Insight: Beating the Capital Drum

While the beat of war drums from down south might currently sound distant to those in the Canadian property and casualty insurance industry, insurer CEOs believe that the restructuring turmoil underway in the U.S. – which has seen some major players exit mainstream lines of business while others such as Kemper are in the process of moving out of underwriting altogether – could soon spill over our border. The main driver behind the global shakeout taking place in the primary insurance marketplace is the dramatic reduction in the industry’s capital during 2002, the consequence of which has seen financial rating downgrades of nearly all the top-ranked international players. As a result, capital has become the prize of the battlefield, with the Canadian marketplace no less exposed to the threat of broad consolidation, they predict. However, while battles produce casualties, they also sometimes present fortune, the critical decider in this respect will be how companies conduct their business this year, the CEOs say.

With the global property and casualty insurance industry having lost about US$200 billion in capital value last year primarily as a result of the slump in investment markets, the benefits of the broad price firming that began in 2001 and culminated in the current “hard market” are looking extremely less attractive to shareholders. While insurers’ premium volumes have been rising steadfastly, many are now seeing the value of their surpluses plummeting – creating a vicious circle where a lack of capital is unable to sustain existing business let alone provide for new business growth. As a result, access to and the employment of capital have become the battle weapons as insurers wage forward into 2003, company CEOs say. The question really is, which companies are best prepared for survival, they add.

‘This is the first time that we haven’t been in a position to manage our top line [premium growth],” says Steve Smith, chief operating officer at Kingsway General Insurance Co. in response to the limitation placed by capital on growing the business. Industry capital has become scarce and is definitely a lot more difficult to get access to, he notes. “Because of our U.S. operations we’re [Kingsway] okay, but if our business was just Canadian, we would have difficulties [accessing capital based on return on investment].”

The capital constraint on companies is a major factor behind the current underwriting capacity shortage that to a large extent is the driving force behind the hard market, he observes. George Cooke, president of The Dominion of Canada General Insurance Co., concurs with this perspective, noting that there is presently a lot of “good business” out on the street because market capacity is no longer there. “There’s no question that the lack of capital availability is adding to the market capacity problem. I don’t think people really realize that this [capacity problem] is largely due to the capital shortage.”

The “capital factor” and its influence on underwriting capacity is not only affecting insurance companies but insureds as well, says David Mew, national broking director at AON Reed Stenhouse. Prior to the “capital drought”, placing large commercial risks entirely within the Canadian market was not a problem, he notes, whereas securing such cover in today’s environment likely means splitting the business between Canada, Bermuda and the U.K. The lack of capacity has been particularly pronounced in the mid-commercial manufacturing market, he adds, as insurers have cut back on less profitable lines of business to focus their capital resources. The capital restriction on insurers in Canada has been more adverse within the ranks of the branch operations of international companies, Mew observes, as foreign parents have been loath to commit further resources to a generally under-performing marketplace. The biggest problem facing insurers in Canada is their exposure to personal auto which has locked up a significant portion of the industry’s capital, he adds.

“There’s no question that capital constraint has had a negative impact on the global p&c insurance industry,” says Larry Simmons, president of Royal & SunAlliance Insurance Group. The effect has been particularly hard-hitting for European-owned insurers which typically have maintained higher equity investment exposures than their North American cousins. Although interest-bearing investments have been poor in performance over the past year, the “meltdown of the stock markets” last year had been far more devastating. “Although, here in Canada, we’ve had minimal exposure [to equity devaluations].”

“Capital [position of the industry] is much weaker today than a year ago. It’s adding a huge amount of discipline to the marketplace because there’s no longer any buffer and companies are being cautious,” says Igal Mayer president of CGU Group Canada Ltd. Some companies are experiencing difficulties just in servicing the business that they have, he adds. As such, Mayer believes that the current underwriting capacity shortage in the Canadian market is just the beginning of the real storm to come. And, while some companies have been forced by their capital restrictions to make cutbacks by exiting some lines and classes of business, he believes that industry consolidation in the year ahead will be far greater than many expect.

Capital “catch-22”

“If you take the top 20 companies in Canada, my bet is that at least half of them are now close to the minimum capital test requirements of OSFI [Office of the Superintendent of Financial Institutions],” comments Cooke. He notes that the regulatory requirements on capital create an added complication for insurers trying to improve their profitability through rate corrections in that, in order to increase gross premiums, a company has to have a greater amount of capital to meet the test level. “It’s ironic that, to grow [the business] through rate [increases] means you need more capital to keep the ratios onside.”

As such, Smith points out that rate actions taken by insurers just to get the business to adequate profitability will, in many cases, absorb a significant portion of a company’s capital resources. “Which limits the potential for growing into new lines of business or new products,” he adds. Mayer notes that, “if you’re down at the minimum guidelines of the MCT [minimum capital test], then you’re in a ‘catch-22’, there’s no question. The test will catch you if you try to move on rates. It hurts you to grow.”

That said, Mayer notes that the MCT, which recently replaced the minimum asset test (MAT), is an improvement on the old testing format in that it is more risk-based according to the different type of premium written. For instance, he explains, different classes of risk now require different levels of capital whereas in the past the same amount of capital was needed for every premium dollar. This has partially reduced the regulatory capital constraint on insurers, he adds. Simmons points out, “the [OSFI] capital tests are there for good purpose”. He adds, however, that the biggest problem with capital constraint under the new MCT is the auto product, “which takes up a high level of capital – it’s a capital intensive product.”

Company positions

“We believe it’s appropriate to grow [our business] in a hard market at adequate rates rather than trying to buy the business in a soft market,” says Gregg Hanson, president of The Wawanesa Mutual Insurance Co. Recent years have shown that smaller niche players can outperform larger competitors, he notes. And, while Wawanesa is a national player, the company has focused its underwriting on areas of the business that have been consistently viable. “We don’t intend being all things to all people. Our focus is on our core business.” Hanson says that the capital constraint on companies is already showing through in the marketplace. “We have found that some insurers are not taking on business because of capital restrictions. We’re being presented with huge volumes of business, more or less everywhere except Quebec.”

Simmons says Roy al & SunAlliance has begun to take a more “focused” than “generalist” approach to its market dealings. The company’s growth for this year into next will come from smaller commercial and specialized lines of business. In the process, Royal & SunAlliance is looking at reducing its exposure to auto, and recently exited from Quebec’s personal marketplace (the $25 million per annum portfolio was sold to CGU). “The company will continue to operate in the auto market, Simmons says, but on a more select basis. “I call it more repositioning than exiting.” With regard to auto, he adds, “we’re withdrawing capacity from personal auto, we’re not going to put new capital into it based on current market conditions”.

Kathy Bardswick, president of The Co-operators General Insurance Co., agrees that personal auto countrywide (except Quebec) is in a poor state. “The fact is that no one wants private auto anymore, this makes me nervous because it increases competition in the other lines.” Bardswick notes that, being a Canadian-owned company, The Co-operators has to be fully committed to the marketplace, “which can sometimes be a disadvantage to international companies in that we can’t react as quickly in reducing exposure to loss areas”. She says the company will maintain its current strategy of being “less aggressive in gaining marketshare” and will gradually reduce exposure to the auto markets. “The pressure is on us just like our competitors.”

Kevin McNeil, president of Gore Mutual Insurance Co., says capital shortage is the least concern for the company. “We have the capital to grow,” he adds, which will be on a “selective basis”. “If you grow too quickly, or non-selectively, you end up collecting loss ratios down the road.” McNeil also feels that smaller-sized insurers have an advantage over larger operations in the current market environment. As such, Gore is planning for a “growth year”, he adds, primarily focused on business generated through its core broker network.

The withdrawal of some insurers from various classes and lines of business has created “good opportunities” for companies to step in and pick up business, comments Smith. However, the emphasis at Kingsway will be highly selective in taking on new business. In terms of the overall industry position, Smith adds, “this year is going to be about claims management, growth is not the answer now”.

“Although we’re [CGU] are still strong, I have less capital today,” says Mayer. “We couldn’t do a major acquisition at the moment, because we don’t have the capital.” CGU recently completed an 18 month-long restructuring plan, Mayer notes, and the company is now ready to begin growing its business with a new business target growth rate of 10% for this year. Once again, the approach will be cautious, he adds, with emphasis on selective risks. “There’s more ‘good business’ on the streets now than 10 years ago, because companies can’t underwrite it. However, there’s also a lot of ‘bad business’, and you have to ask why business is on the street before picking it up. If something like the Royal & SunAlliance deal [the Quebec personal lines book of business] came along, then I’d look at it.” Overall, Mayer observes, “I don’t think there’s anyone out there who has room for exceptional growth at this stage”.

Dominion is in a fortunate position that it has a strong, supportive majority shareholder, says Cooke. As such, the company has access to capital to support growth, he adds, whether it be in new business or through acquisition. Cooke confirms that there is a lot of premium on the move within the marketplace resulting from underwriters cutting back on their exposures. “We’re not having any difficulty in finding good business. I think we’re an exception to the market in that we’re growing marketshare.”

Consolidation

Smith believes the current capital pressure on insurers will lead to further consolidation in the Canadian marketplace. This will mainly result from some European and U.S.-owned companies withdrawing from Canada in order to focus attention in their home markets. However, due to the lack of free capital in the industry, it is unlikely that merger and acquisition activity will increase substantially, he notes. “I think M&A activity will be ‘spotty’ because of limited capital availability.”

McNeil shares a similar view, noting that there has been no “new capital” coming into Canada through international operations. “If anything, some [foreign-owned companies] might want to remove capital,” he adds.

Bardswick does expect to see increased M&A activity this year, primarily as a result of internationally-owned insurers withdrawing under the best terms they can get. “I definitely don’t see Canada attracting new foreign capital. I think this year will see industry consolidation, perhaps withdrawal by some major players. This could present some ‘fire sale’ bargains.” However, Bardswick concedes that scarcity of capital will dampen buyer enthusiasm in the marketplace. “We’re not going to be aggressively grabbing out there, our focus is going to be on the balance-sheet.”

“I think we [Canada] will see further consolidation this year, mostly driven by international events,” says Cooke. In this respect, he expects there will be a few acquisition opportunities opening up within the marketplace. “We’ve [Dominion] looked at some [opportunities], but have walked away.” Cooke believes that international pressure on capital allocation will be the main driver behind market consolidation. Notably, there are several European-owned insurers whose parents are going through financial difficulties, and the Canadian market is unlikely to be one of their priorities, he adds.