Elusive Gains…

Although insurers’ return on equity for the second quarter of this year shows marked improvement at 4% compared with the 2.3% return shown for the first three month period, the industry continues to be plagued by runaway claims costs. Further earnings pressure is now coming to bear through falling stock market values that were largely to blame for the latest 30% drop in the industry’s quarterly net profit. With claims expenses rising above premium rate adjustments and the investment environment being as volatile as it is, insurers are unlikely to achieve an appropriate ROE for at least another two years, observes the Insurance Bureau of Canada’s chief economist Paul Kovacs.

Kovacs estimates that the Canadian property and casualty insurance industry will likely grow from 2000’s premium revenue of about $20 billion to approximately $30 billion by 2003. Despite this 50% jump in premium volume over a very short time period – driven almost entirely by rate increases – insurers are not keeping up with claims costs feeding back into the system. “The industry isn’t making a reasonable profit even with a 50% increase in revenue,” he notes. The question now is, just how far can the industry go in raising pricing before meeting consumer resistance? “Are consumers ready to pay $35 billion, or maybe more, to buy insurance? That’s anybody’s guess,” says Kovacs. One thing is for sure, he notes, “we’re [the industry] not where I hoped we’d be at the half year point. The stock markets are a mess, and I really didn’t think that it would turn out this bad”.

The latest industry financial returns do, however, point to a prolonged recovery with every indication being that price firming will continue to drive the business cycle for some time to come, says Kovacs. Second quarter returns for this year suggest that the industry’s underwriting loss fell to $214 million compared with the $247 million loss reported for the same period in 2001. The latest loss figure is also significantly better than the $473 million loss shown for the first three months of this year. However, the fact that this year’s second quarter loss ratio rose to 74.3% from the 72.8% reported a year ago, is alarming, Kovacs observes. This suggests that the modest underwriting improvement shown for the first quarter of this year had reversed direction by the end of the second half.

Comparing first quarter and second quarter financial data can be deceptive, Kovacs points out, due to seasonal factors. Traditionally, first quarter returns tend to be more favorable whereas the industry’s fourth quarter financial performance is more volatile mainly as a result of reserving adjustments. But, in looking at the latest quarter returns relative to the first quarter and the comparable periods from a year before, the numbers would indicate that the industry’s loss ratio is back on the rise.

The most obvious explanation for this loss trend deterioration is that company’s are making mid-year reserving adjustments, which would be reflected on the books as a claim expense. While making reserve adjustments during the course of the year is unusual, Kovacs says that he has heard talk that some insurers are doing this in response to the sharp and unpredictable escalations in claims costs – primarily on auto business. “I think this is a sign of just how poor a state the underwriting environment currently is,” Kovacs notes. “I believe this [reserve adjusting] is showing up in the latest quarter loss numbers.”

And, while adverse development reserving actions are a clear sign that insurers are under cost pressure, this does not mean that the industry’s financial stability is at threat, Kovacs says. Although there are a greater number of companies that are currently more at risk of failure based on MAT (the minimum asset test) than has been the case over recent years, the industry remains well capitalized, he notes. The real financial test for the industry lies in the fourth quarter returns, he adds, which is when the large reserve adjustments kick in. “This will play heavily on the industry’s full year performance. We’re all holding our breath to see where it [the industry’s financial performance] is going.”

With the prospect of capital gains having dried up (at least for the immediate future) and the investment yield on insurers’ portfolios remaining disappointingly low (the industry’s profit from fixed-income securities fell by 8% year-on-year for the second quarter of this year), it has become glaringly obvious that companies have little flexibility to maneuver. Ongoing pricing adjustments and other underwriting corrections are the only options open to insurers. But, even then, time is clearly the issue at stake, and for some players the prize may prove elusive.