Canadian Insurance Congress 2005: A Rocky Course

Regardless of the monumental “surprises” the property and casualty insurance industry ran into last year in the form of the regulatory investigations into the long-standing practices of broker contingent commissions and the use of finite reinsurance, speakers at this year’s Canadian Insurance Congress were less than certain of the future financial prosperity of insurers as well as the large brokerage houses. The potential of new regulatory restrictions being introduced, coupled with the downward shift that has already become evident in the industry’s pricing cycle, suggest that insurers’ net earnings and capital surpluses will diminish greatly by 2006. However, the period in between will likely see increased merger and acquisition activity as insurers look to “buy business growth”, predicts one speaker.

The two differentials in the most recent “soft to hard market” cycle from past cycles going back 30 years is that insurers were confronted with the “worst of the worst” and the “best of the best”, observes Paul Kovacs, president of the Property and Casualty Insurance Compensation Corp. (PACICC). The dramatic turnaround in underwriting profitability brought on by the most recent hard market saw Canadian insurers post almost record growth in capital over 2004, he says. “We will see further capital building this year.” The industry’s financial result for last year produced near 15% growth in capital over growth in claims costs, showing a stark recovery of the almost 15% deficit in capital growth to claims that insurers incurred over 2000/2001, he notes.

As a result, there are currently few insurers falling into the danger zone of not meeting the minimum regulated capital requirements, Kovacs says. Notably, just under 75% of Canadian licensed insurers produced a stronger minimum capital test (MCT) result last year when compared with 2003 MCT levels, he notes. The improved earnings performance of companies, combined with capital strengthening, began to produce more financial strength rating upgrades than rating downgrades over the first quarter of this year, Kovacs observes. “However, we [the industry] are still below the capital peak of 1999,” he cautions, in pointing out there remain some insurers still facing financial constraints.

The industry emphasis has to remain on underwriting, Kovacs stresses, in order to generate ongoing capital surplus as companies are unlikely to see much recovery in investment earnings performance for “as long as you can think”. But, with approximately $8 billion having been added to insurer’s reserves over the past two years, the industry does have some financial flexibility as it moves deeper into the softening price cycle. “Industry feedback suggests that [underwriting] discipline will be maintained. I guess we’ll just have to watch and see.”

However, not all industry analysts share the view that insurers are facing a “soft landing”. Adam Klauber, chief of equity research at investment banker Cochran, Caronia Securities LLC., believes that the North American insurance industry faces a “tough time” in maintaining earnings growth moving forward. He says that insurers have not set aside adequate capital surplus to hold them through soft market periods. “This has been partly due to [increased] competition as well as the fact that companies are still trying to catch up with reserve inadequacies from the previous cycle.”

In an April 2005 newsletter sent to clients, Cochran, Caronia observes, “trends in [industry] operating cashflow indicate that there will be a major negative inflection in commercial property and casualty core earnings power in 2006…core industry earnings power should sink to 1997 levels over the next year and a half. By 2006, investment income should represent 90% to 100% of industry cashflow.” The investment banker also predicts a significant shortening in the insurance industry’s future pricing cycles due to increased regulatory and rating agency scrutiny and the negative impact on company’s income statements if finite reinsurance arrangements are scrapped. “The time from cycle peak to trough should decline from an average of eight years to two to three years for the current cycle.” As such, Klauber expects industry earnings will fall between 25% to 30% by next year.

“The amazing thing is, despite all the crazy things [regulatory investigations] going on, this has not affected the industry’s ability to raise capital or [reduced] merger and acquisition activity,” says Len Caronia, managing director of Cochran, Caronia. A declining price cycle usually indicates a rise in mergers and acquisitions, he notes, as insurers look to buy growth. “We’re [the industry] currently at the point of actively raising new capital and merger and acquisition activity is increasing.”

In addition to merger and acquisition activity among the existing insurance company players, Caronia says there has been a noticeable uptick in buying interest from private equity/venture capital operators. Much of this interest has been driven through the Bermuda marketplace, he notes. “The last nine months has seen these private equity groups being the driving force [behind mergers and acquisitions] even though they don’t have insurance expertise,” he adds.

CONSUMER INTERESTS

The insurance industry’s journey through the most recent hard market did result in some “collateral damage”, remarks Mary Lou O’Reilly, a vice president at the Insurance Bureau of Canada (IBC). She refers to the significant dent in the industry’s public image resulting from the premium volatility that consumers were subject to over the past two years, and the responding actions of the provincial governments in rate freezes and market investigations.

“It is of utmost importance to restore consumer confidence in the industry,” O’Reilly stresses. Following significant discussion with insurance industry stakeholders, the IBC has identified three key areas/actions which have to be addressed:

* The industry has to get the support of Canadians by responding to them both emotionally and intellectually;

* The industry has to work better with regulators; and

* Any solution or course of action can not be an “Ontario only” approach.

O’Reilly notes that, historically the insurance industry has tended to reach for instant reactions, hence the poor response it received from consumers to the premium hikes of the past cycle. “We’re always in a big hurry,” she comments, in pointing out that any approach adopted in restoring consumer confidence will have to be viewed as a long-term strategy. “We need to make sure that we do it right, so we [the industry] have to adopt an incremental approach.” Furthermore, she says that repairing consumer confidence has to be embraced as an industry as well as by each insurer.

A panel debate, comprised of consumer group and industry representatives, presented a mixed perspective to how and what insurers can do to win back the hearts of consumers. Norma Nielson, the chaired professor of insurance and risk management of the Haskayne School of Business at the University of Calgary, bluntly observes, “this [insurance] industry is never going to be loved. Insurance is for most people a necessary evil, it’s not something that someone enjoys shopping for. The industry needs to recognize some realities: underwriting decisions have to be explained better and consumers have to be given some sense of control [over coverage and pricing options].” Nielson also notes that insurers do not have a good track record when it comes to “innovation” in their market dealings. “Although, I now have some optimism that insurers are beginning to show a willingness to work with [provincial] regulators rather than the old ‘tug of war’,” she adds.

Theresa Courneyea, president of the Consumer Interest Alliance Inc., notes that the media attention surrounding the regulatory investigations into intermediary remuneration has, in the public’s eye, highlighted the lack of independence be tween brokers and insurers. “We believe that independence of brokers from insurers has been seriously eroded.” As such, Courneyea proposes the radical solution of allowing banks to retail insurance through their branch networks. “This will increase competition and availability of [coverage] for consumers,” she adds.

Scott Tannas, president of Western Financial Group, says that consumer perception of the insurance industry is driven primarily from three points:

* Influence from third-parties such as provincial government regulators;

* Media attention; and

* Direct influence between an insurer and policyholder at the time of coverage renewal and through claims.

The provincial governments are increasingly using the insurance industry as a “scapegoat” for their own inefficiencies, and that this situation is unlikely to change in the near future, comments Tannas. Likewise, insurers are unlikely to change media perception while the industry continues to be attacked by the governments. Ultimately, the only effective avenue open to insurers in boosting its public image is to focus on their direct dealings with insureds. This requires ongoing communication and drawing attention to the high level of claims service in Canada. “I think most [industry] customers are happy from a claims experience perspective.” And, innovation and product choice is another important factor that needs to be developed by the insurance industry, he adds.

Product development is probably the most important opportunity available to insurers in repairing its public image, says Larry Shumka, president of Shumka Craig & Moore Adjusters Canada. He believes that insurers should look to developing longer-term policies as a product option (most policies are effective for 12 months) to provide greater comfort to insureds. “I think whoever does this will have a competitive edge [in the marketplace].” Nielson concurs that such an option would provide greater stability for consumers. And, she observes, research shows that longer-term clients produce fewer claims.

However, Shumka is not confident that a “sophisticated message” in communicating the actions of the insurance industry will be effective at a consumer level. Consumers are not interested in the industry’s cost issues, and customer loyalty is a thing of the past, he says. Feedback from consumers suggest that the following four issues do need attention from insurers:

* Pricing stability with smaller, single rate adjustments;

* Eliminating surprises;

* Greater transparency; and

* Better communication

REGULATORY DEVELOPMENTS

“There has been a lot of noise and craziness” surrounding the insurance industry since October of last year when New York’s attorney general Eliot Spitzer first announced findings from investigations launched into broker contingent commission earnings and alleged business rigging, observes Klauber. Subsequently, state regulators, the Securities Exchange Commission (SEC), as well as Spitzer, have bombarded insurers and brokerages with subpoenas as these investigations have broadened. Most recently, Spitzer launched a new attack on industry use of finite reinsurance contracts, claiming that the “creative use” of these financial instruments had resulted in a serious breach of “fiduciary duty” by some senior directors of insurance companies in a bid to boost shareholder value.

The result of these investigations has seen several senior and key board members of insurers forced into retirement while all of the major brokerages have already made legal settlements to avoid prosecution, says Klauber. The top four brokerages have also scrapped contingent commissions in the U.S., he notes. “But, some of the smaller operators [brokers] are still clinging to the right to receive contingent commissions.”

Ultimately, Klauber expects that contingent commissions may well be eliminated through regulation, and overall, the area of intermediary remuneration will be governed by tougher rules and disclosure requirements. At the moment, the top four brokerages are trying in the U.S. to “claw back” the loss of contingent commission earnings through higher basic commission. “I think the brokerages will get this money back in the U.S., but in the U.K. the picture is very different. For the large brokerages, contingent commissions account for about 50% of earnings in the U.K., and the carriers have decided that they are not going to subsidize this margin,” he adds.

The most significant change that will likely occur in the industry over the coming year is that the large brokerage operations will find it increasingly difficult to grow earnings as well as business volume. “The fundamental process of the property and casualty insurance business won’t change, but the competitive landscape will,” predicts Klauber.

Ramifications of Spitzer’s investigations into insurance industry practices have not been limited to the U.S. or U.K., but have had a striking impact on the regulatory front in Canada. While insurers and brokers in Ontario, acting through the IBC and the Insurance Brokers Association of Ontario (IBAO), were quick to respond with voluntary disclosure guidelines concerning broker remuneration and other financial relations existing between the two parties, the provincial regulators were unwavering in their quest to determine the full extent of financial arrangements that exist between insurers and independent brokers. Clearly, the provincial regulators have kept a keen eye on the political fallout against the insurance industry resulting from the premium hikes of the past two years, and therefore have no intention of being caught in the “cross fire” in terms of being accused of not doing an appropriate job in protecting consumer interests. The objective of the provincial regulators is to achieve a balance between industry business operational procedures and that of consumer interests, explains Bryan Davies, superintendent of the Financial Services Commission of Ontario (FSCO).

As a result, the Canadian Council of Insurance Regulators (CCIR) and the Canadian Insurance Services Regulatory Organizations (CISRO) jointly established a special review committee in October of last year to investigate and report findings on the current status of financial arrangements between insurers and independent brokers, Davies says. Investigations by the provincial regulators have revealed that there is no “smoking gun” in terms of inappropriate activities between insurers and brokers, he notes.

While the CCIR/CISRO report, which was released in early June of this year, indicates that more than two-thirds of insurers in Canada offer contingent commissions to brokers/agents, and more than half of all insurers have some form of additional financial relationship with intermediaries, the majority of companies have adequate policies and procedures in place negating the potential of conflict with consumer interests. However, the report also observes, “The IPRC [the special review committee] believes that some current business practices may contribute to a perception of or actual conflicts of interest in the marketplace…This may have a negative impact on consumer confidence in the insurance marketplace.” The CCIR/CISRO report suggests the following regulative actions:

* Codify the priority of clients’ interests by placing a requirement in legislation that a client’s interest has to be placed above those of intermediaries or third-parties;

* Restrict performance-linked benefits offered to intermediaries;

* Enhance transparency of compensation, ownership and other financial interests;

* Regulative disclosure at point-of-sale, both verbal and in writing, detailing existing relationships a broker has with insurers and the number of markets approached in the quotation of the business (brokers would be expected to keep recorded conversations for compliance purposes); and

* Insurers required to provide the names of brokers that they have dealings with and to publish this information on their Internet websites.

Davies points out that the CCIR/CISRO report emphasizes transparency and disclosure. “This, I think, is the appropriate direction, which is something that has been moved on in other financial services sectors.” The CCIR/CISRO is now engaged in getting stakeholder feedback on its report, Davies says, and written comments can be submitted until August 2 of this year, after which the two regulatory organizations will make recommendations regarding possible actions the various provincial governments can take in a harmonized manner, he adds. “The modern approach [of regulators] leans toward a more flexible and cooperative basis [in dealing] with stakeholders to ensure that legislative arrangements remain up to date.”