Spinning Wheels

The Canadian property and casualty industry turned in another healthy year in 2006, but exhibited stagnant growth. Underwriting profitability remained level, with industry combined ratios of 91.4% in 2006 versus 91.7% in 2005 for the same population of companies. (Figures in this article exclude Lloyd’s.) The fact that underwriting profitability remained good in 2006 is due largely to the absence of catastrophic losses in the past year and not to firm pricing or discipline.

Net income increased modestly to Cdn$4.82 billion in 2006 from Cdn$4.62 billion in 2005, translating into an overall return on equity (ROE) of 17% versus 18.4% in 2005. [See Chart A on Page 32]. The declining ROE reflects strong growth in year-over-year equity, which has a dampening effect on the ratio. (For an extended discussion on this, see page 32: “Capital Quandary.”)

Overall, Canada-wide direct premiums grew at 2.6% in 2006. Declines were concentrated in the Maritimes and in Quebec. The largest drop (-4%) occurred in New Brunswick, where property and auto rates declined substantially. Auto writings declined or were substantially flat in all non-government insurance provinces except for growth-driven Alberta.

Liability writings were lower or flat in Quebec, Ontario and PEI, exhibiting growth in Newfoundland, Nova Scotia, New Brunswick and in the West.

Net writings showed modestly higher growth than direct business thanks to lower reinsurance use. [See Chart B on Page 32].

LOSS RATIOS

Canada-wide, loss ratios showed improvements in all major lines with the notable exception of auto, where

deterioration was seen in all provinces except Newfoundland and Nova Scotia. Another exception is in the area of title, where deterioration was evident in most provinces except New Brunswick and Quebec.

Outstanding improvements in loss ratios were seen in commercial property, particularly in Alberta (where losses were very high in 2005 due to the Suncor fire) and Ontario, as a result of lower cat-activity. Personal property ratios were similarly affected by mild weather and subdued fire losses showing reductions in most regions.

Had loss activity matched that of 2005, the industry’s combined ratio would have been in the 95-96% range and pre-tax income would have been lower by approximately Cdn$1.2 billion. Further, reported loss experience in 2006 benefited from prior-year reserve releases in excess of Cdn$700 million, masking less favourable current-year performance.

EARNINGS PIPELINE: MORE OUT, LESS IN

MSA’s earnings pipeline chart, which graphs net written premiums as a percentage of net earned premiums, shows that all major lines of business remain in the ‘softening range.’ [See Chart C]. In other words, fresh premium writings that will be earned over the next 12-18 months will barely replenish current earnings in real terms. For auto and commercial property lines, writings have not replaced earnings for three straight years.

Casualty (liability) pricing is showing the steepest decline. For example, the ratio of written to earned premium fell to 100% in 2006, which is negative in real terms once inflation and economic growth are factored in.

There are signs of firmer pricing in personal property in 2006, recovering from negative territory in ’05. We

attribute this to economic growth in regions such as Alberta, as well as to concerted industry efforts to ‘true-up’ homeowner premiums to better match replacement cost values across the country.

As in the past, the red line represents where we think the break-even mark should be. If a line of business is below the red line, then current writings are not truly replacing existing earnings. The line is set at 102.5%, taking inflation and economic growth into account.

In the highly contested Ontario market, things look softer still. [See Chart D]. All business lines are ‘below the line.’ Liability pricing trends appear to be in the deepest hole, below even nominal replacement. Auto writings, while recovering slightly, are also well below healthy replacement levels in Ontario. The only reason auto premiums are above nominal replacement levels is because of the increasing number of cars and drivers on the road – in addition to the higher values of vehicles – and not because of any price firming.

CAPITAL QUANDARY

In mid 2005, Canadian Underwriter published an article entitled ‘Swimming in Capital,’ in which I explored the

implications of a phenomenon I then described as the over-capitalization of the industry. At the time, the industry’s excess capital at regulatory capital (MCT and BAAT) ratios of 180% stood at Cdn$7 billion. [See Chart E].

Despite net dividend outflows of Cdn$2 billion in 2006, the excess capital position is now more than Cdn$8 billion (without Lloyd’s and most reinsurers counted).

That excess capital, were it able to be deployed at 1.5X, could conceivably support Cdn$12 billion of premium capacity or roughly the equivalent of another Alberta and a replica of Canada east of the Ottawa River (Quebec and the Maritimes). Deployed at 2X, the excess capital could support another Canada excluding Ontario! [See Chart E].

Chart F displays year-end 2006 MCT/BAAT levels for most of Canada’s major insurance groups. Wawanesa Mutual, with almost Cdn$1 billion of excess capital, is clearly the most over-capitalized property and casualty writer in Canada. Northbridge’s operating subsidiaries show a combined quantum of excess capital of over Cdn$400 million at the 180% MCT level. However, given Northbridge’s risk profile as a commercial writer, it would be more appropriate to measure Northbridge at the 200% level (which translates into Cdn$320 million excess capital).

Some of the groups have taken serious steps towards reducing their capital. Specifically, ING Canada’s companies have virtually dividended all of their 2006 income. The holding company, in turn, is in the process of returning up to $500 million to its shareholders via share repurchases designed to maintain ING Group’s ownership level of the Canadian unit at 70%. [See Chart G].

Aviva, TD-Meloche and Desjardins also returned substantial amounts of capital to their respective shareholders in 2006. Despite these outflows, the capital overhang remains large with the possible following consequences:

1.continued soft pricing and intensified market share wars;

2.overpayment of books of business or broker/distribution assets;

3.inefficient utilization of shareholder funds and drag on ROE’s and stock performance; and

4.group level overexposure to the Canadian dollar.