The Solvency Shadow

The Canadian property and casualty insurance industry seems to have come through the hard market relatively unscathed in terms of solvency concerns. There were a few insolvencies and liquidations over the past two years – including Markham General and the windup of the Canadian branch of Home Insurance – but nothing to spark widespread fears of costly collapses or consumer panic. Canada has managed to avoid some of the big-name bankruptcies of firms like Reliance Insurance Co. in the U.S. And, over a 12-year period, the Canadian industry has paid out about $100 million for insolvencies, with the cost of p&c insurance failures less than 0.1% as a share of industry premiums. In contrast, last year alone, the U.S. insurance industry paid out $1.2 billion to cover bankruptcies – a measure that far outstrips the relative size of the two economies. In fact, capital continued to grow in Canada’s insurance industry throughout the period 2001-2003, bucking the worldwide trend of declining capital. At the height of the hard market, many experts estimated that $200 billion in capital had disappeared from the global p&c insurance industry. Yet in 2001, $17 million in additional capital flowed into the Canadian industry. In 2002, $200 million in additional capital was injected, while another $500 million was invested during 2003. Notably, 24 of the last 25 years has seen capital increase in the Canadian p&c insurance industry.

DARK CLOUDS

Coming off a fairly good year in 2003 and what looks to be a promising earnings picture in 2004, insurers are starting to feel more relaxed about capital and solvency. But, companies should not become too relaxed, cautions the head of the industry’s national compensation fund. “There are two things that saved us, I think, from what occurred with insolvencies in other countries, such as the U.S.,” observes Paul Kovacs, president of the Property and Casualty Insurance Compensation Corporation (PACICC). “One, is we were lucky. And two, [I think] we have a superior regulatory system in Canada. I don’t think we want to rely too much on the first factor.” Indeed, Kovacs says despite the low number of insolvencies in Canada, the recent hard market represented a real shift away from a long period of solvency stability to a more volatile situation. And most observers point to late 2002 and early 2003 as a turning point in solvency issues for the Canadian p&c insurance industry. “It was a scary time for the industry,” says Bruce Thompson, director of financial institutions group at the Office of the Superintendent of Financial Institutions (OSFI). “Several companies were experiencing declining minimum asset test (MAT) margins and we were watching some companies closely.”

The numbers show that the relative solvency strength of companies declined from 1997 to 2002. According to the Insurance Bureau of Canada (IBC), in 1997, 75% of insurance sold in Canada was underwritten by companies with capital holdings well in excess of the regulatory minimum capital required, as defined by a score of greater than 15% based on the previous MAT test. By 2002, only 25% of insurance was provided by companies with such a strong regulatory capital position. By the nine-month mark of 2002, about 70% of earned premiums were written by insurers with MAT scores under the 15% mark. According to OSFI’s annual report for 2002/2003, the number of companies that were “staged,” or requiring increased regulatory scrutiny, increased from just over 20 in March 2002 to almost 40 companies by March 2003. OSFI uses a rating system that assesses the overall risk posed by an institution on a scale of 0-4. An institution with a zero rating is subject to routine supervisory and regulatory actions. Where concerns exist, companies are assigned ratings from stage-1 (early warning) to stage-4 (problems so serious that the institution is not viable). The vast majority of “staged” p&c insurers were in the early warning category, according to the annual report.

RICH PARENTS

Several factors pushed the solvency needle the wrong way in late 2002. The five-year period from 1997-2002 produced generally poor industry profitability, which saw some of the lowest returns on equity (ROE) posted by companies over the course of 2001 and 2002. Weak underwriting performance and escalating claims costs over this period were primarily the cause of this deterioration. “I think this really caught up with the industry,” Kovacs says. “PACICC was formed 16 years ago amidst some difficult times. But what followed was a quite long period of solvency stability. Five consecutive years of miserable results beginning in 1997 started to take the solvency issue the wrong way.” One of the main sources of capital growth comes from companies reinvesting earnings. The problem in early 2003 was that the industry limped off two of the worst financial years ever and earnings were weak. The foreign-domination of the p&c insurance market meant that additional sources of capital were available. During 2001 and 2002, more than 33% of insurers received additional capital from owners. Another issue that affected earnings during this period was development on prior year claims. For the first time in six years, 2001 marked negative development on prior year claims. The IBC estimates that insurers pumped $470 million into reserves in 2001 and another $1.5 billion in 2002. Much of the unfavorable development was related to auto and liability business. Investment returns are also an important factor in capital growth. When industry investment income dropped to the lowest level in eight years in September 2002, it led to slower growth in capital. Other factors came into play to make late 2002 and early 2003 a signal period of solvency change. One was the polarization of industry results. While industry numbers were weak, there was also a wide variation in company performance. Even though the combined ratio for 2002 was 105.4%, almost half (48) of the 100 largest p&c insurers in Canada had an underwriting profit. These companies accounted for 32% of the premiums earned. There were, however, many firms with a combined ratio over 110%, and they accounted for 35% of premiums earned. The combined ratio gap between the weakest and strongest insurers increased from 20% in 1997 to 25% by the end of 2003. Clearly, some companies were in a better financial and capital position than others.

BETTER TEST

The introduction of the MCT at the start of 2003 highlighted some of these differences. The IBC has argued that the move to the risk-based capital test has had an adverse effect on some of its member insurers. The MCT, which replaced the MAT model, requires companies to establish a target capital level based on a weighted, or margin-based, analysis of its assets and liabilities. OSFI expects companies to maintain ongoing capital at no less than the supervisory target of 150% of MCT. While there is consensus that the new test is superior and better aligned with international trends in risk-based regulations, the IBC is doing its own analysis on the effect of MCT on its members, particular those that are required to hold more capital under the test. It plans to meet with OSFI in September this year to discuss these findings. Thompson acknowledges there were “some companies that were adversely affected by MCT. However, these companies worked with OSFI to fine-tune capital levels and business risks. By the end of 2003, there were no p&c companies under 150% on the MCT.” In fact, Thompson says the overall impact of the MCT on the p&c insurance industry has been positive. “We did a study of industry capital levels at the end of 2003, comparing the MCT requirement at the level of 150% versus the old MAT level of a minimum 10%,” he notes. “We found there was a 14% decline for the industry in minimum capital requirements, or over $1 billion less capital required under the MCT.” Using MCT as one measure of capital and solvency strength, Thompson says the situation for the p&c insurance industry today is vastly improved from where it was two years ago. “Today, the industry is in a much better positi on, in terms of overall measurements,” he adds. “The MCT has been going up consistently. At the end of 2002, the average score was 197%, at the end of 2003 it was 212%, and for the first quarter of 2004 it was 221%. From the federal point of view, we don’t have solvency concerns about the property and casualty insurance industry.”

LINGERING CONCERN

For Kovacs, the future seems a bit cloudier. The steady emergence of softer pricing and the prevalence of regulatory actions in the auto and property insurance markets in key regions could dampen industry financial results, he says. But, of equal concern is what really lies behind the trend of lower claims. “As an industry, we know we need to get a handle on claims. And claims have been dropping,” Kovacs says. “The question I have is why? I believe many people are not making claims because they fear increased premiums. If that is true, this is a short-term phenomenon. Sooner or later, people are going to start making claims [again].” Kovacs says PACICC’s role is to delve as deeply as possible into all factors relating to solvency in the p&c insurance industry. “We have to look at more than just the capital test, although it is very important,” he notes. “Research coming out of the U.S. says the two main reasons for company failures are inadequate reserves and rapid premium growth.” He notes there is a range of factors that affect solvency which include liquidity, underwriting performance, premium growth, capital adequacy, reserves and liabilities. To get better information on the nature of solvency risks, Kovacs says PACICC has begun research on a series of case studies of Canadian insolvencies. Most of the data on insolvency has come from the U.S., he points out. He says the first, on the Maplex failure, should be ready by year-end.Thompson agrees that the approach to solvency has to be broader than a number on a capital test. “We are on record saying that we won’t stage a company simply because it comes close to the MCT 150%,” he says. “The major thrust at OSFI is not to simply set a number and track it, but to sit down with companies and look at capital levels, business risks and other factors. We want companies to ‘stress test’ their financial position, look at a variety of scenarios. For example, what happens if things happen in conjunction, such as a change in interest rates coupled with a downturn in Ontario auto?”

CONSISTENCY REQUIRED

There are other solvency issues that stand before the industry. One is the concern about provincially regulated versus federally regulated companies. Two-thirds of the insolvencies in Canada have involved provincially regulated insurers. The IBC’s position is that provincial regulators should oversee market conduct, while all insurers should be supervised by one solvency regime under OSFI. The IBC is currently working with the Canadian Council of Insurance Regulators (CCIR) and OSFI to encourage greater federal and provincial integration when it comes to solvency supervision. Another contentious issue is whether Canada’s minimum capital requirements are too high compared to other countries. The IBC commissioned a study by KPMG, published in 2002, which showed Canada’s statutory capital requirements were higher than virtually all industrialized countries, except Australia. “There has been an argument for some time from IBC that regulatory capital requirements are too high,” observes Thompson. “However, most companies still keep their capital at 220%, well above the 150% [mark]. One of the main reasons is that companies are prudent, they don’t like surprises. Another factor is whether the regulatory requirement is really where companies determine their capital levels. For example, rating agencies tend to be much stricter on adequate capital levels. I know of some situations where OSFI has approved capital levels, but rating agencies have downgraded companies.” Donald Chu, a credit analyst at Standard & Poor’s (S&P) – one of the authors of the recent “Industry Report Card: Canadian P&C Insurance” – points out that, “many of the companies we talk to typically tell us they have too much capital. For us, you can never have too much capital. It is there to protect policyholders.” Chu also says, “we have seen a lot of p&c companies restructure their balance-sheets to free up capital and to manage their capital more wisely. The capital adequacy ratio for the industry seems to be sufficient, but you have to look at this on a very specific company by company basis. “The good news for insurers is that ratings for p&c insurers seem to be moving in a more positive direction.” S&P rates about 40 insurers in Canada, Chu notes. The general North American trend is towards a more stable rating environment, with fewer companies on negative Outlook/CreditWatch, he adds. Whether one should be optimistic or pessimistic about solvency in the p&c insurance industry depends, in large measure, on what happens over the next two years. If companies maintain underwriting discipline and post solid ROE numbers, this could quell any fears of weakened solvency and concerns about capital levels in the industry. If, however, the market softens quickly, and companies focus on marketshare and rapid growth, the effect could cast a long shadow on the industry’s long-term solvency position.