Counting the PENNIES

The numbers say it all. Canada’s property and casualty insurance industry suffered one of its worst year-on-year performances last year, posting a modest return on investment of 7.1% — nearly half of 1997’s rate of return. Heavy underwriting losses incurred in 1998 — primarily due to the January ice storm — took a heavy toll on company bottom-lines. However, much of the decline in company net earnings for the year, at both primary and reinsurance company levels, is attributed to substantially lower total investment returns, with both yields and capital gains producing a meager contribution to income statements and balance sheets. The underwriting and investment outlook for 1999 is much the same, which analysts expect will prompt companies to adopt more innovative management strategies to both their underwriting and investment accounts. CU surveys leading analysts, institutional investment managers and company management to identify the business strategies being applied this year and into 2000.The property and casualty insurance industry produced a net profit of $1.13 billion for 1998, almost half that of 1997. The Insurance Bureau of Canada (IBC) points out that underwriting losses for last year were 2.8 times greater than 1997, the real crunch on the bottom-line resulting from a 16% year-on-year decline in investment earnings. According to IBC figures, 1998 ended with the industry’s return on investment at 7.9% against 1997’s 9.7% with capital gains half that of 1997 at $655 million, contributing roughly 23% to total investment earnings compared with 34% the year previous.

At the time of writing this article, 1999’s first quarter figures for the p&c industry had not been released due to a delay in reporting by Statistics Canada. However, most CEOs expect the result to be either in line with 1998’s yearend numbers or perhaps lower after having factored out the economic cost of the ice storm on the first quarter of 1998. In contrast, the U.S. p&c industry experienced a modest improvement for the first quarter of this year, mostly due to a recovery in bond yields as interest rates rose. The rise in interest rates will, however, increase financial market volatility in the mid to longer-term, further eroding the industry’s potential of capital gains on both equity and bond investments (see MarketWatch section of this issue for further details).

The modest recovery of the U.S. p&c market is expected to place greater pressure on Canadian companies to keep pace with their American counterparts, analysts observe. In that respect, Canadian company CEOs appear to be adopting one — or a combination thereof — of three major strategies: cutting expense ratios, focusing on underwriting by either “riding the market out” on the back of capital reserves or attempts at stricter underwriting (with not many takers to this latter approach), and employing more diversified and active asset management.

Canadian environment

A substantial income gain through premium growth is not going to be the answer to the industry’s ails, observes Paul Kovacs, chief economist at the IBC. “Premium growth in the 1980s averaged 10% while the 1990s has produced about 5%.” With surplus levels rising faster than premium (see chart of U.S. market of premium-to-surplus), excess capital will continue to influence the current soft underwriting conditions, he adds. And, on the investment front, there is not much to look forward to this year, he predicts, “companies relied on realized gains last year when market prices weren’t rising, hence the decline in book values as no new value was created”.

Against a backdrop of increased financial market volatility, “which makes planning extremely difficult,” Kovacs expects the Canadian p&c industry to report a similar ROE this year as 1998.

Don Smith, president of Canadian Insurance Consultants, concurs with Kovac’s predictions, “we can look at more of the same as 1998 on underwriting, expenses, investment yields and reduced capital gains”. Even though the investment end of the business is not a popular topic at present, companies will have to place emphasis on investment yield to remain competitive in the market, he adds.

And, companies appear to be applying a more aggressive investment stance, says Joel Baker, general manager of A.M. Best Canada. Two events seem to be taking shape, he observes, “companies are seeking higher returns in the safety of corporate bonds without dipping too far into equities, and at the same time, some are looking to reduce capital surplus through shareholder dividend distributions”. The move on the investment front to slightly riskier exposures and diversification of portfolios is not new, Baker points out, with non-government bond exposures having gradually risen to 30% of total holdings by end 1998 compared with 22% in 1994. “From 1994 there has been a 10 point shift from government to corporate bonds.”

Cameron Laird, senior vice president securities investment of institutional fund managers Zurich Canada Investment Management Ltd., confirms the shift in the p&c industry’s investment approach. “They [companies] have increased their exposure to the corporate and provincial bond sectors, with the emphasis being on single-A or higher risks.” He believes, however, that the industry has not maximized on the benefits of diversifying its bond portfolio, “as a ballpark figure, it’s estimated that a move into corporate bonds would allow a company to pick up 30 to 60 basis points on their yield over the longer term”.

There is definitely a more “nimble” view being taken to investment strategy, Laird says, with three trends emerging: diversification of holdings, investing in bonds over the longer term, and to actively manage investments rather than applying the traditional “buy and hold for yield” approach. Depending on the company, either policy can produce benefits, however, focusing on long-term bonds for a slightly higher yield increases the risk of exposure to interest rate volatility/capital erosion, “a move from a three to five-year term bond currently only provides about 25 to 35 additional basis points on yield, which is not much of a gain. And, sitting on a five-year bond portfolio is not going to provide sufficient yield to offset the current underwriting environment.”

Companies have some soul searching ahead of them in terms of managing their asset allocations to liability exposures, predicts Bill Chinery, vice president and actuary at fund managers YMG Capital Management. A more active position to investment management will have to occur, he adds, with greater focus on portfolio diversification. “Companies will have to take a long-term view to their investment strategies, but in the short-term figure out what is their downside risk.”

Indeed, Chinery notes, there has been a marked move by the industry to portfolio diversification, with increased exposure to equities and preference share investments. The latter class, however, has not been fully utilized by companies, “I don’t think that companies are exploring pref shares to the extent that they should, it doesn’t make any sense…about 80% of the companies don’t hold any pref shares at all”. In addition, Chinery expects a greater number of small to medium size companies will begin to outsource their investment management as increasing pressure is brought to bear on the performance of this side of the business.

U.S. environment

The U.S. p&c sector reported annualized return on equity for the first quarter of 1999 of 10.9% compared with 11.6% for the same period the previous year. The higher-than-expected performance of the sector for the quarter is almost wholly attributed to the rise in interest rates, according to the Insurance Information Institute.

Sean Mooney, senior vice president and economist at Guy Carpenter expects North American interest rates will continue to rise into the year. This, however, will limit the ability of companies to realize capital gains in order to boost overall results. Mooney is fairly optimistic of improved conditions for the industry this year going into 2000, “I expect a modest improvement in primary company results for 1999. There are also signs of a strengthening in premium rates, more like an end to the ‘softness’ rather than a hardening of the market. We will likely see a flat to slightly upward adjustment of commercial premiums this year into the next.”

A rise in premiums bodes well for the industry in the medium to longer term, he says, which, coupled with well-topped capital reserves, should allow most companies to ride through the current hard times.

Rick Sepp, a consultant at San Francisco-based investment bankers Russell Miller Inc., confirms a “market sense” of rising premiums, which is likely to build momentum going into next year. However, similar to the Canadian scenario, the U.S. p&c industry is suffering from the low investment return environment. The p&c sector is currently lagging the performance of the other financial service sectors, he notes, which is unlikely to change over the next two years. This pressure, particularly among stock companies, is motivating the industry to better integrate investment strategies with liabilities, “integrating the management of assets with the liability side of the balance sheet,” he observes.

And, with the industry’s premium-to-surplus ratio declining, coupled with the limited returns achievable in the bond market, companies are looking to increase their holdings in equities and other higher performing assets to boost their operating returns, Sepp remarks. “At December 31, 1997, common stocks represented 43.8% of total surplus, compared with only 36.3% four years ago.”

Another issue coming to the fore is operating expenses, Sepp says, “consolidation has provided companies with a lot more control over their expense levels”. As such, there is a definite move in the market to reduce expense ratios.

Canadian primary company strategies

This market was foreseeable, according to Terry Squire, president of the Co-operators Group Ltd. The industry’s ability to prop up results with realized capital gains is coming to an end, he notes. “I expect capital gain performance to be flat at the 1999 yearend compared with last year — which means we have to work for more with less.”

Squire does not believe that relying on the investment account will be sufficient to stay abreast with competitors this year, the main drive will be on reducing expenses and generating income by enhancing the unique qualities of products. “Our approach is to build our brands, adding value to the product through community initiatives and making sure people know that we are Canadian — this strategy has worked very well so far.”

However, Squire concedes that service and marketing are not the only qualities separating the winners from the losers. “We’re hoping to take out about three percentage points from our expense ratio this year which can be a substantial margin at the operating level to remain competitive.” In a nutshell, he says, “understanding your business and executing it better than the other guy is most likely going to be the business focus this year”.

Commenting on views that the traditional insurance cycle has been broken by current and recent events, Squire adds, “saying the cycle is dead is a bit of a reach, it’s more like it has been stretched like an elastic. It’s only now that ROEs have moved into single digits, this may force the ultimate owners [company shareholders] to look at their position in the p&c business and what do with the capital.” Overall, Squire does not anticipate a rebound in industry profit for 1999 and into next year.

Yves Brouillette, president of ING Canada adopts a similar view, “our approach is straightforward, we have to outperform the market on underwriting to deliver adequate shareholder returns”. ING is keeping a close eye on expense as well as underwriting ratios, which Brouillette demands that the group’s combined ratio will be at least a point better than the industry average. Although the group’s focus will be on underwriting, the investment portfolio will have a role to play. Diversified asset management will grow in stature, he predicts. “Investment management is becoming more important, however, we are in the business of insurance and underwriting comes first.”

CGU Group Canada expects some signs of “selective hardening” of the market this year, mainly in personal lines, says Ross Betteridge, the company chief financial officer. Overall, he does not expect the industry will produce any significant variance in performance for 1999 and the early part of 2000. “Investment yields will probably decline slightly from 1998 levels primarily due to the rise in interest rates since the beginning of 1999. While it is possible that interest rates may decline slightly over the summer months, we expect them to trend higher during the next 12 to 18 months…Equity gains for the balance of the year will not come easily and will likely be in the three to four percent range for the second half of 1999.” As an underwriting approach, CGU will continue to focus on market segments believed to offer above average returns, Betteridge comments.

The failing rates of return on investment will be clearly seen in the industry’s results for this year, says Barry Gilway, CEO of Zurich Canada. If the pressure is on the investment side, then the only options are to improve underwriting and reduce expenses, he adds. Zurich plans on cutting its expense ratio by seven to eight points over the next 18 months, Gilway confirms.

Similar to the approach being taken by Co-operators, Zurich intends building its future strategy on product diversity. “The best way to reduce the expense ratio is to expand the product mix out of the p&c sector and develop new technologies and e-commerce. Our strategy is to be more aggressive on other components of the business. The strength we have in the market is integrated product distribution,” Gilway comments.

Gregg Hanson, president of Wawanesa Insurance, is another member of the camp believing that investment earnings will not provide much support to this year’s figures. The capital gains are not there, he remarks, and although bonds offer the most stability, there is limited potential for realized return.

Underwriting, Hanson says, is where the most improvement on the numbers can be made. “Although our results for the first five months of the year have been good, I don’t expect the industry’s underwriting figures will improve in 1999. However, provided there are no heavy weather-related losses, I don’t think the results will be any worse than 1998.”

Hanson believes Wawanesa has an advantage in the current market in being a mutual insurer, “with the stock companies, shareholders have become accustomed to strong returns, and their expectations won’t be easily dampened. As investment earnings drop, stock companies will have more urgency to produce underwriting profits to satisfy shareholder expectations. Wawanesa has maintained strong underwriting discipline, and I think we’re in a position to weather out the rest of the storm.”

Canadian reinsurance strategies

The market is in a period of cycles within a cycle, comments Angus Ross, president of Sorema North America Re. These economic patterns will most likely produce more “lows” than “highs” in the overall insurance cycle for the reinsurance industry, he observes, which in a low return market, “means that the margin and cash flow simply isn’t there [to support cut pricing]”.

As such, Ross says Sorema has for some time adopted a selective underwriting approach by reducing volume and focusing on profit. “Concentrating on the bottom-line and not the top-line,” he remarks.

As to the underwriting trends being employed in the market, Ross says he has observed three broad mindsets: “there are those CEOs that believe rates will change soon, there are those that don’t see any change at all for the next 12 months, and then those who expect the situation will get worse. Until recently, I was in the ‘won’t change camp’ but I am now seeing more backbone from underwriters which could see a turn in pricing for 2000, but that won’t help this year’s performance. 1999 won’t be a good year even without any sizeable cat costs, the fact is, the premium currently does not equal the risk – period.”

On the investment front, Ross says cash flow is key to asset management. The industry definitely has to do a better job of matching assets and liabilities, he adds, the problem being that in a soft underwriting market the cash flow is not available to structure/hedge asset holdings through a diversified strategy. “Although income on the investment end of the business may rise marginally due to moderately higher interest rates, this will further reduce the availability of capital surplus,” Ross concludes.

Brian Gray, senior vice president of Swiss Re, says reinsurers are beginning to pay closer attention to the combined effect of the underwriting and investment accounts. However, he affirms, reinsurers are still pricing to destroy shareholder value, and without the benefit of an investment runoff, the damage is becoming very visible. As such, Gray expects stronger action from reinsurers in the upcoming reinsurance treaty negotiations (although less than 50% of contracts are renewable this year), primarily as a result of the decline in investment earnings.

The returns on investment simply are not there, confirms Peter Borst, president of Employers Re. And, he notes, there is not much hope on the investment horizon in the short to medium-term. The result of this can only be a strengthening in underwriting prices. Borst is hopeful of a price turn by the end of the year, “accounts that renew at the yearend will get a lot of attention, this is the feeling from both Europe and the U.S. — where the performance isn’t there, then necessary adjustments will be made.”

Overall, Borst expects primary company returns for 1999 will be “below reasonable levels” sparking a market drive to correct prices. However, he notes, “ROEs for this year may still be slightly higher this year compared with 1998 due to the fact that there is no ice storm to contend with”.