Defying Gravity

It is common knowledge Canada’s insurance industry is well into the fourth year of a so-called ‘soft cycle,’ characterized by generous policy coverage and a reduction of premium rates, all in an effort to entice more policyholders and thereby gain additional market share. Soft cycles are no stranger to the Canadian insurance industry: reinsurers and primary insurers alike rode out a particularly nasty soft cycle in the late 1990s. During that time, the Top 28 Canadian reinsurers (measured by net premiums written) reported ugly industry combined ratios of 117.8% in 1998 and 105.5% in 1999.The combined ratio is an indicator of a company’s financial strength and is derived by dividing claims losses by premiums written. Percentages more than 100 indicate more losses sustained than premium collected; no reinsurer wants to see that.

And yet, the same soft market cycle 10 years ago featured a silver lining — booming investment income. The same 28 reinsurers 10 years ago amassed Cdn$357.6 million in investment income, just short of the Cdn$382.6 million in investment income that a similar group of reinsurers posted in 2007.And so, 10 years ago, that investment income was put to use supporting questionable premium pricing and generous underwriting terms and conditions. This led to a situation in which policyholders ended up feeling more than a little sideswiped by the higher premiums and narrowing coverage terms that characterized the subsequent hard market in the early 2000s. Regulators took an active interest in the policyholders’ concerns. Insurers and reinsurers responded that their actions were required to raise the capital that had evaporated during previous soft market cycles.

Which brings us to 2008. Once again, after a few years of relatively few catastrophe losses, the industry is flush with capital. Once again, reinsurers find themselves defying the gravitational pull towards cutting their own rates. This time, however, even though rates on the primary insurers’ side are currently plunging — particularly on the commercial side, which is routinely demonstrating anecdotal evidence of rate cuts between 20-50% — reinsurers riding this soft market are generally holding the line at less substantial reinsurance premium decreases of between 5-10%. The effect is a widening gap between primary insurance premium rates and reinsurance premium rates, and this is something that makes this soft market in Canada quite different than others, reinsurers note.

THE WIDENING GAP

“I would characterize this [soft market] as quite different in some respects from the prior soft markets,” says Caroline Kane, senior vice president and chief agent in Canada for The Toa Reinsurance Company of America. “For one thing, what we’ve seen…happen in the past is this: either the primary market or the reinsurance market starts to soften first and then, very shortly thereafter, the other side follows suit.” This, time however, “the reinsurance market [has] remained fairly disciplined,” she says. “So it was really out of sync with the primary market.”

Which isn’t to say reinsurers aren’t currently experiencing a soft market, adds Cam MacDonald, vice president of the Transatlantic Reinsurance Company. The difference is more one of degree. “On the primary side, on commercial property for example, we’ve got big rate cuts again — in the 20% and 30% [range],” MacDonald notes. “We haven’t seen rate cuts to that degree on any reinsurance program. We’ve seen the fives and 10s, maybe the odd one with a little more, but certainly not the 30s, 40s and 50s you hear have happened on certain primary business.”

One would think Canadian reinsurers would be pleased about their current prudence relative to the primary market. But many still approach this cycle with some trepidation. Andr Fredette, senior vice president and general manager of Caisse Centrale de Reassurance (CCR), notes Canadian reinsurers are still influenced to a degree by ratecutting on the primary side, even if reinsurers remain wary of racing the primary sector down to levels of unprofitability.

“We’re in for the ride,” Fredette says. “In theory, if the client’s underlying price or rate has gone down, our prices should go up, because the exposure stays the same,” he says. “So assuming you have a constant — which is the exposure and the number of losses — if the client’s premium base is going down because he’s cutting the rates, in theory we should charge a higher rate to have the same premium, because we’re going to have the same number of losses. But in fact that doesn’t happen in the real world.”

In the real world, primary insurers, flush with capital, are trying to leverage their ability to retain more risk to get a better rate from reinsurers. Fredette recalls one recent example in which an American primary insurer pitched business to the CCR in exchange for a reduced premium rate. “It was a 20-25% reduction,” Fredette remembers. “In other words, [their] head office decided:’Here’s the price we’re pitching to the reinsurers and if they don’t buy it at this price, we’ll keep [it as] a net [retention] and house it in head office.’We’re seeing a little bit more where the larger companies are throwing some weight around.”

INCREASED RETENTION OF EXPOSURE

Primary insurance companies ceding less of their business to reinsurers is a feature often noted of the current soft market cycle. Having said that, primary companies, when they are awash in available capital, can and do cede more of their portfolio to reinsurance companies, thus taking advantage of lower reinsurance rates and generous terms and conditions. “In a way, in a soft market, you can keep on ceding (premium to reinsurers),” observes Francis Blumberg, chief agent for Canada at PartnerRe. “You can get better conditions [than] in a hard market for your reinsurance.” He says PartnerRe has seen some evidence of primary insurers employing this strategy during the current soft market.

Nevertheless, by and large, the opposite seems to be happening, many reinsurers note. “Typically what we’ve seen in previous soft markets is companies looking at laying off more risk,” says Kane. “In other words, increasing a quota share cession [in which an insurer assigns a proportion of its portfolio to a reinsurer in exchange for paying a premium] or buying an opportunistic excessive loss layer — a layer, in other words, that they don’t really need because the pricing is cheap.” But during the 2008 renewals, Kane notes, “we’ve actually seen the opposite:we’ve seen several companies actually increase retention or replace their proportional reinsurance with excessive loss. That goes against the grain of a typical soft market cycle.”

And so the question becomes: For how long will Canadian reinsurers be able to continue to defy gravity, avoiding the temptation of offering better terms to primary insurers in an effort to regain a bigger portion of the shrinking pie of the country’s reinsurance business? The answer depends on several factors at play in the current soft market.

INVESTMENTS THEN AND NOW

First of all, it would appear at the moment that Canadian reinsurers are not willing and/or able to rely as they once did on investment income to finance rate decreases. In other words, they are less likely to rely on “cash flow underwriting,” in which investment income is used to support unsustainable premiums or unprofitable underwriting terms and conditions, all for the sake of expanding market share.

“In the 90s, we had a very pronounced [soft] cycle,” says Jean-Jacques Henchoz, president and CEO of Swiss Reinsurance Company Canada. “There was a lot of cash-flow underwriting being performed generally, not only in Canada. And this was because companies were expecting good investment returns on their asset base and were counting on asset management revenues to compensate for substandard underwriting.

“I think this is probably the biggest difference between then and today: this kind of cash-flow underwriting is no longer attractive. T oday, obviously you have the current difficulties and challenges on the financial markets. You have a much more volatile situation. The capital markets are experiencing much more volatility, profit margins are much thinner than they used to be, and so relying on revenues on asset management activities is no longer part of the game.”

Canada’s current economic environment features low interest rates, which has contributed to keeping investment income now from reaching the values attained in the late 1990s. “The only truly differentiating factor I see with this soft market is the low interest rate environment this time around,” says Ken Irvin, president and CEO of Munich Reinsurance Company of Canada. “The optimist would say that low investment returns, combined with much more sophisticated modeling and analytical tools, will result in quicker response times to poor underwriting results — and therefore a less protracted and damaging soft market cycle.”

Another factor indirectly affecting investment income is the fallout related to the subprime mortgage crisis in the United States. Canada has been predominantly sheltered from the effects of the so-called “credit crunch” arising from the securitization of questionable subprime mortgage loans in the United States. But as a result of the regulatory response to this event, the movement of capital or credit may be subject to more restrictions than it was prior to subprime; this may in turn have some sort of residual, indirect impact on Canadian insurers’ investments.

“The credit crunch leads to more volatility in the financial market, which may impact the [reinsurer’s] income statement, the balance sheet, as well as the liquidity of the market,” says Christophe Colle, the branch director and chief agent in Canada for XL Re America Inc.

The impact to the income statement is based on the fact that reserves are booked on a “discounted” basis. As MSA Research notes, starting in 2003, Canada’s insurance industry regulators required the country’s property and casualty (re)insurers to “discount” their outstanding loss reserves “to reflect the time-value of money.” Mandatory reserve discounting flows directly through the balance sheet and income statements affecting loss ratios, combined ratios and return on equity (ROE). In other words, insurance companies ‘discount’ or reduce their reserve money, which is used to cover costs associated with prior-year claims, based on how much investment income they anticipate for the year. Reserves might be budgeted at a lower level, for example, if anticipated investment income can make up for any shortfall in the reserve money. An insurer’s combined ratio is partly contingent on a measure of the company’s reserves. Thus if an insurer’s investment income fluctuates because of market volatility, it won’t be clear how much of its reserves should be budgeted for losses. This could throw off an insurer’s combined ratio by as much as two or three points, a significant deviation. Therefore, based on the “storm clouds” on the horizon associated with subprime, many insurers are more hesitant in this soft market cycle to rely on their investment income as a means to a larger share of the business in the Canadian marketplace.

Henry Klecan, president and CEO of SCOR Canada Reinsurance Company, says reinsurers have very little in the way of investments to substitute for a loss of income, relative to past soft markets. “Our investment returns are by no means what they were 10 years ago, so it’s not as if we have this incredible fallback position with very good investment rates to guarantee anything,” he says.

Several reinsurers say there are also fewer players in the game now than 10 years ago, which is also cited as a moderating influence on the current soft market. Steve Smith, president of Farm Mutual Reinsurance Plan, says “the single biggest issue distinguishing [the current soft market] is just that there are fewer players involved.” Certainly a look at Reinsurance Council of Canada (RCC) shows some signs of gradually increasing market concentration over the past 10 years among its 13 listed full members (it also has associate and correspondent members). Such consolidation might be a restraining influence unique to this particular soft market, MacDonald says. “One of the big things, certainly from a Canadian perspective, is that the number of what we’ll call ‘significant’ reinsurers has got smaller and smaller and smaller,” he says. “So there are fewer mavericks out there, or fewer new entrants that are trying to buy their way into the market. I think that is slowing the softening market.”

CONSOLIDATION

There are limits to this argument, says Henchoz. “I would argue…that the barriers to entry in this market are not that high, so there’s always room for short-term, more opportunistic type of capital,” he says. “And to some extent, this is offsetting the potential impact of consolidation. When prices are attractive, when prices are increasing, there’s always a plethora of start-up companies ready to start on the wagon and write more business, so I don’t believe consolidation has had a tremendous impact in Canada.”

THE WORLD IS WATCHING

But it’s not just a matter of fewer reinsurers watching over each other. Certainly the entire industry has promoted a cautious approach after suffering through the public relations debacle following the last soft market cycle. But this approach, in itself, is subject to greater scrutiny by regulators, policyholders and ratings agencies alike.

“There isn’t one reinsurer I know that doesn’t say to themselves,’We have to be very careful in how we manage our businesses,'” Klecan says. “Because between the shareholders, between all of the stakeholders, there are many people watching us. That wasn’t the case in the late 90s. I think that’s something sobering. They saw the sins of the past and there’s always a curiosity about whether those sins of the past will resurface…. How many times does a smart person need to learn?”

Canada’s Office of the Superintendent of Financial Institutions (OSFI), the solvency regulator for the nation’s financial sector, is watching the insurance industry very carefully, paying attention to the industry’s use of capital and whether that capital is supporting sound underwriting decisions.

Many Canadian reinsurers, for example, are waiting to see the outcome of changes to Part XIII of the Insurance Act, which has been amended to be aligned better with the country’s Wind-up and Restructuring Act. And in a recent speech before Langdon Hall in Cambridge, Ontario, OSFI Superintendent of Financial Institutions Julie Dickson announced an initiative that will see OSFI introduce new initiatives related to the oversight of Canada’s reinsurance industry in the fall.

“A discussion paper is currently being prepared by OSFI that will address a wide range of reinsurance issues,” Dickson said. “Its purpose will be to outline OSFI’s current regulatory and supervisory approach and identify a number of OSFI initiatives underway…

“A key subject of the paper will be collateral requirements that are applied to unregistered (or ‘foreign’) reinsurance activities, and the issues associated with the possible pursuit of a system of mutual recognition for reinsurance supervision in the long term. This issue has been the subject of much debate, domestically and internationally via the International Association of Insurance Supervisors (IAIS), the National Association of Insurance Commissioners (NAIC) and regulators such as the Australian Prudential Regulatory Authority (APRA). It is one which is of particular importance for Canada, given that the Canadian reinsurance market is primarily composed of foreign firms, many of which have opted, for sound business reasons, to underwrite reinsurance contracts on Canadian risks directly from abroad.

“The paper will also address corporate governance issues, regulatory limits such as the 25% limit on unregistered reinsurance and the 75% fronting limit, capital requirements and the app rovals process for reinsurance transactions, among other areas.”

Long story short: reinsurance is on the regulator’s radar screen, meaning industry practices are under scrutiny. “There are so many regulatory issues on the horizon that probably will impact both the insurance and reinsurance market that companies are reluctant to go hell-bent-for-leather [with rate cuts] because they’re just not quite sure what the reinsurance landscape will look like over the next year or two or three,” says MacDonald. “So there’s some trepidation there, especially on the part of the reinsurers.”

Investors also are watching the reinsurance industry carefully. And more so than in past soft markets, they are likely to be unforgiving of business practices that result in the injudicious use of capital. “I think that shareholders are certainly expecting a disciplined approach to our business,” Klecan says. “I don’t think any shareholder wants to continue losing business or money for long periods of time. They certainly weren’t as vigilant [in the soft market period of the early 1990s] as they are today. They say capital is easy to get a hold of, but the return expectations are certainly there and shareholders will not hesitate to make a turn when it is necessary. I don’t believe their tolerance for pain is as high as it maybe was once upon a time.”

Faced with increased scrutiny, the reinsurance industry has placed more of its faith in science. Methods for determining rates and the best use of capital are now rationalized compared to what they were years ago, when, as one reinsurer put it, rates could have been established on the basis of cocktail napkin sketches.

“This time, we have more sophisticated pricing, we have better data, you can see more clearly that the rates are insufficient,” says Blumberg. “I’m not saying the quality [of the industry’s pricing models] is outstanding right now, but I think it’s better than what we had in the past in terms of pricing tools. We have made a bit of progress over the last 10 years on that front. And yet, we’re not behaving any differently at all. So that is a big difference [between soft cycles].We know better this time and yet we still behave the same way.”

MARKING THE TURN

What will it take for Canada’s insurance market to reach a point in which it must start to charge increased premium rates? Perhaps more importantly, will these market conditions occur before reinsurers feel themselves getting sucked into a vortex created by falling rates on the primary side?

A future large-scale natural catastrophe is the wild card in all of this. But given how much available capital is floating around in the North American market right now, Kane believes such a disaster in Canada would have little impact on the country’s reinsurance market, given its small size. She points to the 1998 Ice Storm in eastern Ontario and Quebec, which set a record for claims and cost the insurance industry roughly Cdn$1.8 billion, and had virtually no impact on catastrophe rates in the country. In fact, MacDonald notes, catastrophe insurance premiums in Canada actually decreased after the storm. MacDonald says it would take a catastrophe on the order of a US$140-billion hurricane hitting Miami or New York to take out much of the excess capital currently in the system. Joel Baker, president and CEO of MSA Research Inc., recently estimated Canada’s insurance market has an excess of Cdn$11 billion in capital.

In some ways, Smith noted, the primary market’s increasing retention of exposure may ultimately be the cause of market hardening in the future. For example, there has been a dramatic increase in claims severity recently seen in Canada’s auto results. “I didn’t think we’ve seen this kind of severity this quickly,” says Smith, pointing to liability results on the auto side. “We’re seeing those Cdn$10-million, $11-million and $12-million judgments suddenly, which we didn’t anticipate. There wasn’t a gradual trend to it. It was suddenly just ‘Boom,’ they were there.” Smith notes these kinds of severe net losses can add up when they are not reinsured, or when primary insurers’ excess-ofloss treaties start at Cdn$2 million or $3 million or higher instead of at lower excess-of-loss layers. “That may in fact slow down the [soft market] deterioration, if all of a sudden they [the primary insurers] are getting a lot of net losses,” Fredette agrees. “That may shock them into thinking: ‘Gee, we’ve always kept those big retentions and now we’re getting killed with this stuff…’We are seeing more net losses by companies [on the primary side], which may have an impact in slowing down the erosion of the marketplace.”

Others, however, are not quite as optimistic the defiance of gravity witnessed thus far in the current soft cycle will be maintained. “The skeptic in me remains unconvinced,” says Irvin. “I believe that, at least on the commercial lines of business, we are in for another couple of years of falling and/or depressed rates…A horrific storm season with commensurate insured losses could definitely have a global effect on prices — but that possibility exists every year. Also, the industry is currently very well capitalized.”

It remains to be seen how much longer the reinsurance side will be able to maintain its discipline when primary rates in the current soft market continue to go down. Definitely, many factors are in play during this soft market that make it unique:

• an increasing gap between primary and reinsurance rates;

• more financial pressures on investment income now than in the past;

• greater retentions of exposure by the primary side;

• consolidation in the industry that discourages “rogue” rate-slashing behaviours; and

• intense scrutiny by regulators, shareholders and rating agencies alike. And yet, the cycle has lasted four years thus far; absent of any major catastrophes, it may well extend for a few more years. In this context, how much longer will reinsurers be able to hang onto its well-defended notion of underwriting discipline?