The Invisible Hand

For years, reinsurers serving the Canadian market – particularly those owned by the “big globals” – have been warning cedents (especially smaller, regional or strictly Canadian-based operations) to keep on eye on what is going on elsewhere in the world, lest they be unaware of events or trends that occur outside Canada that may immediately or eventually be felt here at home.

The reaction by insurers to such warnings has often been a polite but firm reminder that Canada is a unique market with its own set of problems, challenges and solutions – and that something happening on the other side of the world should not have a material impact on how business is conducted here. However, the reality is that events and trends elsewhere have always had an impact on the domestic market. The goings-on in the world over the last year-and-a-half or two have illustrated this point quite well. But, why is this the case?

OWNERSHIP INFLUENCE

The answer is immediately clear when one looks at the ownership structure of the major players in Canada’s property and casualty insurance industry. It has often been said that of the approximately 240 carriers in the Canadian market, roughly half are foreign-owned – the vast majority either by European or American ultimate parents. Certainly, of the top five primary companies, which together hold more than 33% of the market, three have European parents and two have Canadian parents. Of the top ten (which together hold more than 50% of the market) the numbers change to six foreign-owned and four Canadian owned.

When looking at reinsurers, the numbers are dramatically weighted to the foreign ownership side. Of the 22 member entities of Canada’s Reinsurance Research Council (RRC), 20 are foreign-owned (with nine having European parents, seven American parents, and four in the category of “other” – with two of these domiciled in Bermuda, one in Japan and one in the UK). Just two have Canadian ultimate parents. Additionally, most of the reinsurance brokers serving the Canadian market have foreign ultimate parents.

So, with 50% of insurance companies and 91% of the RRC’s 22 members being foreign-owned, the Canadian insurance and reinsurance market is clearly influenced by outside forces. But, what are some of these forces and how do these “invisible hands” manifest themselves in the Canadian p&c sector?

CAPITAL DEPLOYMENT

The reason for cyclical rate peaks and valleys in the international insurance and reinsurance market always comes down to the issue of supply. In the risk transfer business the supply in question is that of capital – essentially, capacity. When capacity becomes scarce the owner of the capital (the shareholder) has to decide where it would best be put to use in order to garner the most acceptable return. When the shareholder is a big global operation, there are more choices.

Canada is not exactly known as the most capital-friendly jurisdiction in the world. This is one of the reasons why the federal government has aimed to reduce the general corporate tax rate from 28% (as at its February 2000 budget announcement) to 21% by 2004. But, while these tax reductions are good news (they will bring Canada more in line with such countries as the U.S., Germany and France), they still put Canada a long way off from the more tax favorable countries of the Caribbean or the Channel Islands. Additionally, (re)insurance shareholders must take other considerations into mind before deploying capital into Canada, among them are:

The country’s capital gains and withholding taxes;

A complex mark-to-market tax scheme for insurance company investment portfolios;

Provincial taxes;

Significant employer levies for healthcare, employment insurance, Canada pension contributions etc.; and

A relatively heavy multi-tiered (i.e. provincial and federal) regulatory regime which can require multiple licenses and several labor intensive filings each year. A system which oversees, among other things, minimum capital tests, corporate governance, reserving practices, investments holdings, transfers of capital out of the country (via dividend payments etc.), as well as the mandated use of letters of credit and trusts for foreign branches, to name but a few.

In short, it is a system where much capital can be tied up and made difficult to quickly and cheaply untie – depending on the size, complexity and legal structure of an operation.

CAPITAL COST

When capital is plentiful, as it was in the mid-1990s, many of the above considerations were viewed simply as the cost of doing business in Canada. Now, with capital being harder to come by, shareholders are likely thinking twice before deploying funds to this country (and with an industry ROE in 2002 of 1.8%, they probably are thinking a third time).

Given the heavy concentration of foreign-owned (re)insurers in Canada, many of the big strategic decisions are made not in the local head-offices of domestic operations, but in the home-offices of the ultimate parent. Decisions do not get much bigger or much more strategic then when it comes to deciding whether to sell a certain book of business or an entire operation, or to merge with or acquire a competitor.

There is no shortage of examples where a foreign home office has made a decision which either indirectly impacted Canadian operations, or had the sole goal of repositioning a firm’s business in this country. For example, back in 1996 there were several foreign home-office hatched acquisitions which saw General Re buy National Re, Munich Re acquire American Re, and Swiss Re acquire Mercantile & General Re. These are all good examples of how large, global strategic acquisitions triggered by home-offices indirectly impacted operations here in Canada.

More recently, Alea Europe Ltd. sent out a release in June of this year announcing that Alea’s Canadian Branch will discontinue writing reinsurance in Canada effective from the end of August. And, The Hartford announced May 12 a series of actions and plans to strengthen its capital base, including plans to pull out of the p&c reinsurance business (just four days later, on May 16, the company announced that it will sell most of its p&c reinsurance business to Bermuda-based Endurance Specialty Holdings Ltd. It was not immediately clear what the deal would mean for HartRe’s Canadian book).

Gerling Re’s Canadian operations found itself in a situation where it was forced to go into runoff after its ultimate parent ceased underwriting new business due to capital problems. The decision came as a surprise to cedents, brokers and competitors in Canada, where Gerling Re ranked as a top-ten player in the market for a number of years. Such deals as the recent ones mentioned serve to remove capacity from what is currently an already tight market, give cedents a slightly smaller reinsurance universe from which to glean capacity, and give other reinsurers the opportunity to grow their books – albeit to a fairly small degree.

RETRO COVERS

Turnarounds in the p&c rating cycle are often at least partly driven by the reinsurance side of the equation – i.e., from the top down, rather than from the bottom up. The first inkling of a firming in rates often comes from the retrocession (i.e. retro) market (retros are reinsurance for reinsurers). Just as insurers may have to do in a hard market, reinsurers consequently have to either hold on to more risk or pay significantly more for retro protection. This has an inflationary effect on reinsurance rates which may, to some degree, flow down to the primary side, helping to firm insurance rates.

The same can hold for catastrophe reinsurance rates because like the retro reinsurance market, the cat reinsurance market is also extremely international in nature. So, while Canada may have a catastrophe-free year, and though overall loss experience may have been good, reinsurers in the country may find their retro costs soaring and insurers may find their cat reinsurance rates spiraling due perhaps to loss experience or extraordinary events in other parts of the world. Again, the goings -on in the world the last year-and-a-half or two, illustrate this point quite well (it is important to note that the process can work the other way around as well. For example, cat reinsurance rates did not shoot up as much as might have been expected after the 1998 ice storm largely due to the fact that several billion dollar natural loss events occur around the world every year, and the ice storm was just one of many in 1998).

EMERGING RISKS

Companies that operate in many countries will, of course, come across a much broader range of issues than companies which operate only in Canada. When a firm operates in enough markets (both mature and emerging) over enough time, it will see such things as asbestos, mold, large natural catastrophes, products liability, political risk, corporate scandals, environmental liability, terrorism, and overactive plaintiffs bars, to name but a few. With this experience will eventually come expertise and, likely, a sense of caution about markets that are not currently experiencing such challenges, but which could in the future.

This cautiousness could lead to the implementation of strict underwriting guidelines, including the implementation of limits, partial exclusions or absolute exclusions that may never have been seen before in a market such as ours. Whether a (re)insurance company is domestically owned and operated, or foreign owned and domestically operated, oversight from the parent company can range from being very loose and informal, to very tight and rigid. With the latter, the home-office may set the tone for the philosophies of its operations worldwide, laying out all major policies, including underwriting procedures. In extreme cases, the domestic operations of foreign-owned companies may find that they have little or no control of “the pen” – finding themselves forced to defer to the home-office before they can rate and bind business. This is particularly true if the domestic operation is under-performing for one reason or another. This can make a (re)insurer slow to react to market changes, and present problems at renewal time, when companies have to be their most agile (particularly if the renewal season is late).

TECHNOLOGY

Such technologies as e-mail, teleconferencing, videoconferencing, global networking, electronic databases, and real-time Internet-based information exchange platforms can quickly and easily elevate decision-making from local operations to home-offices, in effect, moving decision-making up through the organization. This can be a good thing, or a bad thing.

On the positive side, the exchange of information, analysis and opinions can quickly and easily introduce worldwide ideas and worldwide thoughts into a domestic market. When a company has a lot of global resources and expertise in which to tap into, this will benefit the local operation (and, thus, the client) to a great degree. On the negative side, a company may be structured in such a way that it is unable to react quickly. Further, there could be delays due to time-zone differences and cultural/language barriers. This lag could be deadly in a crisis situation, or if a decision needs to be made fast. Also, as mentioned above, companies may find themselves either wittingly or unwittingly losing their local authority.

INVESTMENT MARKETS

Though the Insurance Companies Act of Canada puts some restrictions on the overall makeup of p&c companies’ investment portfolios, when it comes to the day-to-day management of investments, there is room in which to maneuver. A company’s portfolio may, for example, hold 100% in government bonds, or some combination of government and corporates, with no equities. Or, it may hold some combination of bonds and equities, with the latter being either commons or preferreds.

Many foreign owned (re)insurance companies in Canada have their portfolios managed by affiliated entities located outside the country (which requires OSFI approval). For many, such as with the big global carriers, a group may have the same investment philosophy worldwide. Therefore, decisions made in a home-office in Europe or the U.S. could have an impact on the investment returns of a carrier located here in Canada.

CONCLUSION

In a sense, the Canadian (re)insurance industry is a reflection of the country’s population base itself – diverse and multicultural. A diverse citizenry makes the country an interesting place in which to live, and a diverse insurance industry makes it an interesting business in which to work.

Industry players here have long ago come to terms with the fact that there is a heavy concentration of foreign-owned carriers in this country. However, there will always be that element in society-at-large that is not comfortable with the idea that a large number of foreign-owned companies have such a solid foothold in their country. But, the diverse geographic ownership of (re)insurance companies in Canada underscores the most basic and important premise on which the concept of insurance is based – that of the spread of risk. And, when it comes to Canada, there may be a no greater spread of risk in any other market, anywhere else in the world.