Vice or Virtue?

Following the great “premium chase” of recent years, Canada’s property and casualty insurers have finally woken up to a reality: “we have sinned”. This was the underlying conclusion reached and admitted to by presidents of some of the lead ranking companies represented at this year’s Canadian Insurance Congress.

While the negative impact of inadequate pricing to the cost of underwriting from recent years has levied a heavy toll on insurance markets around the world, the sober gravity of the situation is starkly displayed in the Canadian industry’s financial return for the first quarter of this year. With an average 3.8% return on equity (ROE) for the last four consecutive quarters, plus a rise in claim costs of more or less double the growth rate in written premiums over the same time period, it has become clear to even the most reckless chasers of marketshare that the industry has painted itself into a corner. Notably, the current dismal situation the industry finds itself in is not an “overnight shocker”. The deteriorating financial picture facing Canadian insurers has been in development since 1998, and could have been avoided by more strong-willed underwriters (including many of those bemoaning their current predicament) if they had taken appropriate action.

The fact that no one had been willing to “step up to the mark” has, in my opinion, less to do with so-called “excessive competition”, which has been blamed for on the industry’s current woes, as opposed to the fact that it was easier for executive management to “play the game” rather than risk taking an individual stand. Until the management pressures exerted from the present set of industry results kicked in, insurers had enjoyed the vice of excessive capital with nowhere to put it. In this respect, I believe that the rot which has eaten into the industry’s belly over the last three years has more to do with this excess capital position and generally lax management decision making than market fragmentation.

Paul Kovacs, the chief economist of the Insurance Bureau of Canada (IBC) and a speaker at the Canadian Insurance Congress, points out that, while claim costs continue to outweigh premium growth, the industry will continue to lose money. Kovacs also highlighted the industry’s financial strength in terms of its surplus reserves in his congress speech, as well as in an article published in the IBC’s latest quarterly “Perspective” report. He suggests that this financially secure position is a “virtue” of the industry. However, once again, I have to say that it is this very “financial strength” that has been the root cause of the industry’s past delinquency.

In the latest Perspective report, Kovacs also refers to a significant decline in the industry’s “favorable development” of reserves to unpaid claims. Essentially, this describes the excess margin resulting from reserves the industry sets aside each year prior to match unpaid claims resulting for the coming year. For the industry’s 2000 financial year, the reserve margin, or positive development, had dropped to less than half the level recorded for the year prior based on a ratio of the reserve for unpaid claims to net premiums. This turn in the industry’s fortunes bucks a longstanding trend of increasing yearly positive developments, which until now has enabled insurers to offset the full negative impact of underwriting losses on their bottom-line financial returns, Kovacs notes. “This [positive development] had a direct effect on the industry’s bottom-line and helped the industry to weather the soft market a little more easily. For instance, the margin reduced the industry’s loss ratio by 4.7% in 1998 and 3.8% in 1999…For the industry, excess reserves as a share of net premiums earned [for the 2000 financial year] dropped from the 7% average of the last few years to 4%. This alone accounted for three of the five point increase in the auto loss ratio [for 2000].”

The fact that insurers did not have the flexibility this year of offsetting the real impact of the loss ratio by utilizing the positive development arising from unpaid claim runoffs has much to do with the current sobriety gripping the industry’s major players. And, while some of the individuals responsible for the actions taken by their companies may choke at the following concept, I believe that this could be a positive turn for the industry. Faced with a “high stakes game”, and growing pressure from international head-offices, the leaders of the industry are now left with little choice but to make individual management decisions – tough, and as overdue as they may be.