Cover Story: Canadian Reinsurers: Burn Point

Last year produced some of the worst financial results from reinsurers on a global level. Although strengthened rate pricing had begun early in the year, the terrorist attacks of September 11 set a new stage for the industry. These tragic events not only bore a heavy cost on reinsurers, but resulted in elevated scrutiny of the financial security of companies. The result has seen significant shakeups at Lloyd’s of London, while several major global players in the reinsurance business have been downgraded by rating agencies. At least two of these players, Gerling and Axa, have indicated an interest in divesting their global reinsurance operations.

And, it would seem that global rationalization is catching up with the Canadian market. Recently, the White Mountains implemented senior management changes at its Folksamerica Re Co. operation, leaving a sense of speculation that the company may withdraw from the market. The Munich Reinsurance Group is also expected to wind up its specialty risks subsidiary American Re’s Canadian operation by September of this year – which wrote about $30 million in premium for 2001. In both instances, the prime reason assumed for the shakeouts is the extremely poor underwriting performance over recent years. Market commentary would suggest that this may just be the tip of the iceberg.

CANADIAN & U.S. RESULTS

Canadian reinsurers took a major beating in 2001, even though this was not a “cat year” and few local operations carried exposures to the World Trade Center attack. However, the sector’s combined ratio jumped to an alarming 119% by the end of 2001 compared with the 113% of a year before. The sector’s underwriting loss for last year nearly doubled at $302.5 million, which saw the loss ratio rise by 9% to a ratio of 88%. This resulted in a bottom-line profit of $47.6 million against the $145.5 million reported a year prior. The one shining item on the sector’s income statement is the 31% year-on-year increase in net written premiums of $1.8 billion.

First quarter 2002 results from the U.S. are particularly encouraging. Although reinsurers ended 2001 with a sickening combined ratio of about 140%, this fell back to 102% by the end of March this year. The loss ratio stood at 75% at the end of this year’s first quarter. The latest returns also show a 15% year-on-year gain in net written premiums of US$6.6 billion. As a result, the sector was able to produce a net taxed profit of US$359 million for the first quarter of 2002.

RATE EXPECTATIONS

Early indications from the U.S. and Australian markets, where there are a significant number of mid-calendar year treaty renewals, suggest that the upward momentum in pricing shown in December 2002 renewals will continue through this year into 2003 programs, says Patrick Lacourte, chief agent of Partner Re and the current chair of the Reinsurance Research Council (RRC).

Canadian reinsurance rates rose by as much as 50% on catastrophic covers for 2002, with non-cat pricing showing an average 35% increase, according to feedback from company CEOs. The beginning of this year saw “significant increases” applied to cat and liability treaties, says Lacourte, particularly with regard to proportional-type business. While it is still “early days” in predicting where pricing will go for 2003 renewals, Lacourte believes further rate increases will be the order of the day. The extent of the adjustments will depend on the financial performance of both reinsurers and insurers for the first six months of the year. “Second quarter returns for reinsurers will probably be better than at the primary company level,” he suggests. But, whether reinsurers will be able to achieve the appropriate level of ROE by the yearend, remains to be seen, he adds. “It’s going to be tough, but we have to deliver.”

Brian Gray, president of Swiss Reinsurance Co. of Canada, expects pressure will remain on pricing and a tightening of terms as the 2003 treaty renewals approach. “2002 is not looking overly profitable,” he adds, with the “cat weather season” only now beginning. There have already been several large losses in Canada, he notes, and the loss experience from the auto market has not improved by any noticeable means. “2001 was a really bad year for reinsurers, particularly as it was not a ‘cat year’. Reinsurers’ books are designed to build up the bank in non-cat years, and the industry has not been able to do that. 2002 is still an ‘unknown’, and we’re well away from the ‘happy days’. I expect pricing and terms will continue to tighten for 2003, but not as dramatically as over the past year.”

Although 2002 renewal rates did draw some protest from cedents, the pricing adjustments were generally accepted relative to the loss experience. As such, very little premium moved out of the market as a result of higher primary company retentions, Gray notes. In this respect, he does not see any broad movement by insurers to increase retention levels in the upcoming yearend negotiations. “The last renewals saw some covers fall away, but not a huge volume. I don’t see retentions increasing.”

“There definitely won’t be rate decreases,” coming through the 2003 renewals, says Ken Irvin, president of Munich Reinsurance Canada Group. Action taken in the last round of treaty negotiations mostly affected cat programs, he adds, as reinsurers were under increased pressure from the retrocession market. The upcoming 2003 treaty negotiations will likely be more driven on a “per company experience” basis, with expectations based on the state of this year’s primary company results, he notes. Rate adjustments will probably be more tempered in the upcoming treaty round, Irvin predicts, with companies looking to regain adequate pricing to risk over a series of annual increases. “It’s a little unrealistic to think that we can fix the problem in one year.”

While the downgrading of companies by the financial rating agencies is said to have sparked a run by insurers to so-called “quality reputation” underwriters, Irvin believes this has not been a huge factor driving the placement of business in the Canadian market. The “top ten” insurers most definitely place a high degree of importance on ratings of reinsurers, he adds, but this is less so in the broader ranks of the industry. “As long as a reinsurer holds an ‘A’ rating, it doesn’t really matter whether it is a triple or not. However, I do believe that the ratings are important.”

Mike Rende, general manager of HartRe’s Canadian operation, says he would not really describe the current market as a “hard market”. The rate adjustments that came through in 2002 programs were significant, but not like the increases that were brought in during the hard market that resulted after the “liability crisis” in the late 1980s. That was a hard market, Rende observes, where capacity was short and companies used these circumstances to advantage. The current market has ample capacity, although at the “right price”.

Even though the market has seen rate adjustments of up to 50% for 2002, the increases have been mild relative to the loss experience and the extent of rate decreases that occurred in previous years. “There was not a lot of sympathy for reinsurers when insurers were pushing for rate decreases, knowing that the rates were below cost. We’re simply at a point where we can’t keep doing that [providing cover below cost].” As such, Rende is hopeful that the upward pricing momentum will continue into 2003. “There’s no ‘excessive aspect’ to these rate adjustments.”

Catastrophe covers attracted rate increases of between 30% to 40% for 2002, confirms Roy Vincent who is responsible for Canadian treaty decisions at Hannover Re. Casualty-related business, including auto covers, drew rate increases for this year of about 30%, he adds. However, rates are not the only concern of reinsurers, he adds, greater attention is being placed on the nature of the risk being covered. “Reinsurers are trying to get a better idea of exactly what they are covering and have looked at ‘definition of risk’ as well as target risks, and were demanding [through 2002 renewals] mo re information on a number of selected risks.”

At this point, Vincent notes, commercial risk rating at the primary company level is still at least 25% below what it was 10 years ago, and auto remains significantly under-priced relative to the loss experience. “Yes, there will be further momentum to increase pricing [for 2003]. Price momentum must be maintained to deal with the consequences of poor results, falling investment income and loss inflation. One year will not put right the failings of the last few years.”

“We didn’t create this problem in one year, and we’re not going to solve it in one year. Long-term pain takes a good deal of time to correct,” concurs Patrick King, chief agent of Canadian business for Alea Europe Ltd. He expects that reinsurance financial results for this year will remain poor, however, the pricing correction implemented in 2002 will hopefully provide the platform for future profitability. He points out that, although this year has not produced any noticeable losses, companies are still trying to come to terms with past years’ adverse developments. “There’s no fat in the reserves, they have been wrung out. Although there’s adequate capital in the industry, there is shareholder restrictions on how it can be used.”

King does not expect that reinsurance programs for 2003 will rise by as much as the average 40% increase reflected through the market for this year, but as he notes, “rates won’t be going down”. He expects an average rate upward rate adjustment of between 10% to 15% for 2003 renewals. “I think the view is to bring in [price] improvements over several years.” Looking toward the 2003 renewals, he believes that proportional treaties will receive the most attention.

Gerald Wolfe, chief agent of Canadian operations of General Reinsurance Corp., says the company withdrew this year from several accounts because of unfavorable experience. He notes that rates rose on average by between 25% to 40% for 2002 renewals, and expects this price firming to continue into next year. Wolfe points out that a significant part of General Re’s franchise in Canada is facultative casualty and property business. In this respect, rates have been climbing in these sectors steadily over the last 18 months and continue to remain strong. Covers that have attracted some of the largest increases are those with U.S. exposures, specifically the long-haul trucking line. Overall, he says General Re’s Canadian book is now looking to be on the “right course”. Looking ahead, he expects pricing and term adjustments for 2003 will be applied more selectively. “I think that 2003 will be a much improved underwriting year, with a combined ratio of less than 100%.”

Price firming will continue into 2003 renewals, says Andre Fredette, senior vice president and general manager of CCR. However, Fredette expects that reinsurers will enter the upcoming annual renewals with a more “consistent approach” than some of the stark adjustments made for the current year. Corrections made for 2002 were made mostly “across the board”, he adds, and a more selective process is likely to drive next year’s renewals. The placement of pro-rata business by cedents will be particularly difficult, he predicts. Fredette is looking for a combined ratio of about 104% by the end of this year with an ROE of around 6%.

“I expect to see upward pricing adjustments of between 10% to 30% for 2003, but a lot will depend on the primary company results. I also think the 2003 renewals will depend on individual company experiences,” comments Patrick McGuinness, vice president of multi-line underwriting at Scor Canada Reinsurance Co. He believes the rate adjustments applied to 2003 programs will be “not as heavy as 2002”, although the market is likely to see a further reduction in capacity.

In this respect, McGuinness thinks the Canadian market has the potential to harden further than the U.S. where new capital has begun curbing the extent of rate increases. At this point, rates are still a long shot short of adequacy, he notes, “and there’s no way I foresee a softening of the market for at least the next two years”.

Bob Ysseldyk, president of Odyssey Reinsurance Co. of Canada, notes that the 2002 renewals brought in generally hefty price hikes. While this price firming is likely to continue into the 2003 treaty negotiations, the rate adjustments are expected to be less severe, he adds. “I think the hard market is here to stay until interest rates increase. Quiet simply, reinsurers have to provide a return to their shareholders.”

EXPOSURE CONCERNS

Ongoing losses stemming from the auto market are without question one of the biggest concerns within the Canadian market, says Irvin. Specifically, corrective action has to be taken in the Ontario and Alberta marketplaces, he adds. “Because of the sheer size of the auto market, it impacts on everything.”

“Ontario auto drives both the primary and reinsurance markets,” concurs Wolfe. At this stage, “no one seems to be really stepping up to the plate”, he adds, and until product reform is brought about, insurers are unlikely to make a profit on this particular line. For reinsurers, the loss tally at the primary level is not something that can be ignored, he notes.

Gray believes that reinsurers still face grave risks through natural catastrophes, specifically earthquake exposures. “I believe that more tightening of terms is needed mostly on proportional-type covers applying to earthquake risk. The potential risk of natural catastrophes is not reflected in the current pricing.” In addition, Gray sees toxic mold and asbestosis liability risks as being of high concern. “we do think these are important concerns in the Canadian marketplace.” He says Swiss Re is pursuing clients to identify potential exposures to mold claims and what primary companies are doing to mitigate this particular loss threat. “On the asbestosis side, there has been a resurgence of claims, and there are concerns about the reserves of reinsurers and insurers to this exposure.”

The recent directors’ and officers’ (D&O) “false accounting” liability exposures of insurers/reinsurers displayed through the Enron and WorldCom incidences is an area which will likely draw attention in the upcoming treaty renewal discussions, says Vincent. Other top-risk priorities include “cyber-space liability” and toxic mold. “Toxic mold was, and is, a coming issue for the 2003 renewal season. The market will also have to carefully look at the issue of ‘false accounting’ and the impact on the surety bond and D&O markets.”

CONSOLIDATION & SHAKEOUTS

“I think that [Canadian reinsurance] management shakeups are in the pipeline,” says Ysseldyk. Parent owners are placing greater pressure on branch operations this year to provide adequate returns, he adds, with the underlying threat that operations will be pulled unless local companies “clean up their act”. In this respect, Ysseldyk sees some reinsurance operations in Canada disappearing from the landscape. However, this is not likely to occur through acquisition, as there is little incentive for a reinsurer to buy another player. Consolidation is likely to come through companies withdrawing from the marketplace, he predicts.

Lacourte also anticipates potential management reshuffling within reinsurance ranks. “Pressure on reinsurance management is high, the message is clear: we have to deliver.” However, Lacourte does not expect that the new capital that has sprung up in Bermuda will have the same dire competitive results as in the hard market of 1993. “It’s clear that this new capital is only available at the right price. A lot of this new equity is coming from experienced brokers in the market.”

Senior management changes have already occurred at reinsurance global head-office levels, observes King. This management restructuring is beginning to surface in the local marketplace, he notes. “Parent companies are taking a more active position with their Canadian operations. You can see this in the stricter underwriting guidelines, and the reduced autonomy of branch offices.”

Gray concurs with this view, noting that many reinsur ance branches in Canada have lost their local decision-making ability. “Decisions are now being made in the U.S. and Europe for many players.” Furthermore, he points out that “new capital” is always a “competitive factor”. However, the so-called new capital that has entered the global marketplace through Bermuda does not come close to the amount of “easy capital” that was withdrawn from the market last year. Plus, Gray observes, the new Bermuda capital is being targeted at markets with a higher premium base, and where opportunities have opened up through tighter underwriting restrictions, namely terrorism-related risks. As such, the “Bermuda factor” is unlikely to have much

bearing on the Canadian marketplace.

“If we deal with just the reinsurance market, Canada has to face the fact that control of this market is basically offshore,” says Vincent. Against the backdrop of dismal financial results that have plagued the sector for several years, it became inevitable that management would eventually be taken to account for their branch’s performance. “Even local management cannot escape the consequences of poor performance. Recent changes have shown that head-offices are prepared to act. We all know that right now there are reinsurers whose future is currently being decided.” Vincent also believes that the new Bermuda capital will have little impact on the Canadian front, as “Canada is not high on their radar-screens”. Also, he notes, many of these new players are not licensed to operate in Canada, and therefore pricing in the market will continue to be driven by the existing players. “It should be noted that the reinsurance market in Canada is broker dominated. For this market to function, there must be enough participants. With the potential demise of current market participants, there is a need for alternatives.”

Irvin notes that management restructuring is already well underway in the U.S. reinsurance sector. In this respect, he believes that there could be a spillover of change and consolidation in the Canadian market, although this is likely to be led by companies withdrawing rather than merger and acquisition activity. “There is no value in a reinsurer buying another reinsurer. I think some of the smaller players may pull out of Canada if the operation is not deemed to be viable. The focus is definitely on profitability.”