Adequacy Stakes

No one within the North American property and casualty insurance industry donned “rose tinted glasses” in their anticipation of the final financial returns for 2001. Beleaguered by a long-term worsening claims environment, plummeting investment returns, and the final blow of the September 11 terrorist attacks, most insurers were left in a state of “battle shock” by the time the bells of 2002 were ringing out.

It therefore came as no surprise upon the release of the Insurance Bureau of Canada’s (IBC) 2001 final quarter data that Canadian insurers ended last year with a sickly 3% return on equity (ROE). Notably, U.S. insurers, who were to a greater measure negatively affected by the September 11 events, are expected to end the 2001 financial year with a negative ROE. Already, on a global level, at least one insurance/reinsurance group that had carried a heavy cost from the terrorist attacks, has indicated that its majority shareholders have lost appetite for being in the risk business. The Gerling group recently announced that Deutsche Bank — a major shareholder — was looking for a buyer for its stakeholding. Is this a sign of a new consolidation phase in an industry which financial investment analysts have long regarded as being excessively competitive?

Maybe, and maybe not… However, what is of significant import from the latest Canadian numbers is the reduction in industry capital, and the impact this may have on the solvency of companies. Despite the firming in insurance pricing globally, and the attractiveness this offers existing players to stay in the business, the reduction in company capital reserves and the restrictions this places on the ability to write new business could well spark a new period of mergers and acquisitions. In this regard, raising operating capital will be particularly challenging for smaller operators.

Speaking at the recently held Swiss Reinsurance Co of Canada annual “breakfast seminar”, the IBC’s chief economist Paul Kovacs notes that nearly 60% of 82 insurers reporting their returns to the bureau had incurred an “unfavorable development” on prior year claims for 2001. This compares with only 25% of companies having reported an unfavorable development for the year before, Kovacs adds. “This is a massive, massive swing.”

Specifically, Canadian insurers had, prior to 2001, benefited by an estimated $550 million a year in positive reserve developments for the previous six years, Kovacs observes. This enabled companies to realize gains and prop up their ailing financial returns. “We estimate that insurers pumped $470 million into reserves last year to account for prior year claims…The unfavorable development was not limited to any one line of business or to a small group of companies. It was evident in all four of the major lines of business, including personal and commercial property, auto and liability.”

In addition to the impact weakened prior-year claim reserving played in the industry’s financial returns for 2001, this also proved to be a significant factor behind the alarming rise in insurers failing the minimum asset test (MAT) — the number of vulnerable companies nearly doubled in 2001 compared with the previous year, according to the IBC. MAT reflects a ratio measuring the assets of an insurer according to its expected liabilities, and therefore its solvency or financial adequacy to respond to its risk exposures. As a whole, Kovacs is quick to point out that the Canadian p&c insurance industry remains well capitalized. However, he admits that the stark rise in the number of vulnerable companies does create an environment of concern.

That said, Kovacs points out the solvency position of insurers as measured by MAT takes into account many factors, including the market value of investments held. Against a background of plummeting stock values, declining interest rates and rising claims costs, he says “it was therefore not surprising to see insurers’ results on the MAT weaken in 2001”. As an aside, he adds, “in calculating the value of assets available for test purposes, insurers add to their assets the amount by which the market value of their investments exceeds the book value. Therefore, an improvement in the stock market can increase the assets available for test purposes. However, the second largest percentage decline in the TSE-300 occurred in 2001.”

In this respect, Kovacs expects that the investment strategies of companies, and the returns thereof, will have noticeable sway in determining the winners and the losers in the year ahead. But, with the investment environment remaining less than bullish, Kovacs does not believe that investment income will be the industry’s savior. “Investment performance is going to be a big issue for the industry [for 2002], …however, there is not a lot of optimism on the investment side going forward.”