November 1, 2001 by Vikki Spencer
“It’s just not possible to have a $30-40 billion loss running through the industry, both insurance and reinsurance alike, and not have an effect on pricing,” John Phelan, president of Munich Reinsurance Co. of Canada told attendees at the Canadian Insurance Accountants Association (CIAA) conference in Montreal, just days after the September 11 terrorist attacks in the U.S. While “time will tell” what the final losses are from the terrorist attacks, Phelan notes that the industry’s profit margins are not sufficient to handle the perils, natural or man-made, it is now facing.
Lack of discipline
Speakers agree that the industry is already facing an uphill battle, with the heady days of big investment returns and inadequate pricing long gone. In challenging the traditional underwriting cycle, CGU Canada president Igal Mayer points out that the industry runs on both underwriting and investment returns. “And don’t kid yourself, the two are linked.”
He notes that good equity returns in the late 1990s led to “a tremendous level of undisciplined pricing”. The net result is a rolling 12-month return on equity (ROE) of 2.6%. He expects the combined ratio for 2001 will be in the 110% range as well. Although rate hardening is becoming evident, it may not be enough to save some companies, speculates Bob Fellows, president of St. Paul Canada. Weak players will “hit the wall”, he predicts. Capital management is going to become crucial in what is currently an “over-capitalized, price sensitive and slow growth” industry.
“It surprises me an intelligent group of people can run a business so badly,” observes Phelan. With a combined ratio of 113% last year, “I don’t care how good your investments are, you’re not making any money”. He predicts this year the industry will not see an ROE much better than 2%.
For reinsurers, the pricing situation has been just as unreasonable, Phelan notes. And, despite the fact that catastrophe losses were not so bad prior to September 11, he says existing treaties, particularly proportional treaties, are simply inadequate. With increasing emphasis being placed on shareholder returns, the current malaise in the Canadian market is being viewed with a jaundiced eye globally. “I have to demonstrate to my shareholders that they should invest in Canada, and why should they when the returns are so poor?” Phelan observes.
Pricing is not the only problem eating away at the industry. The Ontario auto market is suffering from unsustainable pricing and spiraling costs, notes Mayer. “We have a product that isn’t working for us.” Under-pricing of the auto product has been estimated at 26%, a figure Mayer recognizes will never be met through price corrections. “I don’t see people ever getting close to that.”
In Alberta and Atlantic Canada, auto insurance is also at issue, with tort laws adding to the cost factor. Add to this the recent decision in McNaughton v. Co-operators, where Mayer says insurers are facing a big penalty for inadequate wording of contracts. “It was pure stupidity on our part as an industry,” he says. Proper wording and standard forms should have been in place long ago. “This is going to cost millions, tens of millions of dollars probably,” he suggests, as other insurers face similar lawsuits in the coming months. Another problem exists with broad-form homeowners policies, Mayer adds, which are now being interpreted to cover burns, spills, and the like. “That’s not what the product was intended to be.”
And, insurers are moving into new lines of business they are not suited for, such as large commercial business which historically fell under the domain of only the largest insurers, he adds. “The rest of us have no business there”.
Part of the crisis in Ontario auto is the inability of insurers to get their point across with the regulatory authorities. Healthcare costs in particular are a sticking point, says Mayer. “We need to have honest discussions with government about what this industry should be funding and what other industries should be funding.” The other issue is the inability to devise a rate filing system that gives insurers the leeway they want to increase prices.
On the whole, however, Mayer thinks the regulatory landscape is strong, and something other countries look to as a model. Fellows agrees that Canada’s ardent regulations are needed to avoid the insolvency problems seen in other countries, especially on the commercial risk side of the business.
Speakers were also reacting to a new set of corporate governance guidelines released by the Office of the Superintendent of Financial Institutions (OSFI) this summer. The guidelines, which are not yet regulatory requirements, set out OSFI’s recommendations for risk-control at the corporate governance level and are similar to those used in deposit-taking institutions, notes Nick Burbidge, senior director of compliance at OSFI.
Phelan says the concept is great, but “it’s just too much…the cost of putting it into place is just astronomical”. Mayer agrees the guidelines are “aspirationally right” but does not see them as necessary.
Phelan adds that many Canadian branches of global operations are already subject to such requirements from their home-office countries, which should be taken into account by regulators here. “What I would like to see OSFI recognize is the home domicile of global companies.”
Other speakers, including Ron Bilyk, director of compliance at Zurich North America Canada, sees the OSFI requirements, including its risk-based rating criteria, as “nothing more than risk management we [as insurers] should already be doing”. Neil Parkinson, partner at KPMG, agrees. “It’s not just something the regulators are making you do. If it is, you’re probably missing the point.” Shareholders, rating agencies, directors and management should be requiring this diligence regardless.
Phelan believes, however, that the federal regulator should be cracking down on minimum capital requirements, which he says are currently ineffective at $5 million, which has partly resulted in the “overcrowding” of the primary insurance marketplace in Canada. The standard should be 10-times what it is to prevent investors who see two or three years of good returns and decide to open up an insurance company. “Guess what, it’s too late,” Phelan notes, because by then the market has turned. A minimum capital requirement of between $50-100 million is more likely in order, he adds, “it doesn’t make sense that you should be able to start an insurance company for less”.
Price is right
Insurance company CEOs were unwilling to lay blame at the feet of regulators or anyone else in looking for a cure for the industry’s ills. Proper pricing and stricter underwriting are clearly the answer, they agree.
Mayer suggests rate hikes in line with those being made in the U.K. and Spain, where rates will go up 50% over two years, are needed here. “I’ve gone on record as saying the industry is under-priced by about 10-15%, and that’s what needs to happen.”
The Canadian market is lagging behind the U.S. as well, Fellows notes. In commercial lines, increases of 15% are being seen, “and they’re needed”. In particular, pricing consistency across the industry is needed, and special attention needs to be paid to properly pricing Canadian companies’ U.S. exposures.
But whether the primary industry is prepared to make the necessary rate hikes is still a question. “This industry is very insecure about asking for price increases,” Mayer notes, and many company leaders have not been through a hard cycle before. Linking actuarial and underwriting more tightly to business decisions is necessary, agrees Phelan. “Financial people need to push”, Mayer confirms, in order to get company leaders to see the need for substantial increases. In this respect, Phelan expects to see significant future price increases from both insurers and reinsurers, notwithstanding the U.S. terrorist attack losses. Increases of 15% will not be uncommon, he predicts.
Mayer adds that insurers are now coming to grips with reinsurance rate
increases, “something I don’t think we have anticipated”. The reason, speakers agree, is that global catastrophe losses are now trickling down to Canadian balance-sheets. “We are in an international market and [up to now] we have been sheltered.” Phelan expects perils will also be on the rise in the future, along with rate increases and new policy exclusions. For example, the Reinsurance Research Council (RRC) is recommending companies write exclusions for “hack attacks” for the coming renewal season.
The “C&C” theme
The themes of consolidation and convergence have been playing out in the insurance industry for several years, and speakers see these trends continuing despite the tougher economic times. Convergence will certainly be a factor, particularly in light of the opening of legislation in many countries. But, Fellows notes, it may not progress in the way once thought. “We don’t believe banks will run out and buy insurers for risk management purposes”, and nor will insurers become banks. Rather, both segments, he believes, will look at diversifying their product base. Product diversification, like geographic diversification, may be a way for companies to avoid having “all their eggs in one basket” in the face of losses.
As for consolidation, Mayer thinks this may be a key to turning around pricing woes. “Insurance doesn’t behave like a commodity because smaller companies can’t see the big picture.” Fragmentation is a barrier to consistent rate increases, and he consolidation will bring “clarity and honest pricing” to the industry. Phelan also thinks consolidation will continue, and that the gap between the largest players and the rest of the industry will widen. He does not, however, see consolidation as a barrier to competition. With the top three reinsurers writing 45-50% of the business, “that hasn’t stopped them beating each other”.
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