollars. We have already witnessed the near collapse of one of the largest insurers in the world. Six months ago, few would have recognized this as a possibility. One outcome is the potential dissection and sale of parts of this company. Will anyone be interested in or capable of buying? The “crisis” has virtually dried up the ability to raise capital or it has become onerously expensive.

For the moment, we are unlikely to see many new start-up reinsurers in tax-advantaged jurisdictions. Will some markets look to alter their portfolio or risk selection, fearing their inability to replenish capital should a major loss — or losses — occur?

Although no one is predicting significant price increases within the Canadian insurance/reinsurance market, we are likely going to see increased caution and discipline. I think we will see greater scrutiny of the operations and balance sheets of those companies assuming risk.