Minding the Farm

“It’s different this time” is an infamous phrase heard in investment banking community circles. I referred to this expression when kicking off a panel discussion on automobile insurance residual markets at the National Insurance Conference of Canada (NICC) in October 2009. It’s said to be the most expensive phrase in investment banking history. At the NICC, I wondered aloud whether it might be in our arena too.

In the months leading up to the NICC, I had some discussions with conference organizer Joel Baker, president of MSA Research. We asked each other if we believed auto insurance in Ontario, and auto insurance residual marks in particular, were really “different this time.” If not, were we on the verge of another explosion in residual market volumes similar to what we had seen earlier in the decade?

LOSS TRENDS

In the years leading up to 2009, when Joel and I had our discussions, a trend of escalating loss ratios paralleled a similar trend during the earlier part of the decade. The earlier manifestation of this trend foreshadowed an unstable auto insurance product, which also featured rising claims costs that outpaced premium growth. Industry- wide private passenger car loss ratios for 1998-2008 looked like this: (Please see Table 1 on Page 56.):

As it happened, the 88.9% loss ratio in 2009 was well in keeping with the trend of increasing loss ratios.

In the first part of the decade, the response to the trend was classic: business flooded into the Facility Association Residual Market (or FARM). At the beginning of 2002, the FARM private passenger vehicle (PPV) written vehicle count was just under 16,000. It peaked at 226,000 in March 2004. Meanwhile, in Ontario’s other residual market mechanism, the Risk Sharing Pool (RSP) — to which companies cede risks at their own filed rates (presumably because the risk is a money-losing proposition at that rate) — changes in volume were marginal. Written vehicle counts increased from 112,000 in 2002 to 116,000 in 2004.

Moving forward to 2006-09, we witnessed another deterioration in the Ontario auto insurance marketplace, in which claims costs were outpacing premiums once again. This time, however, the response from a residual market perspective has been the opposite of the earlier experience. In the FARM, PPV written vehicle volumes have dropped by roughly two-thirds, from 26,500 at the beginning of 2007 to just below 8,000 at the end of October. But in the RSP, it’s an entirely different story: written vehicle counts increased from 136,000 at the beginning of 2007 to 204,000 as at the end of October 2010.

So what changed? What is different this time?

DIFFERENT THIS TIME?

I would suggest a number of factors are in play. From our perspective, we at Facility Association have paid far more attention to two things: 1) seeking approval for adequate rates and 2) the relationship between our prices and the prices charged by voluntary market companies willing to write the business that would otherwise come to us. Our goal in this regard, consistent with our role as the “market of last resort,” is to ensure we are not inadvertently attractive to consumers from a pricing standpoint. We have also worked with our servicing carriers to be much more stringent in the enforcement of the declination rule. This ensures the business coming our way is truly eligible for the FARM. Other factors include:

• more than adequate capital in the industry;

• a relative consolidation of the private passenger insurance market in Ontario;

• intermediaries working harder to keep business out of the FARM (including the use of the OPCF 28–Reducing Coverage for Named Persons endorsement); and perhaps even

• an increase in consumer branding in our industry, which presumably means increased reputational risk is associated with significant non-renewal activity by insurers.

SMALLER FARM, BIGGER RSP

Viewed in terms of marketplace stability (not to mention public optics), the smaller FARM and larger RSP volumes can be considered a “good thing.” That is to say we haven’t had a repeat of the 2002-04 experience, in which thousands of drivers found themselves insured through the FARM at premium levels often two to three times higher than what they’d been paying — with no change in their underlying risk profile whatsoever.

This is not to say the impact of the contemporary residual markets on the industry has been particularly benign. In fact, it has been anything but. On a financial statements basis (which does not cover the full impact of the RSP results in the members’ hands), the annual deficits for the Ontario RSP just keep mounting. The Ontario RSP deficit was $70 million in 2007. This grew to $140 million in 2008 and $226 million in 2009. As this article goes to press, it appears the projected 2010 Ontario RSP deficit will continue the worsening trend. This could be the result of the analytical sophistication companies employ to cede business to the RSP. Such sophistication may be keeping some business out of the FARM, for example, because companies are confident they know which risks are adequately priced for their own book.

Unfortunately the trend noted above leads to the risk arising that at some point (don’t ask me when), the negative performance of the RSP will be such that it will not make financial sense for a company to transfer some money-losing risks to the RSP; this is because of the share of the results it will attract back to them. If they ceded the risk to RSP in the first place because they believe it to be a losing proposition, and it becomes more of a losing proposition when they send it to the RSP, what then? There’s a great deal of potential those risks will ultimately find their way to the FARM. That would certainly reinforce the view that the RSP is a leading indicator and the FARM a lagging indicator of marketplace distress.

Of course they might not find their way to the FARM — especially as the recently introduced product reforms and positive pricing changes companies have pursued over the past 12 to 24 months gain traction. However, given that some estimates have the 2010 industry-wide combined ratio for Ontario auto looking like it could come in around 110%, I am only willing to say: “It’s different this time — so far.”

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If a company cedes a risk to the RSP in the first place because they believe it to be a losing proposition, and it becomes even more of a losing proposition when they send it to the RSP, what then? Potentially, those risks will ultimately go to the FARM.