IBC Financial Affairs Symposium Weathering Storms

There was no finger pointing, but an acceptance of widespread failure on the part of the industry as a panel of reinsurers addressed last year’s dismal results at the recent Insurance Bureau of Canada (IBC) Financial Affairs Symposium in Toronto.

The numbers are tough to take, admits Gerry Wolfe, chief agent in Canada for GeneralCologne Re. Since the takeover of GeneralCologne by Warren Buffett and Berkshire Hathaway three years ago, the company has lost US$6.1 billion, a frightening number, he says, but an indication of problems hampering the entire industry. Losses have come from many lines — commercial auto, commercial umbrella, medical malpractice, directors and officers (D&O), general liability. In Canada, the Ontario auto market is plaguing the entire industry, he adds.

The downward spiral faced by reinsurers comes as a result of a loss of underwriting discipline, asserts Wolfe. Companies were underwriting for volume and growth, to attain marketshare, rather than to make a profit. Poor results were “camouflaged” by this gain in volume or marketshare.

Exposure-based analysis

Reinsurers should not be looking simply to get their combined ratio under 100% (in 2001, it was 110% for Canadian reinsurers, 142% in the U.S.), but should aim for the low to mid-90% range in order to weather long-tail risks, man-made catastrophes and volatility in the market, says Wolfe. They should not be looking at “what they can get”, but at “what they should be getting” in terms of pricing risks.

A new approach to risk analysis is needed, a departure from past approaches relying on a client’s loss history, and toward the assessment of potential future losses. “We need to include an exposure-based analysis”, he adds, and to look at emerging risk areas, such as terrorism, the Internet, D&O and surety.

The World Trade Center (WTC) event is one example of insufficient pricing, given that the risk was underwritten based on the potential loss of just six to eight floors of the building. Such policies also have failed to take into account workers compensation losses from having a concentration of white collar workers in a “head office” location, such as the WTC.

Pricing is a concern, agrees Peter Borst, chief agent in Canada for Employers Reinsurance Corp. The industry finds itself attracting under priced, bad business when it fails to price according to risk, and instead looks to increase marketshare. And the same is true during a hard market, when the market institutes “blanket” increases that do not respect the actual level of risk involved in a specific portfolio.

Another problem adding to reinsurers’ woes is reserving strategies, adds Borst. In life insurance, reserving is based on exposure, while in p&c it is done based on premium. “Unfortunately this rarely tracks accurately with exposure.”

Expecting the worst

Reinsurers have shown “naive optimism” in denying that the worst could happen, says David Wilmot, chief agent in Canada for Toa Re. For example, the first terrorist attack on the WTC in 1993 should have been a sign of its vulnerability, but terrorism exclusions were quickly withdrawn after that event. The same is true in earthquake risks, where reinsurers are prepared for a US$7-9 billion hit, despite the US$15 billion damage done in 1994 by the Northridge, California earthquake. In Canada, “writing profitable business in B.C. [on earthquake risks] may be our greatest tribute to optimism”.

The industry is also not prepared for the new risks that they could face, everything from climate change that is likely to create more hurricanes, forest fires and tornadoes in the future, to prophesies of large-scale damage from falling meteorites, Wilmot adds. At the same time, the world is increasingly urbanized, with greater reliance on technology and greater potential for massive lawsuits, such as in the case of Enron. The question becomes “do we not write this” or can reinsurers find a way to price the unimaginable, worst-case-scenario risks?

Wilmot says it is not enough to raise rates and underwrite more tightly, reinsurers need to better understand risks and be willing to walk away from the uninsurable when necessary. Beyond rising reinsurance rates, the market will also see capacity restrictions for large property risks in the facultative market, predicts Wolfe. And many companies will likely back away from quota share business, where it is “almost impossible to generate a profit, especially if the industry is at 110% combined”.

“Sober” capital

The industry’s woes have not gone unnoticed by investors. The “sober” corporate capital that reinsurers represent have said “enough”, says Wilmot. “DeutscheBank just announced that they don’t love insurance anymore”, and they are not the only ones.

Yet, he adds, at the same time that insurance is falling out of favor for some investors, others are establishing new off-shore reinsurance operations. These new entities do not have the baggage of current losses experienced by existing players, but will not likely be around once the market turns again. They “can cream the business” until they bring the market back to competitiveness, then they will execute pre-arranged exit strategies.

Wolfe expects that increased spin-off and initial public offering activity, as has been seen in the past several weeks in the reinsurance market, is also likely to continue.

Taxing issues

As part of the symposium, the IBC also took the opportunity to update its activities in lobbying for tax reform, however, its efforts have been stalled by the overall rough shape of the economy, says Stephen Donohoe, manager of taxation, Lombard Canada Ltd. and chair of the IBC’s tax panel.

A new international study by the IBC comparing Canada’s taxation system for p&c insurers to other G-7 countries finds companies here face the heaviest tax burden. The study also shows that Canada is the only G-7 country that currently levies significant taxes on capital, and the only one to apply sales tax on the premium inclusive of the premium tax, notes Ian Campbell, manager of policy development for IBC. If the study’s recommendation to eliminate capital taxes and phase out sales tax on premiums were implemented, the effective tax rate would drop to 5.3% from its current 11.8%. It would be reduced further to 5% if premium taxes were dropped to 2%. The U.S. rate is 4.5%

The IBC is “doing all this research now and keeping it in our bottom drawer until the economy gets better”, says Nunzio Tedesco, partner in KPMG’s insurance industry practice. He also refers to a study by the Ontario Chamber of Commerce that recommends corporate capital taxes be phased out, and a decrease on premium taxes, proposals that would be difficult to implement in the current economic downturn.

Financial services companies will also be watching the outcome of dispute between Riverfront Medical Evaluations Ltd. and the Canada Customs and Revenue Agency (CCRA) over the application of GST/harmonized sales tax to independent medical evaluations (IMEs) in the Tax Court of Canada, reports Danny Cisterna, partner at Deloitte & Touche. Currently, the tax court has ruled that IMS reports are tax exempt and Cisterna advises insurers to “get on the bandwagon and file rebates” if they have paid for GST on these services, in advance of a ruling on the CCRA appeal this fall.