Flatland

“All beings in Flatland, animate or inanimate, no matter what their form, present to our view the same, or nearly the same, appearance, viz. that of a straight Line.” — Edwin A. Abbott, Flatland

Canada’s reinsurers, the companies insuring Canada’s primary insurers, might very well be living in Edwin Abbott’s fictitious, two-dimensional world of Flatland. Over the past four years or so, their premium growth, their overall rates and their clients’ retentions of their own risk have all been fairly flat.

One might view this state of affairs positively, euphemistically describing Canada’s reinsurance market as “stable,” as many industry observers do. For global reinsurers with head offices overseas, Canada is a great place to diversify risk. That’s because this country hasn’t witnessed huge, catastrophic claims events experienced in Europe (windstorm Xynthia), Haiti (earthquake) or Chile (earthquake) this year, not to mention the hurricane claims of the southern United States in 2005. “The capacity in Canada is still plentiful, and Canada is perceived by a lot of global reinsurers as being a fairly stable market,” says Lambert Morvan, senior vice president and chief agent in Canada for Odyssey America Reinsurance Corporation. “It generates good return on a long-term basis, so as capacity is growing, then people want to grow their business.”

But therein lies the problem. Canadian reinsurance market “stability,” even if it shades slightly into the territory of marginal profit, is not necessarily a good thing if reinsurers want to grow their business by more than 2% or 3% each year. In hospital emergency TV shows, a flatline represents the death of a patient. And certainly the price of financial stability has been a nominal-growth environment for Canadian reinsurers. “I think the market is still flat,” says André Fredette, senior vice president and general manager of the Caisse Centrale de Reassurance. “If you look at the Reinsurance Research Council (RRC) numbers over the last five or six years, there’s not very much growth, if any, on the amount that the domestic reinsurers are writing. It’s pretty flat. It’s about $2-plus billion now. So it’s not a growing market out there.”

And so how does a company writing the same amount of premium each year make money for its shareholders? Well, it could raise premium rates. But there hasn’t really been a justification to raise reinsurance rates in Canada, because the Canadian insurance market is flush with capital. Joel Baker, president of MSA Research, says the licensed Canadian reinsurance industry has about $3 billion in capital right now; that’s in addition to the $1.4 billion it wrote in net premiums in 2009. And this doesn’t count the capacity coming to Canada from the Lloyd’s market in London, as well as from the unlicensed market in Bermuda. To put this in perspective, the biggest claims event in Canadian history, the 1998 Ice Storm in eastern Ontario and Quebec (which resulted in nearly 800,000 Canadian claims), cost the industry about $1.8 billion. And yet, “even the Ice Storm, when you go back, had minimal impact on reinsurance catatstrophe rates in the Canadian market,” observes Caroline Kane, senior vice president and chief agent in Canada for The Toa Reinsurance Company of America.

And so that begs the question: What would it take for Canadian reinsurers to deploy enough capital that their reinsurance rate increases would be justifiable? “Good question,” responds Sharon Ludlow, CEO of Swiss Re in Canada. “I’m not entirely sure what that event would be. I’m not sure I would want to guess what it would be, because it would be pretty awful.”

Flatland

Welcome to the Canadian world of reinsurance, which features flat (or “stable”) premium growth and flat financial results.

Since 2006, members of the RRC have annually written within a range of $2.2 billion of net premium at the most (in 2009), and $1.8 billion in premium at the least (in 2007), according to RRC figures complied by Hans Rohlf, managing director and chief underwriting officer for North America at Hannover Re. On average, they have written $1.9 billion, Rohlf’s figures show.

Canadian reinsurers experienced premium growth in 2009, featuring a 10% increase in business assumed from primary insurers, as MSA Research notes in its 2009-Q4 MSA Baron/Outlook Report. “The growth in assumed business can be partially attributed to capital relief that primary insurers sought out during their 2008 renewal season amid the financial upheaval that occurred then,” MSA/Baron says. “Since that time, the financial markets have calmed down and primary insurer financials have stabilized, leading us to believe that the growth the reinsurers experienced [in 2009] was short-lived.”

And while reinsurers’ net premiums written have more or less hovered around the same mark, so, too, have the reinsurers’ financial results. Canada’s primary insurers have posted an underwriting loss during the global financial crisis over the past two years; in contrast, during the same period, Canadian reinsurers posted modest underwriting profits (an $18.4-million underwriting profit in 2009, according to MSA Research, and $16.2-million profit in 2008).

As for the Canadian reinsurers’ combined ratio, it is flat as a pancake. Canadian reinsurers reported to MSA Research that they paid out $962 million in claims costs in 2009. Against this, they reported underwriting — or assuming from primary insurers — about $1.4 billion in premium. When you divide these claims costs by the premiums earned, you get a combined operating ratio in 2009 of 98.6%. (A combined ratio of more than 100% means the company is paying more in claims costs than it is earning in premium, meaning the company is losing money.). Let’s compare this 2009 result to Canadian reinsurance results in 2008, when Canadian reinsurers underwrote or assumed $1.2 billion in premiums and paid out $848 million in claims. This resulted in exactly the same combined ratio of 98.6% as in 2008. Read: flat.

Losses: the Usual Suspects Catastrophe Losses

Assuming Canadian reinsurers end up writing approximately the same amount of premium in 2010 as they have over the past four years, the question MSA Research poses is this: “Can commercial insurers and reinsurers continue to coast without rate?”

Not if they want to generate a healthy return on their abundant capital. Especially when signs exist that commercial property claims costs are on the rise. On commercial property business, Canadian reinsurers saw their combined ratios for commercial property lines go from 62.8% in 2008 to 75.4% in 2009. This had to do with several mid-scale business losses, including, for example (to list only a few): a $110-million loss for a fire at the Chapman’s ice cream plant just outside Toronto; a $30-million loss sustained by a tent manufacturer for the Dallas Cowboys; a $30-million loss due to faulty foundations in Quebec; and some catastrophe losses arising from tornado damage in Ontario and storm damage in Alberta. In the grand scheme of things, these losses hardly equate with the monster, $1.2-billion loss Suncor sustained in a 2005 fire. But they do add up. “On the reinsurance side, it has translated into some rate increases for loss-affected treaties, sometimes higher retentions, but no general firming,” reports Hervé Castella, chief agent in Canada of PartnerRe.

Canadian reinsurers reported receiving some additional business from primary insurers as a result of RMS changing its Canadian earthquake model in 2009. RMS upgraded and extended its earthquake modeling capabilities throughout the Americas, establishing a consistent view of risk from Canada to Chile. “In the majority of cases, the model updates [led] to increases in risk for Canada’s high hazard and densely populated regions, roughly translating into a 25% increase in modeled losses across Canada,” RMS reported in Canadian Underwriter in 2009. The modeled increase was be
tween 30% and 40% for B.C. quakes. “Some companies were buying an extra $50 million to $100 million in coverage” as a result of the RMS model upgrade, Fredette said. “That happened last season. It was purely a result of the models doing some updating.”

Also, as A.M. Best observes, “in Canada specifically, an increase in property claims from weather related losses is resulting in a 5% to 10% increase in ‘catastrophe’ protection costs for 2010 for some insurers.”

Auto Insurance Losses

Reinsurers’ excess-of-loss treaties respond to catastrophic auto accident injuries. And there have been some concerns about the frequency with which catastrophic auto injury claims costs are penetrating into these upper layers. Ontario has introduced auto insurance reforms that are intended to address the province’s catastrophic injury definition; this in turn will address reinsurers’ concerns about escalating claims severity. But the new cat definition is a work in progress and may take the better part of a year to resolve. “On the reinsurance side, I don’t believe there’s any impact [of auto reforms] on the reinsurers,” Morvin says. “Basically, we get catastrophic-type losses with the bodily injury and accident benefit… the reforms don’t really address that.” Steve Smith is the president of Farm Mutual Reinsurance Plan, which wrote almost $40-million worth of auto liability business in 2009. He believes it is far too early to tell whether or not Ontario’s recent auto insurance reforms will have any impact on catastrophic impairment losses. “The new reforms in my mind are going to do very little from a reinsurance point of view, if no impact at all,” he said. “I don’t see any change. My concern is that the frequency of severity may escalate, because the catastrophic impairment rules are too loose. They’ve not yet been defined [in the reforms].”

Rates

And so, if reinsurers’ losses end up being comparable in 2010 to what they were in 2009, what does that say for reinsurance rates going forward? Not surprisingly, reinsurers are gazing into the distant horizon from their porch, searching for any signs of a hard market, featuring higher premium rates and tighter coverage — and seeing nothing but a flat line.

“If I go back to last renewal season [July 1, 2010], I would have thought it would be a harder market,” Fredette says. “To be honest with you, I didn’t appreciate how interest rates have reached historic low levels and the primary market was flat. So I thought reinsurers would start to price up themselves a little bit [to make up for a decrease in their investment income], but that didn’t happen.”

Morvin concurs. “The general sense is that [since] it’s been less-than-expected loss activity over the last couple of years, you would have rates that are basically as-is, as far as renewals are concerned,” he says. “Overall, for our portfolio, the average rate is up by 2% or 3%, but that’s because maybe 20% of our treaties are going up by 10% and the others are as-is. It’s about a 2% increase [overall].” In other words, basically flat. “Rates are not really softening anymore, but they’re not hardening either,” Morvin says. “It’s like we’re sitting at a point in the cycle where everyone is basically waiting for some large event, or a shock-loss, before rates start going up.”

Abundant Capacity

Most reinsurers are at a loss to say what kind of catastrophe that might be. “From a cat perspective, I think it’s going to be interesting, because first of all, there’s a lot of capital in the market,” Smith observes. “There’s a lot of surplus in the market. So it’s going to take a really significant, almost market-changing event for anything to happen to harden the market…. Unless something really dramatic happens with hurricane activity in the United States [in 2010], probably it will take some kind of Hurricane Katrina-Wilma-Rita event to have any real effect on cat and property rates from a reinsurance perspective.”

And even that might not be enough. Insured losses from Hurricanes Katrina, Wilma and Rita in 2005 are estimated to have totaled just under $80 billion. Meanwhile, Aon Benfield’s June 1, 2010 Renewals Update reports global reinsurance capital hit the $434-billion mark in 2010 Q1. That level of capitalization only further insulates the Canadian market from the effect of global catastrophes, several sources suggest. For example, Chile’s February 2010 earthquake measured a magnitude of 8.8, causing an estimated $8 billion in losses. Nevertheless, is not expected to have any far-reaching implications for Canada’s reinsurance market. “With Chile, which was very well insured, the ramifications of that event haven’t really gone even beyond the borders of Chile itself,” Ludlow observes. “Even within South America, we’re not seeing any dramatic change in pricing, which also demonstrates that there’s some significant capital out there.”

Of course, it remains to be seen what the 2010 summer hurricane season brings. The Canadian Hurricane Centre has warned of an active hurricane season, citing U.S. forecasters. The U.S. National Oceanic and Atmospheric Administration (NOAA) predicts between three and seven major (Category 3-5) hurricanes this year. “If [the hurricane season] is really bad, then balance sheets may be damaged, and then we can have a general reduction in capacity,” Castella says. “After any catastrophic event, it creates an adjustment in models and pricing. And in that case, particularly for the rare event, it affects top layers.” Still, he adds, these types of catastrophes happening elsewhere, such as the Chilean earthquake in particular, “do not translate directly to the Canadian market.”

In Canada, the current level of capital will easily absorb some of the 2010 losses seen thus far in this country. These include floods in Alberta and Saskatchewan (the Saskatchewan floods resulted in 4,700 auto and property insurance claims totaling $57 million); tornadoes in Ontario and Saskatchewan (one tornado in Leamington, Ontario caused caused at least $85 million in damages); a 5.5-magnitude earthquake on the Ontario/ Quebec border, relatively minor damage arising from the G20 summit held in Toronto — you name it, reinsurance catastrophe treaties will cover it.

And from where does all of this capital come? Head offices of reinsurers overseas send their capital here, because Canada is a much-needed “stable” market. “Reinsurers have the capacity and would like to do more business in Canada because it provides further geographical diversification and historically has been a stable profitable region in which to do business,” A.M. Best says. In fact, it may well take global reinsurers to decide for themselves to drain excess capital out of the Canadian market, assuming they encounter no opportunities to deploy it, Kane observes. But that is where Canada’s solvency regulator, the Office of the Superintendent of Financial Institutions (OSFI), steps in, says Ludlow. When asked if there might be any inclination to pull capital out of the Canadian market, Ludlow responded: “Well, not if you’re OSFI. And that’s the other side of the equation: [industry observers] can use the term ‘overcapitalized,’ but our friends down the road in the regulator’s office would say: ‘We’re quite happy at that level.’ And for some companies, they’d probably like to see a little more. There’s a fine line there.”

Certainly OSFI’s long-term policies have required Canadian reinsurers to keep enough capital in Canada to cover the losses of their Canadian policyholders. Right now, “MCT levels for the reinsurance sector are healthy at slightly over 300%,” Baker reports, referring to the Minimum Capital Test (MCT). It takes a test score of less than 175% for OSFI to become actively involved on the re/insurer’s file.

Some speculate OSFI’s latest proposal to eliminate the so-called “25% rule,” which prohibits Canadian insurers from ceding more than 25% of their business to unlicensed reinsurers, will bring even more unlicensed capacity into a Canadi
an market that is already flush with capital. Time will tell, but Canadian reinsurers are sounding a skeptical note that the rule change will have much effect.

“Our view is that it’s not ‘game-changing,'” Ludlow says. “They’re not removing the requirement for collateral for unlicensed reinsurance, so it doesn’t really move the needle. You’re not going to see Canadian companies fleeing to offshore reinsurers and then demanding that they put up collateral. The collateral is still expensive relative to what it was a few years ago.”

Smith said the elimination of the 25% rule would only make a difference in a different marketplace environment — one in which many small players were vying for scarce capacity. “If you look back to the late 70s, early 80s, there were a lot of small players around struggling to buy reinsurance, to keep fronting,” he says. “With a lot of unlicensed reinsurers, it was happening quite a bit. And there was the liability crisis that was happening in the early 80s. If we see a liability crisis take place, and all of a sudden capacity becomes a real problem for some players, or if you see major collapse in the reinsurance market, then I see [the elimination of the 25% rule] becoming an issue. But I don’t see it happening. I don’t think the [25%] rule is going to be overly material.”

Retentions

Although significant reinsurance capital is available, primary insurers appear loath to use it. Some time ago, after the hard market in 2005, primary reinsurers started to retain more of the risks themselves, declining to transfer the risk exposure on their books to reinsurer partners. The theory was that the primary insurers were doing well financially in a low-claims environment; therefore, they could afford to pay for the risk exposure on their own balance sheets. By not transferring their risk exposures to their reinsurers’ balance sheets, primary companies thereby improved their own financial returns. But the trend of primary insurers starting to take on significant retentions of risk was somewhat counter-intuitive, Kane says. “They started that out several years ago, which went against the grain,” she says. “It was at a time when rates were fairly soft [low], so theoretically they should have been buying lower down, but they didn’t. We haven’t really seen much of a trend in the last year, as far as further increased retentions.”

Fredette says companies are still retaining large amounts of risk. “They are still retaining what they have,” he says. “No one has handed back [to reinsurers] too much on that, and they [primary insurers] have the capital still and I haven’t seen any movement.”

But while retentions are not decreasing, they are not increasing much either, Morvin says. In a few instances when primary insurers reduced their retentions, primary companies were addressing capital issues in light of the global recession — a short-term phenomenon, says Morvin. “Some treaties and retentions are starting to [dip] a little bit, but I think what generates that is mostly the soft market environment on the primary side, when companies are actually looking for ways to cut their reinsurance costs, even though it means taking more risk,” he says. “There are some instances where some companies are just not willing to spend more on their reinsurance costs. [Reinsurers are] asking for more premium and [the primary insurers are] not willing to do that, so [the reinsurers] say: ‘Okay, well, if you’re not willing to spend more, you can increase your retention.’ But that means taking more risk. We’ll see down the road, when the losses start coming in, to see whether or not they change their minds.”

But until they do, retentions can join the rest of the Canadian reinsurance denizens in Flatland.

———

The capacity in Canada is still plentiful, and Canada is perceived by a lot of global reinsurers as being a fairly stable market. It generates good return on a long-term basis.

———

If you look at the Reinsurance Research Council (RRC) numbers over the last five or six years, there’s not very much growth, if any, on the amount that the domestic reinsurers are writing. It’s pretty flat.

———

Rates are not really softening anymore, but they’re not hardening either. It’s like we’re sitting at a point in the cycle where everyone is basically waiting for some large event, or a shock-loss, before rates start going up.

———

There’s a lot of surplus in the market, so it’s going to take a really significant, almost market-changing event for anything to happen to harden the market. Probably it will take some kind of Hurricane Katrina-Wilma-Rita event to have any real effect on cat and property rates from a reinsurance perspective.