How to Survive The Soft Market

It may not be immediately obvious, but competition is alive and well — and quite prevalent — in the Canadian insurance market. One need only look at the size of the market and the sheer number of insurers operating here, along with their respective market shares, to appreciate the validity of this statement.

On more than one occasion, I have been introduced at an industry function to an insurance broker who asks me about the “state” of the reinsurance market, usually as it pertains to catastrophe. Are “cat” prices up or down? Is capacity shrinking or growing? I presume the answers to these questions are determinative as to whether the market is hard or soft, and thus prescribe how brokers should be acting/reacting upon it. With these comments, I’d look to clarify a few points.

Cat covers generally represent the largest value of limits purchased. Although insurers generally find it prudent and necessary to purchase catastrophe protections as a risk management strategy, it might not be the only reinsurance that is purchased. In many cases, the cost of cat covers is not the insurer’s greatest reinsurance expense.

Data taken from the MSA Research and the Reinsurance Research Council (RRC) show the Canadian property and casualty industry wrote approximately Cdn$35 billion worth of premium in 2007. RRC member companies collectively wrote about Cdn$2.2 billion of premium. Reinsurance premiums therefore represent slightly more than 6% of the Canadian total; this number has been declining for a number of years, for a variety of reasons. It would appear safe to say that reinsurance is therefore not the industry driver, but only one component of a fluid market.

To help define current market conditions, let’s look at industry results, again taken from data available from MSA Research. The industry’s combined ratio in 2006 was 92.06%. In 2007, the combined ratio increased to 94.16%. Given that pricing for insurance products is generally decreasing, many in the industry suggest we are currently in a “soft” cycle. How long will it last? What are some possible outcomes?

SOFT CYCLE SCENARIOS

I have created a chart to provide some possible scenarios [see Figure 1]. These scenarios may end up being for specific lines of business and/or for the industry as a whole. The basic premise is that rates will continue to soften. A couple of assumptions are built into the calculations. The first is that rates will continue to decrease at a rate of 10% per annum. Another is that claims will continue to inflate at a rate of 5%. Other percentages can be/could have been used or debated, but the percentages used here are not outside the realm of possibility. Additionally, these calculations were made on the basis that no significant CAT events/losses occur during this period.

As you will note from the chart, the first year with a combined ratio of 95%, is almost precisely the actual industry result for 2007. In the next year, 2008, the ratio jumps to 109%. If the same conditions remain for four consecutive years, the combined ratio is projected to increase to 149% — a staggering number, either for the industry or any single insurance company.

How does a reinsurer survive in this environment? Although some of the answers to this question may be applicable to insurers, the comments offered here are made from a reinsurer’s perspective.

I reference at this point two studies/ reports completed by the consulting firm McKinsey & Company. The first is entitled The Journey. The second is The Journey:Revisited. The primary conclusion is that long-term success depends on a company’s ability to manage risk, as measured largely by the combined ratio. Four main success factors for managing risk are: enterprise risk management; strategic capital management; product market management; and transaction-level execution. Some in our industry refer to this as “managing the cycle.” Others refer to it as having “underwriting discipline.” The key is to establish benchmarks to accurately price risk in support of achieving a targeted combined ratio. Also important is the discipline to decline business when pricing is deemed to be inadequate.

One has to appreciate that a reinsurer’s risk may not be identical to that of the ceding company. A contract may cover the same “risks” as the ceding company, but not necessarily at exactly the same premium. The contract may not cover the same perils. The contract may not have the same attachment point. The reinsurer may provide higher limits. These factors generally mean the reinsurer is more susceptible to severity losses than the insurer. Reinsurers’ results are therefore much more susceptible to volatility and they need to price for that volatility.

In order to succeed, reinsurers generally have to use all of their resources to achieve long-term success. Rather than just relying on a single underwriter to make a decision, they may draw upon actuaries, accountants, lawyers, claims professionals and mathematicians/ modellers.

While balancing the need to maintain strong relationships with clients, reinsurers must also recognize the need to maintain underwriting discipline. This involves many things, but must include the following.

• recognize the need to make an underwriting profit;

• develop metrics and use appropriate statistics;

• assess the “risk” correctly/consistently;

• price the “risk” correctly/consistently;

• be prepared to make difficult decisions;

• be patient and search out new opportunities.

All of this may sound easy enough, but it is difficult to achieve. Just ask any one in the insurance business in Canada. Or better yet, look at our results!