Canadian Insurance Congress 2004: Collateral Damage

Auto insurance, which for two years running has been a “hot potato” between insurers and the provincial regulatory regimes, once again took the debate spotlight at this year’s Canadian Insurance Congress. But, the significant attention paid to the auto product by the industry leaders is hardly surprising considering that most of the provincial cost-control reform measures, regardless of their adequacy, have only been implemented in the past six months, while rate freezes still apply in many of the provinces and the tired call by politically-motivated parties for the institution of government run auto insurance continues to echo from coast to coast.

With uncertainty remaining over the direction of the auto insurance reform process in Alberta – the third largest private insurance market in Canada – insurers are also less than happy with the overall regulative changes brought about in Atlantic Canada. In fact, several insurers have indicated their intent to withdraw from Newfoundland.

Overall, the CEO speakers believe that the mandatory auto product remains under-priced relative to the mid to long-term potential rise in claims costs, as well as being excessively restricted by the provincial regulators. The CEOs say the only viable solution to curb double-digit auto insurance rate increases is to bring the “base level” of benefits available under the mandatory product down, and allow insurers the option of marketing “add-on” coverages without the anchor of regulated pricing.

While the challenges presented by auto left the congress audience with much to lament over, a broader perspective of the business environment as outlined by two economist speakers suggests that the insurance industry’s return to profitability could be short-lived. The investment waters, for both stocks and bonds, appear murky as both the Canadian and U.S. federal governments struggle to maintain stable economic growth without having to apply drastic measures. However, all signals from the capital markets suggest that both governments will have to introduce several interest rate hikes during the course of this year and 2005 – which will adversely impact the capital value of insurers’ bond holdings, the economists note. And, with signs of price softening having already emerged in many lines of business, there is concern that the most recent “hard market” may have been too abrupt to provide a firm financial platform to sustain long-term industry profitability.

ECONOMIC DRIVERS

“[Industry] earnings got off to a good start this year,” observes Paul Kovacs, former chief economist at the Insurance Bureau of Canada (IBC) and current president of the Property and Casualty Insurance Compensation Corp. (PACICC). However, Kovacs notes that there is significant variance in financial performance of companies, with some insurers still operating in a loss situation while others are producing returns on equity of 50%-plus.

Kovacs points out that insurers went very quickly from a soft market to a hard market, and it would appear that the industry is moving as rapidly back as the rise in rate pricing has faltered. “Which is keeping all of us on the edge of our seats to see where the market goes.” Kovacs says he is pessimistic regarding the sustainability of industry earnings growth, “because we’ve moved so rapidly into a soft market”. He also refers to the considerable uncertainty surrounding the auto product, which due to the sheer volume of business represented by this line, holds sway over the financial performance of the major players.

And, while the current earnings inflow will provide much needed relief in terms of capital replacement, Kovacs remains concerned over the increased frequency of adverse reserve developments within the industry. The financial volatility with the industry is highlighted by the variance in rating of insurers when measured against the Office of the Superintendent of Financial Institutions’ (OSFI) minimum capital test (MCT). “There are several companies we’re [PACICC] concerned with their capital adequacy.” Despite the improving capital situation due to the industry’s earnings boost, Kovacs does not expect a “capital excess” to emerge.

The investment markets will present their own challenge to insurers, says Jeff Rubin, chief economist at CIBC World Markets. The investment community is expecting the U.S. Federal Reserve Bank to bring in about five interest rate hikes this year, with a further five-point increase during the course of 2005, he notes. “A doubling, or tripling, of interest rates is expected by economists over the next year and a half, which will destroy stock and capital bond values.”

Rubin, however, does not believe that either the Canadian or U.S. reserve authorities will react as strongly on interest rates as the investment community believes. He cites a slow-down in economic growth in the U.S. as the short-term positive benefits of tax refunds are depleted, the political influence of the pending U.S. election, and the fact that a significant percentage of long-term consumer debt (such as property mortgages) are now subject to variable rates. “If they [interest rates] do go up [as predicted], then you can expect a crash in the housing market.”

From a Canadian perspective, Rubin expects Canada’s economic growth will lag that of the U.S. this year, with a gross domestic product (GDP) figure of around 3%. This will put pressure on the reserve bank to hold back on interest rate increases to avoid strangling economic growth, he adds. “In fact, the Bank may even have to cut interest rates to prevent a sharp rise in value of the Canadian dollar [against the U.S. currency].”

REGULATORY SPARKS

The year past has seen significant change brought about within the mandatory auto insurance product, observes Bob Cooke, senior vice president of State Farm Insurance Co. Cooke, along with four other company CEOs, partook in a panel debate moderated by the IBC’s president Stan Griffin.

Cooke notes that regulatory changes impacting auto were largely driven by political forces, within the provincial governments as well as external opposition groups that forced the hand of those in office. The political attention was sparked by events leading up to the provincial election in New Brunswick, he adds, which created an opportunity to be politically exploited elsewhere. “The governments were watching what was happening in N.B., and they felt the need to act.”

And, Cooke points out that the political cost surrounding auto insurance can not be blamed on insurers for not having identified the cost problems associated with the auto product well before the governments were forced to react in a crisis-management style. The result of the auto reform initiatives taken by the various provinces fell into “two camps”, Cooke says, with the governments in Ontario and N.B. having acted with insurers to take positive action. “These systems are now so much healthier.” The other camp saw provincial governments acting unilaterally with barely any insurer consultation, and coverage availability remains problematic in these regions. Specifically, he questions the effectiveness of the auto reforms put forward in Newfoundland, as well as Alberta. “Alberta may claim there has been consultation with the [insurance] industry, but this has really been wrapped around a preconceived plan.”

The overall result of the auto reform processes has turned up a “mixed bag” says Cooke, with the true cost-saving an unknown factor as insurers are forced to continue offering coverage based on regulated pricing. “Over the next 12 months, we [the industry] face rate reductions in every jurisdiction.”

“The [industry] profitability in 2003 did not come from auto…With auto [representing] about 50% of the Canadian p&c insurance business, how confident are we [the industry] with the costs involved? I don’t think we are [confident],” comments George Cooke, president of the Dominion of Canada General Insurance Co. He also questioned whether the auto reform in Alberta is workable. “Alberta is far too large a market to be an experiment.” Specifically, Cooke t ook aim at the Alberta government’s decision to exclude age and gender as rating criteria applied by insures in setting rates. The age and gender issue is seen to be a form of discrimination, he adds, which is perceived to be politically incorrect. “We’ve allowed the notion of discrimination to become a bad thing…but, in the Alberta scenario, insureds will be subsidizing high-risk drivers, which I think is nuts, but that’s the system we’re stuck with.”

Claude Dussault, president of ING Canada, describes the auto reforms as “phase-one, the quick-fix”. Notably, in bringing about regulative change to auto insurance, the provinces have yet to deal with the more difficult issue of fixing the cost factor in the equation, he says. “I think most governments know the right direction required, they just need help to make the right decision.”

Ultimately, the problem with auto insurance is government interference, observes Dussault. “This is where it all starts. Insurance has come to be seen as a government department.” This “mindset” is largely due to the fact that the markets have been regulated to have a single mandatory product – similar to a government service, he notes. The auto solution, therefore, is to introduce flexibility, and provide insurance buyers with the choice of coverage, he adds.

Igal Mayer, president of Aviva Insurance Co. of Canada, agrees that creating product choice is a crucial part of the “fix” for auto insurance. But, he also points out, in so doing, the benefits available under the basic mandatory auto product have to be reduced. “I hope that a framework allowing for other products, rather than a single ‘commodity product’, does come about…Our base product starts up here, where the base product should be down here.”

A choice of benefits in terms of “add on” product options will help relieve the current cost/pricing problem, says Jude Martineau, president of Desjardins General Insurance Co. Referring specifically to a question posed to the panel concerning the viability of the auto reforms introduced in Ontario earlier this year and the overall impact this will have on insurers’ financial performance, Martineau adds, “The only hope is that we will be able to fix Ontario. But, past experience points to the opposite.”

Mayer also believes the picture in Ontario is a lot less rosy than many think. Although there have been initial positive results emerging from the Ontario auto market, it is still too early to make a prediction, he adds. “Insurers are seeing a ‘false security’ in Ontario. Ontario always shows some temporary relief [after reform action], but it always comes back to bite us. We have to realize that we’re now in the rehab business.”