The Burden of RSPs

Recently, there has been some public debate about whether both the Facility Residual Market Mechanism (FARM) and Risk Sharing Pools (RSP) are necessary. Both are administered by the Facility Association (FA), but each has a completely different role in today’s marketplace.

My personal view is both are necessary. However, for the benefit of all automobile insurance consumers, RSPs are in serious need of reform. Since the first RSP was introduced in Canada nearly 20 years ago, RSPs have generated a combined loss of more than $1 billion. To offset these losses, the cost of premiums for consumers in the voluntary market has increased.

The automobile insurance industry created the FA as the insurer of last resort. The FA provides legally required automobile insurance to all drivers, even those who are deemed too high a risk and uninsurable through the voluntary market. The FA administers the FARM and RSPs. Every insurer licensed to write automobile liability insurance where the FA operates is required to become a member.

THE FARM: HIGH RISK, WELL-RUN

The main difference between the FARM and other insurance companies is that some FA member companies are contracted to act as ‘servicing carriers’ to issue and endorse policies and adjust claims on behalf of the FA. The FA does not have its own resources to provide these services. Contracted companies are reimbursed from the FARM for losses paid, provided an allowance for adjusting claims and a fee for policy handling.

All policies written by servicing carriers are subject to the filed rules, rates and classification of the FA. This ensures any customer in that jurisdiction, regardless of level of risk or claims history, can obtain the minimum insurance coverage required by law. Profits or losses are the responsibility of FA members who are the shareholders.

The FARM has been well-managed by the FA for more than 30 years. It provides a necessary and highly specialized service both to the industry and society, by providing a mechanism to underwrite drivers who have nowhere else to turn and whose driving experience demonstrates that they represent an unaffordable risk to themselves and to others. Insurers in the voluntary market don’t necessarily employ the highly-specialized underwriting expertise to properly assess the risk presented by these drivers, nor do they have the claims expertise often required to protect everyone.

Since its inception in 1977, the FARM has provided protection for the highest-risk drivers and generated a surplus of $335 million despite suffering some significant losses last decade. This has been achieved without including the cost of capital in its pricing model, meaning the FARM has generated a surplus without charging appropriately for the level of risk.

RSPs: RISK AVERSE, UNSUSTAINABLE LOSSES

The Ontario and Alberta non-grid risk sharing pools were created to provide insurers in the voluntary market a place to ‘park’ risks for which they have a filed rule and rate, but for which they aren’t comfortable assuming the risk. This may be due to a variety of reasons, including:

• other rating variables that can’t be used;

• consistency in price and product offerings to consumers;

• sound underwriting experience; or

• other proprietary information.

The consumer is unaware that they have been placed in a RSP and, because coverage can’t be denied, this can be seen as the only practical alternative. In this situation, the original insurer performs all underwriting and claims services; as in the FARM, any profits or losses are assumed by FA members.

The Alberta grid pool and RSPs in Nova Scotia and New Brunswick were introduced to provide social pricing in the marketplace, meaning the total cost of insurance is shared across the entire driving population but not proportionately to risk. In the Maritimes, this model was intended to provide affordable market access to inexperienced drivers who, according to considerable industry data, present a higher risk than many other consumers.

It can be argued that RSPs create both a consumer and company benefit.

Consumers placed in a RSP benefit because they pay a lower premium than they would if insurers priced according to the true risk the consumer actually represents to them at that time (based on the insurers’ data and experience).

Insurers benefit because they develop customer loyalty while bearing no responsibility when a risk is at its greatest. RSPs allow insurers to take the risk back when they think it’s more appealing and profitable.

However, not all consumers benefit from this practice. In any social pricing model, better drivers subsidize those in RSPs by paying higher premiums.

Financial results for RSPs across Canada are alarming and a cause for concern. The RSP in Ontario has lost close to $1 billion since 1993; of that, $260 million was lost in 2009 alone. Together both pools — grid and non-grid — in Alberta have lost more than $180 million since 2004.The RSP in New Brunswick has lost $20 million since 2004. In Nova Scotia, the loss is $12 million since 2007.

If an individual business sustained losses of this magnitude, its shareholders would demand significant change or the company would not survive.

Since the first RSP was introduced in Canada in 1993, RSPs have generated a combined loss of $1.2 billion. The fact that these losses are spread among FA member companies should not make it any more acceptable. Consumers in the voluntary market have been forced to pay increased premiums to offset the losses arising out of an inability to charge the right rate for the right risk. It is clear that RSPs in Canada are broken.

IF IT’S BROKEN, HOW DO WE FIX IT?

A well-functioning insurance system embraces fairness and strikes a balance between affordability and competitive ness. Both insurers and government regulators must play a critical role in ensuring these principles are in balance. Insurers should have the necessary tools to better segment risks — including the use of additional underwriting variables such as occupation, lifestyle and insurance scoring. The inclusion of these variables would enable insurers to properly evaluate a risk so they can determine a premium that is fair for each individual consumer. The inability to use proven underwriting variables in the interest of public policy objectives detracts from the insurer’s ability to fairly assess and price risk. Ultimately social pricing actually compromises affordability and market capacity through artificial subsidy of true risk. In a balanced market, insurers would be accountable for this risk, and RSPs would be smaller or unnecessary.

Governments also play an important role in providing a regulatory environment that promotes fairness, affordability, accessibility and sustainability. Regulators can enable competition by allowing insurers to use proven underwriting variables when conducting full risk assessments, as well as by limiting social pricing as a means to achieve consumer protection strategies that might otherwise be addressed by a competitive marketplace. A 2006 comparative study of auto insurance among 10 Canadian provinces, 50 U.S. states and the United Kingdom published by the Fraser Institute found that across all jurisdictions, a lower burden of auto insurance regulation was statistically linked with lower and more affordable premium costs. Residual markets are almost non-existent in the state of Illinois and the United Kingdom, with very little premium subsidization.

The numbers tell a very compelling story. Without significant reform, losses incurred by RSPs will continue to grow. Consumers and policymakers need to understand how risk sharing pools work, and their true cost. Most importantly, they need to understand that RSPs have a negative affect on the majority of consumers who are forced to pay more as a result. This topic requires greater debate.