Capital Allocation in Canada: The Three Strikes

Why invest capital in the Canadian p&c [property and casualty insurance] market?” This was the question posed by speakers at a recent Toronto Insurance Conference (TIC) panel discussion on capital allocation. The answers painted a grim picture of doing business in Canada.

While results for the first-half of 2003 show improvement, with insurers posting a profit of $1.1 billion, there are significant challenges remaining in the market. This is no more so true than for auto insurance, which has become a campaign tool in every private insurance market, with insurers under the gun to reduce rates in response to consumer ire, but little relief being seen on mounting claims costs.

Results notwithstanding, these are not the only adverse conditions insurers experience in this market, sources agree. Hefty regulatory capital requirements and a mammoth tax burden face companies who seek to sell insurance in Canada. “Canada is not exactly known as the most capital friendly jurisdiction in the world,” notes Glenn McGillivray, senior vice president and head of corporate communications for Swiss Reinsurance Co. of Canada (moderator of the TIC panel). And, when one considers that about half of primary companies and all but two Reinsurance Research Council (RRC) Canada members are foreign-owned, the implications of an adverse environment are significant.

“If you have excess capital, is this the number-one place to put it?” is the question companies are asking themselves, admits Bob Fitzgerald, executive vice president and COO for Aviva Canada Inc. And, capital is at a premium right now. For example, since September 11, 2003, reinsurance capital worldwide dropped from US$200 billion to about US$132.5 billion, notes Johnathan Stephenson, a principal at Guy Carpenter & Co. Ltd. (see chart 1). Furthermore, the “quality of capital” is even worse, remarks Nick Smith, attorney in fact in Canada for Lloyd’s of London, who points to the number of reinsurers facing downgrades since September 11. “Companies are becoming more parsimonious will their allocation of capital. They’re asking a lot of questions.”

Within this global capital malaise, Canada, unfortunately, stands out as a tough market to sell to foreign investors, from parent company boards to shareholders. Smith notes he has seen evidence of this jaundiced view of Canada with Lloyd’s own underwriters, despite the country’s status as Lloyd’s second-largest overseas market. “Canada does continue to be a tough sell for brokers in the London market and a tough sell for me when I go to London.”

New test

Among the strikes against Canada is its capital adequacy requirements. As insurers struggle to improve returns, shareholders may want to see them hold less capital, notes Geoff Shields, senior vice president at Chubb Insurance Co. of Canada. But, regulators see things differently. Shields adds that as companies try to increase premium rates they are required to have more capital to meet requirements, even if their exposure has not changed, creating a drag on profitability.

This year, insurers began using the new “minimum capital test” (MCT) for regulatory capital. The change to a risk-based approach to capital testing came after lengthy discussions between the industry and the Office of the Superintendent of Financial Services (OSFI). “MCT is a step forward,” says Jane Voll, acting vice president and chief economist for the IBC. “It’s harmonized across all jurisdictions, all of the provinces and at the federal level, it’s risk-based…if you’re a riskier insurer you should have to have more capital.”

Essentially, MCT was intended to be “neutral” relative to the former minimum asset test (MAT) – in other words, no more conservative or less, but giving greater weight to a company’s risks in terms of assets, policy liabilities and off-balance sheet exposures, with capital available expressed as a percentage of capital required. The minimum level was intended to be 150%. However, “some [IBC] members have raised concerns that OSFI has, in addition to the ‘official’ expectation of 150% being the minimum, that additional standards have been applied,” notes Doug Hogan, vice president and CFO at Dominion of Canada General Insurance Co.

Among proponents voicing concern over OSFI’s new approach is Fitzgerald, who notes that Aviva Canada is being held to a standard much higher than 150% – and the company is not alone. “Practically, they [OSFI] want 150%, but realistically that’s not what we’re being held to…we are being asked, and are working with OSFI with a target of 170%-175%.” Other companies are being held to an even higher standard, he observes.

MCT is a conservative test by nature, notes Shields, as it takes a company’s equity, adjusts it for risk and then adds 50% on top of that. “It’s cushion on cushion on cushion.” The test is particularly punitive to companies who use non-admitted reinsurers, notes Smith. “It’s a very penal test for Lloyd’s”, because the Lloyd’s underwriters are buying their reinsurance from companies licensed in London, rather than Canada.

The “neutrality” of MCT to the old MAT test “was probably true based on industry balance-sheets of a few years ago” when insurers may have been more invested in volatile equities, says Neil Parkinson, partner in KPMG’s insurance practice. The move to high-quality bonds has actually pushed up scores above the 150% mark. Moreover, Parkinson notes, “this system has been introduced when companies are having bad underwriting results. Regulators may be looking for more of a cushion.” Kevin McNeil, CEO of Gore Mutual and chair of IBC’s financial affairs committee, adds that, “it’s a new test. Both OSFI and the industry need to work with it for a year or two. For some companies, 150% may be appropriate, for some more than 150% or less, may be appropriate.”

Conservative standard

However, whether using MCT or MAT, a recent IBC study bore out the industry’s existing stance – that Canada is a very capital conservative environment. “There’s more regulatory capital required in Canada than most other jurisdictions,” Gore notes. “OSFI needs to look at this and make sure we are not requiring companies to have more capital than is required to protect policyholders and investors.”

Voll agrees with this position. “The problem is the target level at which regulators will intervene is much higher than other jurisdictions. Our position is this isn’t necessary. You shouldn’t need a risk-based buffer on top of risk-adjusted capital.” The problem with requiring companies to hold more capital is that it requires them to charge more premium, or to write to a tighter combined ratio which results in “dumping” of unprofitable business. “Right now there are companies that would like to write more premium”, especially in commercial lines, she notes. “They’re tied…the companies are saying, ‘let me operate at 150% and I can write more business’. It’s exacerbating availability concerns out there in the marketplace.”

The IBC study showed that on several fronts, including asset charges and target capital requirements, Canada was second only to Australia in its conservatism (see chart 2 and 3).

Ultimately, such conservatism could take a toll on the industry. “Right now we have a lot of companies competing in the business, but we should not assume that’s the way it will be forever. If the economics of insurance are bad, it will drive competition out of the business,” notes Parkinson. “It may enhance the ability to pay claims in the short-term, but in the long-run it will probably make insurance more expensive; capital is expensive. There’s a balance to be struck there.”

But, OSFI defends the test and its high standards. Responding to concerns, the regulator notes that when Australia recently restructured its capital test, it used Canada as a basis, and adds, “certain jurisdictions have undertaken a review of their regulatory approaches, in part due to problems in their domestic markets, and are in the process of enhancing their supervisory practices and capital requirements”. OSFI also notes that a great deal of the onu s for determining the “target zone” for the MCT is the responsibility of company boards, with the 150% mark acting as a baseline. “The 150% supervisory target is a benchmark against which companies establish their own higher target and provides an early signal to assure that intervention will be timely enough for there to be a reasonable expectation that action can be taken to address difficulties…To establish their target, companies determine for themselves the level of capital necessary to mitigate the residual credit, market, legal and regulatory, operational, strategic, compliance and insurance risks in their business.”

Industry sources admit that financial results and high-profile failures such as Markham General have not helped their case. “We have to stop having ‘poster children’ out there that he [OSFI superintendent Nick LePan] can point to,” notes Fitzgerald. The industry needs to show that it has its financial house in order if it’s going to make a case for easing regulatory requirements. And, OSFI observes of the industry’s latest financial results: “The first half of 2003 has shown a noticeable improvement in results. However, we believe that it is too soon to conclude that the trend of deteriorating financial condition has been reversed. Sustainable profitability at reasonable rates of return is important for the safety and soundness of the industry.”

Nonetheless, the IBC also plans further study to address the issue of whether Canada is in fact a risky environment for insurers. “You would expect if Canada has the highest asset requirements, then Canada would have a particularly risky market,” notes Hogan. Common sense, however, would indicate this is not the case. Canadian insurers are most invested in bonds than in volatile equities, and the spread of risk here is seen as an attractive factor for insurers. “Our expectation is that this is not as risky an environment as the other countries in the study,” Hogan predicts.

Taxing situation

If the regulatory situation does not turn off capital investment in Canada, the tax burden may, sources say. “Insurance in Canada is the most heavily taxed in all of the G-7 countries,” says Voll. “What happens here is there are taxes on taxes on taxes, adding to the cost of insurance to consumers.”

This situation was borne out in a recent study commissioned by the IBC comparing Canada’s insurer tax burden to other G-7 nations. It looked at capital, premium, sales, value-added and corporate income taxes, explains Steven Donoghoe, chair of IBC’s tax panel. “Canadian p&c insurance is being hit with every type.” Other countries had at least two fewer taxes applied. But, he adds, “transaction taxes are the highest part of the tax burden”.

Transaction taxes, i.e. provincial sales and premium taxes, are “really where the big dollars are”, says Donoghoe. He adds, “we have to pay those taxes regardless of the profitability of the industry”. On premium taxes, rates in Canada vary between 3%-5% of premium, versus an average of 2% in the U.S. (see chart 4). Some provinces also levy a “fire tax”, for example in Manitoba, where the IBC has successfully lobbied against increases to this tax recently.

Some headway has also been made on the federal tax front, where the capital tax is to be phased out by 2008, while the government is working to harmonize and reduce corporate income taxes. “This has a positive influence on the ability of the business to perform well,” says Donoghoe. “We [Canada] want to remain competitive.”

And, at the provincial level, Ontario has reduced its premium tax and there is potential for Nova Scotia to phase out its capital tax, which would leave Manitoba as the only province charging a capital tax on insurers. But the battles really continue at the provincial level. “There have been provinces who, in the course of recent discussions on auto reform, said ‘we won’t discuss taxes’,” Voll notes. This, despite the fact that every province is making more money on insurance taxes because of rate increases. “It comes up as a threat, every year the government wants to look at ways to get more money out of insurers. It’s a constant battle to keep the status-quo.”

Spread of risk

At the end of the day, these hurdles, both regulatory and taxing, may be overlooked if the Canadian market were providing strong returns. But this has not been the case, particularly on the largest market, auto insurance. Auto insurance has “really fallen off the end of the cliff”, comments Smith. And while pricing across lines is improving here, that is true everywhere else too, he adds.

Stephenson demonstrates that Canadian rates in the reinsurance market, as well, are following international trends and are the result of global pricing pressures. “If Canadian rates are not made in Canada, it is unlikely capital is going to be here if there isn’t a reasonable prospect for returns,” he adds.

The combination of the “three strikes” – capital requirements, taxation and returns – has to be on the minds of global parents. “If you’re a shareholder, a board member, an analyst, you’ve got to be saying to yourself, ‘there’s got to be a better place for your capital than in Canada’,” Fitzgerald says. Canada may be the seventh-largest property and casualty market in the world, he remarks, but it is not respected as such. His parent company, Aviva plc, has increased capital levels in Canada over the last four years, but this is on reserves, rather than growth, he observes, and “that faith won’t last forever”. For this reason, Canadian branch staff need to get “front of the line” with their global parents to show that progress is being made on the regulatory and product fronts, and that Canadian staff have what it takes to be profitable. “Players in Canada say “yes” to the OSFI challenge, “yes” to believing in product reform and “yes” to Canadian operations as excelling.”

There are, however, factors drawing capital to Canada. This is true with the new capital that has cropped up since September 11, notes Stephenson. “From a Canadian perspective…a lot of these companies do want to participate in this country.” This is because of Canada’s favorable spread of risk. Indeed, Canada’s relatively small catastrophe loss history and its favorable litigation environment (particularly compared to the U.S.) are two big attractions for global insurers.

In addition, improved industry returns for the first half of this year are also attracting notice. As Smith notes, Canada has grown to a $30 billion market, and premiums in lines other than auto are now outstripping claims growth. Compared with Australia, he notes, there are many more companies wanting to do business here and the large-scale withdrawals experienced “Down Under”, such as Royal & SunAlliance and Aviva, have not taken place in Canada. The future, however will be determined by the balance-sheets of Canada’s insurers, Smith notes. “If people are satisfied with earnings [in 2003], I don’t think there will be a lot of change in the market…the market will decide.”