An Industry Divided

A gang of four insurers on Dec. 5, 2006 effectively hijacked the Facility Association (FA) board of directors by forcing through a radical restructuring plan for the Risk Sharing Pool (RSP) administered by the FA in various Canadian jurisdictions. In doing so, the recommendations of FA’s own broadly-based working committee were completely ignored.

The new RSP model would provide for 100% transfer of risk (that is with no retention of risk at the account level by the transferring insurer) and sharing of RSP results among all insurers based solely on market share and not at all on RSP usage. This compares to the current structure of 85% transfer of risk and sharing of results based 50% on market share and 50% on usage.

Risk transfers to the RSP are to be capped at 5% of underwritten exposures at the group level as opposed to the individual company level. In addition, a new set of the ‘worst-of-the-worst’ rules is proposed for the Facility Association Residual Market (FARM). These rules are designed to force so called “clean” business out of the FARM.

Subsequently, on Feb. 4, 2007, the new structure was confirmed by only six FA directors. This means less than half of the FA’s current directors are supporting the proposed new structure, and yet the proposal is to proceed to the FA membership for an ‘up-or-down’ vote. Given that the gang of (now) six insurers controls some 43.9% of the votes, one can anticipate a majority of votes – but not insurers – will be in favour of the new structure.

It now appears that the RSP – first created to provide some transitional relief to insurers, assisting them in fulfilling their ‘take-all-comers’ obligations – are now to become a significant market factor. As proposed, the pools would allow the dominant insurers to recklessly underwrite under-priced business, bypassing insurers who currently underwrite this business for their own accounts.

THE PROBLEM: A BRIEF HISTORY

The commandeered FA Board says it is preparing for “the next hard market” and must – to avoid draconian government intervention – prevent the development of another 2003-type market (during this period, much of the “clean” business went to the FARM). The politicians’ main concerns in 2003 included the very substantial premium increases faced by consumers who did not have a demonstrably bad driving record, as well as the stigma for those consumers of being relegated to the FARM. In 2003, as standard insurers’ marginal business became unprofitable, they did not use the Risk Sharing Pool, the FA Board says, because the RSP’s retention aspects on transferred risks (15% on each risk transferred and sharing of RSP results based 50% on usage) made the RSP an unattractive alternative. Standard-line insurers instead discouraged much of this business at the ‘front door’ by means that were fair and sometimes foul (i.e. by breaching ‘take-all-comers’ regulations). The FARM depopulated during 2004, when FARM rates were increased to levels generally above those of several voluntary markets.

HOW BAD WAS 2003?

FARM market share ranged from 3.2% in Alberta, to 8.0% in PEI in 2003, compared to a range of 0.3% (in Alberta), to 6.1% (in Nova Scotia) in 2006. Overall, business in the FARM in 2006 constituted just 1% of the market, not a level that causes concern for most politicians.

The critical question is this: Did the business go heavily into the FARM in 2003 because the RSP was structured incorrectly, or because of the FARM’s competitively low rates at that time? Many voluntary market insurers in 2003 found themselves losing accounts to the FARM at discounted premiums. Highly-competitive pricing is hardly what should have been expected from the so-called ‘market of last resort.’ The FA board’s time would be far better spent convincing insurance regulators to allow FA to set FARM rates above those of the voluntary markets with the highest-filed rates (i.e. the non-standard carriers). This step, on its own, would allow a competitive market for higher-risk business to function effectively and go a very long way towards preventing another market like that in 2003.

WHAT IS WRONG WITH FA’S PROPOSAL?

* The proposal is inherently unfair to the majority of consumers. As revealed in FA board meeting minutes, it absolutely depends on the overcharging of the premiums of lower-risk drivers to cover the expected deficit in the new RSP. The proposal is anti-competitive and can be expected to further consolidate the market, reducing consumer choice.

* The proposed mandatory insurer participation in and sharing of RSP results based solely on market share is underpinned by the FA Board’s assumption that the financial impact of the new RSP will (proportionally) be the same for all insurers. This simply is not true. Standard insurers not using the new RSP proportionally to other standard insurers will be inflicted with the residual losses created by the inherent under-pricing of risks ceded to the pool by the larger personal auto underwriting companies.

* Moving to a 100% transfer of risk from the current 85% means the certain loss of a measure of due diligence applied in the initial underwriting and subsequent claims handling of transferred risks. What will the insurer’s motivation be to ferret out all rating information (undisclosed drivers, actual use of vehicle, etc.) and to be thorough and firm in the handling of claims when the transferring insurer has no direct ‘skin in the game’? Many insurers can be expected to use their least experienced underwriting and claims personnel on this business. What is the estimated cost to the industry of this change?

* The cap on transfers to the RSP of 5% of exposures at the group level – as opposed to the individual company level – will open up opportunities for groups to implement nefarious marketing schemes and underwrite significant amounts of under-priced business at the expense of the industry in anticipation of some immediate or future collateral benefit to the underwriting group. What will be the cost of these marketing schemes to the industry?

* The current proposal for the FARM and RSP strongly favours large standard insurers over mid-size and smaller standard insurers. There are no proposed restrictions on the criteria used by insurers for the selection of risks to be transferred to the new RSP. Potential selection criteria include credit scores, postal codes and employment histories. The largest insurers have databases that will enable them to design selection criteria more effectively, most probably using variables that are banned for use in ‘up-front’ rating and rule-making. These large insurers can be expected to transfer relatively more loss to the RSP then they will get back in their sharing of RSP results, further destabilizing the market.

* The current proposal for the FARM and RSP favours insurers that distribute their coverages directly to consumers – particularly if such a company is a member of a larger group of insurers, and therefore able to use the RSP allocation of other group members. These insurers will accommodate previously-declined, higher-risk business by transferring those risks to the RSP at premiums below cost. This will negate by anti-competitive means the independent brokers’ traditional role of matching risk and premium. Brokers do this by using an array of available markets, a process that leads to fairer treatment for the majority of consumers.

* The proposal moves significantly away from the ‘competitive market model’, in which many insurers, writing business for their own accounts, compete within several identifiable market segments (i.e. select, standard, grey and non-standard). Instead, the proposed model moves toward an administrated market, in which uneconomic risk-sharing pools create unfair pricing for most consumers. Also, the administered market introduces opportunities for abuse by ins urers (particularly predatory pricing), creating the need for a complex set of administrative rules to give the structure any chance of working. Any market without a sound economic base creates unfairness and invites “cheating”, thus sowing the seeds of its own destruction.

* The current proposal addresses the wrong issue. FARM business peaked in 2003 not because the RSP was not properly structured, but because FARM rates were lower than the rates of many voluntary markets. FARM business during 2004 declined to politically acceptable levels when FARM rates were restored to levels befitting the ‘market of last resort.’

OPTION TO OPT OUT?

Scandalously, the FA board has not prepared any models or forecasts to assess the market impacts and fairness of its own radical proposals. At a minimum, now that its proposed redesign construct is finalized, the FA board should commission a market impact study to provide all stakeholders with assurance that the proposed structure is fair for all concerned and will result in a long-term competitive market. The results of such a study should be provided to the FA membership prior to their voting on the matter.

The largest standard carriers on the FA board are driving the current restructuring proposal. By glibly putting forward the wrong solution for a hypothetical problem, we believe those carriers are acting in a way that is totally self-serving. They want to further consolidate the market and write, for marketing reasons, business that they do not want to retain for their own accounts. If they can force smaller markets pick up a disproportionate share of the financial loss that the new RSP creates, so much the better, in their view.

Due to a lack of resources, neither the FA nor regulators will be able to administer effectively the additional ‘market conduct’ rules made necessary by the new structure. They will be unable to prevent predatory pricing and other possible abuses, and the ineffective enforcement in the past of existing rules such as ‘take-all-comers’ is a case in point. The preferred competitive market model is largely self-adjusting. A big, uneconomic RSP will, among other things, delay rate adjustments, making for a seismic shift when the ‘lid’ ultimately ‘blows off’.

If adequate and convincing market impact information is not forthcoming, the FA should allow dissenting insurers to opt out of the new RSP entirely by voting against the proposal. One can anticipate that only the most adversely affected non-standard and grey market insurers would opt out. These insurers represent a small percentage of the market; their absence will not materially affect the financial impact of the new RSP on the remaining participants. If a broader spectrum of insurers opts out, the FA Board would have to question the wisdom of its proposal.

It is just not fair to drag dissenting insurers into a mandatory plan by merely achieving a ‘50%-plus-1’ vote on the matter – particularly when the companies that will benefit most from the new RSP structure control an overwhelming percentage of the votes. Given that regulatory approval of any proposed change will be required, regulators should be able to see a broad industry consensus, which (in our view) has not been achieved at either the FA board or working committee levels. Any proposal submitted to insurance regulators must have widespread support among all stakeholders and show equitable treatment of the less powerful.

Facility Association’s only sanctioned mandate is to serve as ‘the market of last resort.’ It is absolutely not to compete, by design, with certain of its members. Historically our industry has often lapsed into business practices that, when viewed by ‘outside’ interested parties, are seen as being anti-competitive and damaging to consumers in the long run. The proposed new RSP will likely be viewed in hindsight as, in effect, a giant bid-rigging scheme, designed to rapidly consolidate the market by tipping the competitive landscape in favour of the largest and direct marketing insurers (who are often part of the same organizations). Will consumers really benefit from the resulting ‘bank-like’ market, offering very little true competition, that will ultimately result from this process?