Insurers: Playing the Loss Game

“Swallow a loss and learn a lesson”, reads one Chinese proverb. With after tax income plummeting by 95% to $22 million in the first quarter of 2001, the Canadian property and casualty insurance industry should be very well educated indeed. Although premiums grew by 6% over this period, claims soared by almost 18%, and nearly half of the insurers that report data to the Insurance Bureau of Canada (IBC) posted net income losses. Is it time for a new game plan?

Insurers and their public relations departments are quick to lay much of the blame for the Canadian industry’s misfortunes on the automobile insurance sector, especially in Ontario, which represents more than a quarter of the country’s entire private property and casualty market. The number of auto accident claims had been on the decline, but the severity of those claims has increased at an alarming rate – especially bodily injury. As a result, insurers suggest that they are effectively subsidizing provincial health care costs to the tune of millions of dollars.

Healthcare to blame?

Don Forgeron, regional vice-president of the IBC, has some dire predictions for the market as a whole in outlining the deterioration of the auto markets in Atlantic Canada. “For several years, the average cost per claim rose while the frequency of claims and accidents fell,” he observes. “In recent years, the frequency of claims has started to rise again, creating the worst possible scenario, a higher average cost per claim and more of them.”

In a June submission to the Financial Services Commission of Ontario (FSCO), the IBC called for the government to take action on the issue of rising health claim costs, drawing the regulator’s attention to the fact that “there is no standard for the submission of invoices for health care services provided to auto accident victim”, which “has made it virtually impossible to analyze and control health care costs”.

The IBC submission goes on to show that while Ministry of Health expenditure rose less than 50% in the 1990s, auto insurers’ medical and rehabilitation costs skyrocketed by more than 350%. FSCO may have approved recent rate increases averaging 8% in the last couple of quarters, but according to the IBC, “these did not even begin to address the rising costs that insurers have had to absorb”. With insurers recording such massive losses, IBC vice president Mark Yakabuski urged regulators to implement their proposed Auto Insurance Standard Invoice system by October 1, 2001.

Underwriting fiasco

It is certainly possible to attribute some of the industry’s misfortunes to poor regulation and uncontrollable trends in healthcare, but insurers’ own sloppy underwriting and complaisance have also played a key role. Swimming in excess capital, some industry watchers have suggested that insurers wer not as vigilant in managing expenses as they could have been. A research paper published by American investment counsellor David L. Babson and Co. earlier this year says that the recent spate of underwriting losses should come as no surprise given the market conditions of the time.

When there is an oversupply of capital, price competition abounds, and in order to attract customers and fully utilize their surplus, insurers start writing business at a loss, much like “the paper and chemical industries that always cut prices in slack demand periods in a vain attempt to keep their plants operating close to capacity”. Tom Stafford, manager of Royal & SunAlliance’s Quebec operations, sums up the situation a little more bluntly in a recent interview with a Montreal magazine. “It’s a fiasco!” he cries, “We sold too many premiums too cheaply for the number and value of claims”.

Investment subsidies

One could argue that the industry has been selling its wares too cheaply since 1978. A closer look at data from Statistics Canada and A.M. Best Canada’s “WinTRAC” shows that, for more than two decades, Canadian p&c companies have been able to use the investment gains from their colossal reserves to offset significant underwriting losses. A report issued in January 2000 by the rating company points to the perils inherent to this method of operation, warning that, “Canadian companies’ reliance on investment income – rather than underwriting performance – does not bode well for the industry in the event of a sudden and sustained stock market downturn”.

A.M. Best also highlights the fact that a dozen Canadian insurers had invested more than half of their entire portfolio in equities, while U.S. companies have applied greater caution by limiting their stock holdings to under 25% (investing primarily in less volatile fixed-income securities). Such a heavy weighting in equities may have paid off handsomely when the markets where high, but now that the economy has cooled and interest rates have descended, the business landscape is beginning to look considerably less rosy. Analysts predict that Canadian insurers will not achieve the same investment income offsets against poor underwriting for the 2001 financial year, “as the opportunities for large capital gains have been exhausted.” This change in circumstances leaves insurers sitting without the comfortable cushion of additional revenue to which they have grown accustomed.

Despite these dangers, The IBC’s chief economist Paul Kovaks remains relatively optimistic with regard to the long-term performance of the p&c insurance industry. In March of this year, he noted that the “insurance industry has always recovered from market slumps in the past” and claims, “improvements in premium growth and investor confidence suggest that the beginning of the end of this downturn is now in sight”. But, by the next quarterly edition of the IBC’s “Perspective” newsletter, Kovacs had changed his tune considerably. “Just when it appeared safe to expect that insurance results could get no worse, new data shows further deterioration”.

Capital concerns

Although some insurers south of the border are beginning to feel the bite of reserve deficiencies, which has driven the need for upward price adjustments, there is no similar concern regarding the financial solvency of Canadian companies. Kovaks is quick to point out that the industry’s claims provisions have never been higher. “The ratio of p&c insurers’ provisions for unpaid claims to premiums has increased considerably since the 1970s”, he says, “insurers are becoming increasingly conservative and that consumers can rest assured insurers’ funds are sufficient to cover their claims.”

While this news may be of some comfort to the public, it is in fact this very same excess of capital that has allowed the industry to slip into such a difficult position today. Industry analyst Ted Belton, editor of the “Belton Report”, claims that the industry is “awash in capital,” and, “is currently operating at only about 40% capacity utilization, its lowest level ever”. Rather than putting money out to work, insurance company management have been able to use the earnings from this unused capital to subsidize ever increasing losses. It has been this way for so long, one wonders if sound underwriting has been all but forgotten.

Going Up

Rate increases are obviously required in order to return to profitability and, for the most part, they are being implemented. The process, however, takes time – especially in auto insurance. “You can’t just increase premiums, then submit the changes to the government,” said Stafford . “First, you need government permission. There is a whole procedure to follow and it’s a long one.” Underwriting practices will tighten in tandem with the rise in rates, according to a 2001 review and forecast conducted by Marsh Inc., meaning that ” all new and renewal account business will require more comprehensive submissions than in the past, with greater attention to the details of risk identifications, valuations, losses, and loss prevention/risk control efforts.”

It will take at least a year for the any rate increase, once implemented, to have an effect on loss ratios. Other underwriting practice adjustments will also not yield immediate dividends. If the industry had heeded the warnings of A.M. Best and other market watchers, and implemented price changes earlier, considerable grief might have been avoided. But, hindsight, they say is “20-20”. Insurers will have to look to other methods besides rate increases if they want to control costs and send more money towards the bottom-line.

Tech rescue?

A survey conducted by Celent Communications in Boston revealed that insurers are using the Internet to streamline their operations, drastically cutting communication costs in particular. Matthew Josefowicz, the analyst who wrote the Celent report, says insurers no longer consider the Internet a “frightening challenge to established retail distribution channels”. Rather, he claims, the attitude has swung toward that of “an enormous opportunity for potential savings in time and money”. Josefowicz suggests that some carriers have reported “cost reductions of as much as 90% on communication with agents and policyholders.”

Faced with astronomical legal costs, some insurers are also looking to technology to help them track and ultimately reduce legal expenses. In 1993, Canadian insurers spent $235 million on legal defence, In just six years, by 1999, this amount had nearly doubled to reach $465 million. Software packages like Legalgard, produced in the U.S., but used in Canada by insurers such as CGU, can be used to analyze billings and then benchmark results with other companies to assess law firm efficiency.

The consensus, however, appears to be that the agent – complemented by high-end technology in order to streamline the underwriting process – will be one of the most critical ingredients to the future financial success of insurers. Clyde Fitch, president of Travelers’ personal lines business in the U.S., believes that insurers who use the Internet to complement, rather than compete, with their agency distribution channel will ultimately prevail. “Many carriers invest in automation skewed toward the top-line, emphasizing a lot of ‘gee-whiz’ stuff and cosmetic features on their websites. But, we have always focused on the middle-line, which is using automation to create internal efficiencies with our agents.”

“By eliminating paperwork and telephone correspondence, the independent agent can better respond to customers and their risk-management needs, rather than focus on administrative duties.” says an article published by “Best’s Review”. Profitable companies will be the ones that “effectively invest in technology and intellectual capital, embracing the Internet as a way of lowering costs”.

No longer able to play the loss game, Canadian insurers are going to have to find ways to create efficiencies in underwriting and enhance frontline efficiency before they can bring in new, and more profitable, risks.