Who’s Watching the FARM?

Industry representatives should actively pursue the formation of an Insurance Market Monitoring Board (IMMB) to consult with government on the state of the insurance market

With the recent defeat of the Facility re-design proposal, it is appropriate to review the issue of why the insurance-consuming public may require risk-sharing pools and other types of insurance facilities to ensure universal access to compulsory coverage.

From my perspective, the re-design of Facility Association and the recommendation of risk-sharing pool expansion both contradict the aim of the Insurance Bureau of Canada (IBC), as well as the goal of other industry associations, to build and maintain a competitive, open market for property and casualty insurance products in Canada — particularly in private passenger auto coverage. Insurance industry participants need to step back and re-consider the impact of major structural changes that would very likely inhibit the evolution of a competitive private insurance market that we profess to be the industry’s goal.

As part of that process, let’s consider the circumstances that led to the re-design proposal and determine if there isn’t a better way to deal with the potential shifts in pricing and availability that may lie in the future.

WHY IS THERE PRICE VOLATILITY?

First, let’s ponder the following question: Why does the private passenger automobile insurance market experience price and availability volatility?

Without question, competition in any industry drives a certain level of market volatility in both product availability and price. Market-driven swings tend to take longer to develop and generally do not create significant market dislocation as characterized in the insurance “hard market scenarios.”

In Ontario’s private auto market, for example, we are in the early stages of market hardening due to a period of price competition. The natural tendency is for market forces to overshoot the benefits of product re-design, market segmentation or refined underwriting criteria; then, market forces require a period of price adjustment to account for the assumption errors that had the effect of lowering prices. Such swings are the natural consequence of a free market system; generally, the insurance-buying public tolerates them, provided the market adjustments are not sudden and coincide with other market-moving events.

However, more material swings of availability and price in the private passenger auto market in the most recent past can be directly linked to two specific systemic issues. They are:

* government intervention (product and price); and

* judicial liberalism

Although judicial liberalism is attributable to volatility in insurance results in certain tort-based systems (by virtue of courts and judges granting higher awards for negligence), the primary cause for hard-market scenarios has been excessive governmental intervention into the insurance market. Such intervention is often characterized as “product reform” and/or “consumer protection.”

Most industry participants admit the need to work within a solid regulatory framework related to both solvency and market conduct. That framework needs to offer citizens a fair and equitable system that is both available and affordable. However, for the open market model to work effectively over the longer term, most would strongly suggest that the role of government — and the rationale for intervention — should be closely aligned to the goal of promoting an open, broadly-based, competitive market within which availability is plentiful and price options are wide.

THE PURPOSE OF FARM

How does the Facility Association (FARM) fit into that competitive market model?

Without a doubt, certain driver profiles will always exist that, from a free-market insurer’s perspective, would be deemed “unprofitable or uninsurable.” Such profiles will always exist even with an active, non-standard market.

The role of the FARM is to provide availability of compulsory insurance to individuals who cannot find insurance in the competitive marketplace. It should be a tightly focused facility to accommodate the worst-of-the-worst drivers. Access to Facility should be limited to a defined number of driver profiles that are endorsed by insurance companies participating in the end results.

However, it is not the role of the FARM to offer the same level of affordability to drivers who have routinely violated the law and created dangerous situations for other law-abiding members of society. The FARM should maintain a static price level (within relatively narrow ranges) that should normally exceed the private market price in most — if not all — situations in which insurance is otherwise available.

Prices for FARM-type risks should not be regularly changed unless excess losses emerge. The standard for excess losses might be defined to everyone’s satisfaction using periodic reviews to ensure the definition remains appropriate. FARM should never be an “insurer of choice” for brokers or the driving public. Government must take a different view of FARM pricing than that of a private market insurance company so as to maintain as many private market options for coverage as possible.

Using the current FARM population in Ontario as an example, it would appear the competitive or open market is functioning as intended: the number of individuals forced to acquire insurance through the FARM is currently an extremely low percentage of the driving public. The primary reason for the low FARM population in Ontario is directly linked to the lack of product reforms dictated by government since 2003, adjusted FARM pricing to appropriate levels and the existence of an environment conducive to price flexibility in the open market (both up and down).

The Ontario market model — including FARM in its current configuration — should not be changed: it is working. FSCO should grant price changes as requested, provided the necessary actuarial support exists. Insurance industry associations should remain vigilant and regularly review emerging product design issues with FSCO and other provincial regulators to ensure timely recognition of product design defects that could jeopardize long-term auto insurance availability or create a climate of unacceptable price change.

LARGE FARM POPULATIONS

Why do some provinces have large FARM populations?

Provinces with large FARM populations can be characterized as those trying to achieve broader public policy objectives through insurance regulation. Either that, or they might be neglecting to recognize the close relationship between product features and costs in the price regulation process.

In the case of Alberta, cheap insurance was/is a public policy required to attract workers (young and old) to a booming economy.

The judicial liberalism in Alberta prior to the 2004 product reforms — which limited damages for minor injuries — created a constriction in availability and increased prices for both poor and new drivers. The Alberta government and other private industries could not tolerate the inability of the driving public to get to work due to unavailable insurance or its higher costs. Instead of using its powers to cooperatively reform the product so costs and prices could be adjusted in the open market (which would have been the natural result of product re-design), Alberta implemented price controls that removed a large section of the buying public from open market, private insurance eligibility.

Today the FARM, through its administration of the Alberta Risk Sharing Pool (RSP), is the largest insurer of Alberta drivers. Ultimately, the inadequate price ceilings the Alberta government imposed will generate losses in the FARM that will be passed along to the private market. It will reduce or eliminate private market profits; in turn, this will ultimately drive private insurers from the marketplace, further reducing av ailability. Is this the model the insurance industry should be promoting for other jurisdictions? The answer is no.

RISK-SHARING POOLS

Why do we need risk sharing pools? The simple answer is we don’t. However, to accomplish certain public policy objectives, risk-sharing pools provide the necessary mechanism to segregate specific risk types from the overall pool of otherwise insurable drivers. Such is the case for providing affordable insurance to new drivers (New Brunswick model). If Alberta had pursued this option, instead of lumping poor drivers into the equation, more private market options would exist and fewer drivers would populate the RSP.

The case for risk-sharing pools should be centered on specific and limited objectives, such as affordable insurance for new drivers, for which no other solution exists. Severe limits should be placed on using risk-sharing pools or they will grow to the disadvantage of the open market’s long-term health. (See the Alberta example, noted above.)

INSURANCE MARKET MONITORING BOARD

What are the next steps for the insurance industry and government to protect a functional insurance market? Provided the long-term goal is to maintain an available and affordable private insurance market, industry representatives should actively pursue the formation of an Insurance Market Monitoring Board (IMMB) comprised of insurance industry executives (representing both companies and intermediaries), regulators and consumer group representatives. The IMMB would consult with government on the state of the insurance market. Its primary role would be to identify the warning signals of significant market dislocation — i.e. claims cost escalation, fraud trends, overall industry profitability, capital adequacy, etc. — and recommend action items to mitigate potential sources of material market disruption.

The IMMB would create a transparent and comprehensive view of the insurance industry for all citizens. It would provide a balanced assessment of how society should alter its insurance products to maintain relevance. Public hearings would be held to ensure a regular and ongoing “dialogue” with the public to promote the virtues of a competitive and functional insurance market.

Any free-market economy — and any industry working within such an economy — will experience change over time. Insurance industry stakeholders are responsible for preventing severe dislocation of availability and price that breaches public trust in the insurance system. Such a breach in trust provokes adverse government intervention into an otherwise viable and functional system. We all agree FARM should not become the dumping ground for market dislocation as it did during 2002-05.

AVOIDING THE HARD MARKET

What caused the last hard market? Can it happen again? Can we avoid a repeat of significant market dislocation?

At this point, it is clear to most insurance industry participants that the hard market in Ontario and other provincial private passenger auto markets in 2002-04 was a direct result of poor product design (and the regular and ill-conceived changes in the auto product since 1990), the inability of governments to recognize the product flaws and resulting price inadequacies, along with the insurance industry’s inability to effect timely changes through its lobbying efforts. Without a doubt, the financial system meltdown post-9/11 also contributed to a dramatic reduction in capacity, further exacerbating a difficult situation.

As our more recent history has exhibited, almost anything is possible these days. To say a repeat of the market conditions triggering the last hard market will not re-occur would be nave. However, should we be rushing into market model changes that will have significant and long-lasting effects on the competitive insurance market in Canada? The answer is a vociferous ‘No.’

Industry and government should look to create a joint, market-monitoring mechanism that can provide early-warning signs of potential significant market dislocation. Ideally, the mechanism would encourage a consensus-based approach for dealing with such a potential dislocation in a spirit of fairness and transparency, thereby protecting the availability and affordability of compulsory insurance coverage.