Rate Outlook: Back to the Future

How did we find ourselves in this position? Essentially, both past decisions and recent economic developments are now haunting our present and jeopardizing our future. In particular, three powerful factors have combined to force us into the unprofitable corner we now share.

First, the over-capitalization of the industry caused competition to become over-heated. In reality, insurance companies make their money from underwriting and from investment income. The strong investment returns the industry achieved over the past four to five years actually helped subsidize the cost of claims and deliver a competitive price to the consumer. Moreover, we continued to chase after marketshare to the detriment of sound pricing and underwriting even when we knew it was time to take aggressive action on the rate front.

Second, as an industry, we were slow to react to the downturn in investment yields, which is now affecting the financial services industry worldwide. We are currently experiencing an economic environment not unlike the low-interest years of the 1960s, and this is expected to continue for the foreseeable future. While investment income in recent years allowed us to subsidize underwriting losses, that income is simply not there anymore.

Third, we were slow to react to both rapidly increasing claims costs and a reverse of the 1990s trend that saw claims frequency drop.

Claim cost rise

Claims costs have shot up dramatically in almost all areas of the country except Quebec (there, prices rose and underwriting firmed almost two years ago, yielding far better results than other regions). Insurance Bureau of Canada (IBC) statistics show that claims costs nationally increased 18% for the first quarter of this year compared with the same period in 2000, and while automobile contributed to most of this rise, personal and commercial property results have also been disappointing.

In Ontario, problems with controls on healthcare costs and increases in frequency are leading to double-digit annual claims inflation. Auto claims costs in Ontario in the first quarter 2001 have increased more than 20% from the first quarter of 2000. The consensus among actuaries is that the Ontario auto product is currently under-priced by at least 20% and, unless dramatic action is taken, will be under-priced by as much as 30% by the end of 2002.

Auto claims costs have also risen almost 15% in Alberta, and 30% in Atlantic Canada over the same period – the result of increased frequency and rapidly escalating payments for soft-tissue injuries.

For several years in the 1990s, claims frequency dropped particularly in the automobile line of business. Results for most insurers improved, but the underlying severity, or cost-per-claim, increased. As a result, when the tide turned (as was inevitable), and frequency began to increase over the past two years, claims costs rose more quickly than anyone expected. So-called “normal” industry rate increases just cannot keep pace with accelerating loss costs such as these.

The cost of cars with their increased complexity and features, labor rates and building materials – all underlying costs of our business – have increased. But, in the last five years of competition-driven decisions, rates have, in some cases, actually gone down.

No rewards

The result of all of these factors combined is an abysmal return on equity (ROE), which shareholders will not accept over the long term. As an industry, we produced a total ROE of 3.8% over the last four quarters. This figure does not provide shareholders with a return equal to that on a first mortgage, let alone reward them for the risk to their capital.

In the current economic climate, with expected continuing low interest and modest equity returns, companies need to achieve a combined operating ratio of 98% to 100% to generate an ROE of 11% to 14% – certainly not an excessive number and quite modest in comparison to the rest of the financial services sector.

The property and casualty insurance industry in other countries around the world has experienced the same set of circumstances and faces the same economic environment, yet its reaction has been markedly different. Most of Europe has experienced dramatic rate increases. In the U.K., the two worst performing lines of business, personal auto and commercial auto, have seen rates rise by 15% and 25% respectively for the last two consecutive years. In Spain, rates have increased by over 50% in the last year. And, in the U.S. for the second consecutive year commercial rates have been raised with increases of 15% or more.

What has surprised everybody is not that these markets have hardened, but how quickly they have recovered to acceptable levels of pricing and returns for shareholders. Yet, Canadian p&c insurers have failed to react in the same disciplined manner.

Action and resolve

With the industry in such a sad state, one wonders if there is a way out. The double-digit rate increases that are now starting to be put through in many areas are a step in the right direction. But, the solution does not stop there: we need to continue to stay on top of the cost of our product and charge appropriate premiums for the risks we are underwriting. More importantly, the major companies need to lead the industry by showing discipline in their pricing and underwriting decisions.

I feel we must also remind and educate all our stakeholders – consumers, brokers and government – on the strong link that exists between the pricing of our products and performance of the capital markets.

When investment returns are high we, as an industry, use this income to subsidize or lower prices. As in any mathematical equation, opposites must remain balanced. When investment returns come down, prices or premiums must rise. I have encouraged my staff and our brokers to educate our customers on this basic dynamic of our industry and not to be ashamed of pursuing the required pricing action.

Action on other fronts is required too. The IBC is leading several initiatives to control costs, including measures to reduce auto theft, reduce the cost of personal injury frauds and promote road safety. In the meantime, introducing and maintaining the underwriting and rating programs necessary to achieve, and sustain, adequate levels of underwriting profit will be no small feat.

Starting now and moving forward, aggressive action is required. The price we will pay for not meeting this challenge is far too great to consider any other direction. It is the only way to bring the industry back to the future we all want to see.