Auto Insurance: Will it Bite Back?

The sheer business volume of auto, which accounts for more than 50% of total premiums written in Canada, dictates a close relationship with the product by insurers, even if there is no fondness involved. However, like master and dog, this relationship is fraught with the uncertainty that auto might bite the hand of insurers as it has so many times in the past.

The net cost of auto claims incurred over the course of 2004 fell by 6% year-on-year, according to the fourth quarter “MSA/Baron Outlook Report”. In fact, auto across all of the provinces except Prince Edward Island shows marked improvement in the difference between the industry’s loss ratio for last year compared with that of 2003, the MSA/Baron report notes. Direct auto claims incurred for 2004, as measured by industry financial data collected by federal regulator the Office of the Superintendent of Financial Institutions (OSFI), also reflects a 5% decrease in cost to $19.8 billion from the $20.9 billion in direct claims costs recorded the year before.

Why then did growth in auto premiums over 2004 reach almost stalling point? OSFI data suggests that direct written auto premiums last year rose by 4% to about $29 billion from the $27.8 billion that insurers wrote over 2003 – this represents a dramatic drop on the annual growth of auto premiums between 2002-2003. The most obvious explanation is that pricing of auto has declined over the past year, a combination of provincial government rate-rollbacks and rate-freezes as well as increased underwriting capacity and competition between insurers as profit margins have grown.

However, closer analysis of the industry’s business expansion shows that insurers have not been all that “gung ho” in wanting to take on new auto exposures. Notably, the annual growth rate of insurers’ net written auto premiums for 2004 clocked in at a meager 1.8%, according to the MSA/Baron report, which indicates a significant disparity between the 4% year-on-year growth seen in OSFI’s direct premium data. The higher direct premium growth is due to higher retentions taken by insurers last year, thus less premium was ceded to reinsurers, observes Joel Baker, president of MSA Research Inc. And, as primary retention levels are believed to now be “maxed out”, premium growth in auto will continue to decline moving forward, he predicts. “Regulatory machinations in the Maritimes and Alberta caused direct auto writing to decline in those regions. Ontario auto writings grew a modest 2.3%, scarcely keeping up with economic and population growth,” the MSA/Baron report says. And, the growth seen in Ontario auto – which accounts for over 25% of all premiums written across Canada – also includes commercial auto, the report observes while suggesting that personal lines auto writings more than likely declined last year.

Could the lackluster growth of the auto line be due to a wariness of insurers to take on business that so many times in the past has left them in pain? Can it be that insurers lack long-term confidence in the cost-containment auto reform measures introduced by the provinces over the past 18 months? Can it be that auto insurance is still seen by the industry to be the “dog of the business” as it has historically proven to be?

For the Canadian insurance industry the auto line is about volume business and marketshare, and success in the line is dependent on cost-effectiveness, says Baker. In the current poor investment environment, insurers are unlikely to rush into auto recklessly, he notes. “I don’t see reckless pricing moving into auto, insurers are a lot more wise today than they have been in the past. There’s no benefit in creating intense competition in auto, the investment environment can’t support it,” he adds.

Like many in the insurance industry, Baker believes that the decline in auto claims frequency and cost will turn for the worst. With the current “ceiling” on price growth of premiums, the profit margin on auto will diminish, he predicts. “At the moment, the picture beyond 2005 is cloudy in terms of where auto is going,” he says. The uncertainty impacting the marketplace is not based on the actions of insurers, but what will happen in terms of claims experience, he adds. Many insurer CEOs seem to also share a dour view to where auto claims costs are going.

“Frankly, I expect auto insurers to start doing poorly,” comments Bill Star, president of Kingsway Financial Services Inc. The higher premiums driven by pricing over 2004 kept companies’ results healthy, he says, but with the rate reductions that have been brought into force by the provincial governments, the claims experience this year will produce combined ratios of 100%-plus, he predicts. “I expect to see deterioration in company results on a quarter-by-quarter basis, and this will become obvious by the first quarter of 2006,” he adds.

George Cooke, president of The Dominion of Canada General Insurance Co., says that the timing to when the auto claims experience will turn for the worse is anyone’s guess. But, he notes, “it will turn. We [at Dominion] believe that it is already happening in Alberta.” The only certainty regarding the auto product is that extreme pressure is going to come to bear on the bottom-line of insurers, Cooke says. “But ‘when’ is the question. It is also unclear to how insurers are going to react.”

Alain Thibault, president of Meloche Monnex Inc., agrees that auto claims costs will eventually begin to rise. “It’s when that I don’t know. I can’t say I’m optimistic about auto’s future, I’m cautious.” For Thibault, the uncertainty surrounding auto is two-fold: not knowing how the governments will react (or not) in future to rising claims costs and pricing, and secondly, whether competition between insurers will undermine pricing adequacy.

ING Canada Inc., which recently disclosed its first quarter financial results for this year as a publicly traded company, attributes auto insurance as being the driving force behind the near 40% year-on-year rise in its net income for the period. “Reduced claims frequencies, favorable reserve developments as well as improvement in the year over year results of the Facility Association contributed positively to our results.” However, ING cautions that the future of the auto product will continue to be impacted by regulatory changes. “Sustainability of the cost containment measures [regulatory reforms] adopted as well as the ongoing rate reductions will be key drivers of our [ING] performance in the short-term.”

REGIONAL REFORMS

The fact that many of the provincial auto insurance reform measures are still relatively new in terms of being in effect is the cause of industry uncertainty regarding whether there is current pricing adequacy, observes Jane Voll, chief economist at the Insurance Bureau of Canada (IBC). “It’s so early going [into the reforms], and you’re never done [in evaluating the process]. If we’ve learnt anything over the years, it’s that the auto system is not something that you can take your hand off the wheel,” she notes.

However, early indicators suggest that the reforms in most provinces are producing the necessary cost-containment benefits that have allowed premium rates to decline, Voll says. New Brunswick and Nova Scotia have both seen third-party liability claims drop, she notes, and the cap on minor injury awards has taken the steam out of the cost pressure. But, there remains political uncertainty as opposition parties seem determined to keep auto insurance on center-stage. Nova Scotia also presents a unique problem in that depopulation of the high-risk Facility Association (FA) has not been as rapid as insurers and government would like to see – this, however, is primarily due to complications with the rate filing approval process and that the rating board has not allowed the FA to increase its rates above standard market levels, Voll notes.

While the Atlantic region appears to moving in the right direction, the biggest concern for insurers is Alberta where the government introduced a host of “less than insurer friendly” changes to the auto product. These include a fixed pricing grid system that prevents insurers from using traditional risk rating criteria such as age and gender, and a new high risk “sharing plan”, or industry pool, that essentially serves the same purpose as the FA. With rates having been forced back, the problem with the reforms in Alberta is that insurers have nothing to work with in determining true cost, Voll says. The new risk sharing pool, she notes, is also really just a political move by the government to get rid of the public stigma associated with the FA. What has set warning bells ringing for insurers in Alberta is that the cost of treatment of soft tissue injuries began rising in the post-reform era. Overall, accident benefit (AB) claims are rising in Alberta, she adds. “Early evidence from a sample of companies indicates that claim frequency is up markedly over the pre-reform period. We do not yet know why this is happening, but it will clearly have to be watched.”

Star is particularly unimpressed with the auto reforms introduced in Alberta. Forcing rates down on high-risk young drivers does not make any sense, he notes, and the price rating grid is simply putting more inexperienced drivers on the road. “I’m willing to bet that the combined ratio of the risk sharing pool will soon be up around 150%,” he adds.

Cooke shares this frustration, noting that ‘Alberta is a difficult marketplace. People [in the insurance industry] are just fried from dealing with the regulative changes brought in.” He says the biggest concern for insurers moving forward is the subsidization cost associated with the pricing grid system. Whether insurers are working with reliable cost data is the million dollar question, he adds. “There is considerable uncertainty.” The only “bright light” on the Alberta front is the government did introduce a provision allowing companies with inadequate pricing to be exempt from standard regulated rate reductions.

Igal Mayer, president of Aviva Canada Inc., shares the sense of unease regarding the ultimate cost of Alberta’s fixed pricing grid. The industry calculated that about 20% of the province’s auto business would be subject to the grid rates, he notes, which insurers have priced at about an 8% subsidy. “I don’t know if we’re correct,” he says. A higher level of marketshare subject to grid rates, or a miscalculation of the subsidy, could present a serious financial setback for insurers, he adds. “I’m optimistic, but cautious,” Mayer says. He notes that the costing calculations applied by insurers were based on 2003 data. Subsequently, Aviva has updated its projections based on 2004 claims data, he adds, “and this has still left us feeling comfortable”.

In contrast to the uncertainty and upheaval associated with the auto reforms in eastern and western Canada, Ontario has emerged from the political dust as the “golden child” of insurers. “I think the auto reforms in Ontario have been methodical and generally successful. The past 12 to 18 months have definitely seen an improvement in the claims experience. While we have to continue to monitor claims experience moving forward, I don’t think there’s any reason at the moment to expect claims frequency or severity will rise,” says Mark Yakabuski, vice president of policy affairs and the Ontario region. Furthermore, Yakabuski is optimistic of future government cooperation in addressing cost concerns. “One of the more important issues to have evolved from the reform discussions is that the government has indicated a willingness to respond to unexpected cost developments.”

That said, Yakabuski points out that the Ontario government still has to finalize regulations allowing for a replacement system for the existing designated assessment centers (DACs). A more cost and time effective system is much needed, he notes. In this respect, there will still be a six-month transition process after the government introduces the necessary legislation, he adds.

A pending regulatory development being motivated by the government is to bring about some form of standard “accident forgiveness” clause in auto covers in an attempt to address the so-called “fear factor” that is believed to have caused insureds not to submit claims for fear of punitive rate increases. Yakabuski says the IBC has held discussions with the government in this regard, and that it has presented a “fuller sense” of what insurers already provide to consumers in terms of “protection coverage”. A survey of the Ontario marketplace reveals that about 60% of insurers currently offer their policyholders some form of accident forgiveness cover, he notes. “Our view is that this [accident forgiveness] approach should be based on market mechanisms. I think it would be a step backward if companies are forced to impose a single solution.”

The role of the consumer “fear factor” being the underlying reason for the decline in auto claims frequency has been greatly exaggerated, says Thibault. “There is a long-term downward trend in claims frequency,” he notes, and this decline has also been witnessed in regions such as British Columbia and Quebec where the trauma of auto pricing adjustments have been minimal – thus consumers have not had to “fear” submitting claims. Claude Dussault, president of ING Canada Inc., points out that the decline in auto claims frequency is actually a North American phenomenon and not Canadian-specific. As such, he too believes that the impact of the “fear factor” has been given excessive credit for the drop in auto claims. ING recently announced plans to introduce an accident forgiveness option for its policyholders. “We’re not ignoring that people might have fears. I just don’t think that the government should be involved with industry product design.”

This sentiment is supported by Cooke, who notes “I don’t think the answer here is more regulation and rules. Let’s not get in the business of taking risk rating out of the business.” But, Cooke does believe that the consumer “fear factor” has played a major role in the decline of claims. “Anyone who says otherwise is not telling the truth.” He expects, however, that marketplace stability has reached a point where insureds are likely to become more confident in their dealings with insurers, and that claims costs will begin to rise as a result.

Mayer also does not believe that a standard and enforced accident forgiveness clause is the best solution in winning back the confidence of insureds. Should the government prescribe such a requirement, the cost would have to be factored into premiums and ultimately all auto policyholders would bear the cost whether they wanted this form of “protection premium” or not, he says. “I think it should be about choice.”

RATE ADEQUACY

Rate adequacy is something that everyone is watching very closely, says Mayer. “We’ve been through this [auto reforms] so many times before, and basically, each time it’s like dealing with a new product.” For the next 24 months, insurers will be “pricing in the dark”, he notes, looking for early lead indicators to confirm whether adequate pricing has been built into the auto product, he adds.

Dussault concurs that insufficient market data currently exists to determine whether insurers have finally got auto pricing correct. However, he believes that there is presently sufficient margin costed into auto rates to absorb rising claims costs. He adds that, “let’s just say that our [ING] pricing is not based on a ‘best case scenario'”.

Cooke echoes the sentiment of his fellow insurers in saying that it is simply too soon to tell whether current market pricing is in alignment with the real claims costs lurking in the shadows of auto insurance. However, insurers have gained the cooperation of Ontario’s regulator, he notes, and the size of the marketplace means that getting auto pricing on track in the province will hold significant sway over the fortunes of the national companies. “I do believe that the [Ontario] government will respond to cost pressures as it has promised,’ he adds.