Getting Beyond “Recovery”

Merger and acquisition (M&A) activity has resumed in the Canadian property and casualty insurance industry, with direct writers emerging from their shells and long-suffering insurer, State Farm having turned a profit. Carriers, particularly commercial ones, continue to reap the benefits of prior rate increases as they flow through earnings virtually assuring that 2004 and early 2005 will show impressive returns.

Canadian p&c insurers’ results continued to perform extremely well through the second quarter of 2004 with many companies posting high double-digit ROE’s and excellent combined ratios, according to the “MSA/Baron Outlook Report” for that quarter (the report is produced jointly by MSA Research Inc. and Baron Insurance Services Ltd.). Based on data from most federally licensed companies, the industry turned in a combined ratio of 91.8% at six months 2004, almost eight percentage points better than the same period in 2003.

The question on many a mind is whether this performance is sustainable beyond 2005. We believe not. It is our opinion that the top of the pricing cycle is behind us and that political and economic forces will serve to reign in profitability going into the latter half of 2005 and early 2006. Of course, this does not mean a return to a reckless soft market any time soon. Several factors will moderate the softening and give the industry a shot at what is now being dubbed the sought after “soft landing”.

COMMERCIAL MOVEMENT

Knowledgeable industry sources assert that easing is occurring in the short-tail commercial property (CP) arena where perceived profitability is the most pronounced and competition the most fierce. This, they say, is mostly evident when it comes to large accounts. We must, however, caveat this, as softening is not yet evident in the most recent numbers. Direct CP premiums have grown at a compound annual rate of 17% over the past five years, significantly outpacing the robust 13% CAGR compound annual growth rate) for all lines over the same period. Loss ratios in CP have declined from 80% in 2001 to 51.5% at the end of 2003 to 46.5% midway through 2004. The chart below depicts the heady premium growth in CP experienced by a selection of the leading CP writers on a four-quarter moving average basis starting from 1996 through the second quarter of 2004. Premium levels marched steadily upwards since 2000. Barring heavy cat activity in Canada, this growth is poised to reverse over the next several quarters.

CASUALTY WARY

For several reasons, pricing is expected to hold flat in long-tail casualty lines for now. Loss development trends in these lines have been unfavorable for some time. Having approached acceptable levels at yearend, loss ratios have again risen sharply midway through 2004. Further, the current interest rate climate cannot support softening. That is not to say, however, that pricing erosion is not occasionally taking place.

AUTO VOLATILITY

Forecasting pricing and profitability in the tumultuous private auto market is a “mug’s game”. And we will not attempt it here. What we can say is that auto loss ratios have been trending downwards overall to a recent low of 71.3% at the end of the second quarter. Several non-permanent factors such as the sharp decline in frequency and the one-year waiting period on settlements of accident-benefit claims in Ontario, are contributing to this improvement. As the first cycle of pending settlements matures and as nefarious players adjust to the new realities we expect claim costs to again ramp up. In fact, holes are already being punched in the pre-approved framework (PAF) via phony psychological assessments and bogus paperwork holdups.

In addition, the “frequency bubble” will likely pop as market availability improves and as consumers perceive “pricing give”. The currently proposed choice model in Ontario and the social redistribution of premiums in Alberta will not remove costs from the system, rather they will simply shift the burden from one set of insureds to another. Even if political pressures seem to be abating somewhat, there is not likely much in the way of upwards rate movement which will be countenanced in the mid-term. For the time being, auto insurers in Ontario are enjoying a lull and an opportunity to earn profits while the going is good. Longer-term stability remains murky.

BATTERED REINSURERS

The heavy cat activity in Florida, continued legacy liability problems in the U.S. and market-security concerns underlined by Converium Re North America’s unraveling will contribute to pricing discipline in the global reinsurance market this renewal season. We expect that these factors combined with local adversities will slow softening of pricing and terms in Canada as well.

Canada’s reinsurers have only just begun to recover from a series of extremely poor years. As a group, their five-year (1999-2003) ROE was 6.6% and their five-year combined ratio was 108.3%. Both of these numbers, however, were significantly propped up by decent results in 2003. Net premiums written by licensed reinsurers grew at a compound rate of 16.7% since 1999, outpacing the primary market’s growth of 12.6%. This growth is due exclusively to the dramatic rate increases of recent years, offsetting higher primary company retention levels. Growth has been particularly high in the liability line as well as the commercial property arena. Even so, loss ratios in these lines continued to exceed those of the primary market by a significant margin in 2003.

Significant adverse reserve development actions are contributing to the reinsurance sector’s woes. Most of the recent development is attributable specifically to the years 2000 and 2001. The analysis of the reinsurance sector’s runoff is complicated by the fact that some reinsurers present their loss development on an “underwriting-year” basis, while the rest use the more accepted “accident-year” basis. However, adverse development for accident-years 2000 and 2001 is still clearly evident even when the differences in methodologies are taken into account. While reinsurers are clearly motivated to hold the line, several factors may get in the way, including the following:

Local competitive forces including elevated retention levels amongst primary writers will limit reinsurers’ ability to continue raising rates;

New licensed entrants (Aspen & Endurance) and increased competition from Bermuda;

Underutilized capital; and

Primary softening in commercial property.

In conclusion, it is our expectation that some softening will occur this renewal season, though it will likely be muted by the reasons outlined earlier. Time will tell.

M&A SPARKS

Last year’s move by Meloche-Monnex to acquire Liberty Mutual’s personal lines portfolio heralded a new wave of consolidation in the Canadian market. Meloche-Monnex’s play was followed by the U.S.-driven merger of Travelers’ Canadian business into St. Paul’s operation here, and most recently by ING’s acquisition of most of Allianz’s Canadian business. Clearly the lull in M&A activity is now over.

ING, already Canada’s largest player, has increased its lead and is expected to have 13% marketshare in 2005. Digesting Allianz will be no cakewalk, however, even for the legendary ING machine. The purchase will significantly ramp up ING’s exposure to the unstable Ontario auto market, thus propelling its share beyond that of State Farm and making its stake in that market second only to Aviva.

Also, unlike the deal that ING struck with Zurich in late 2001, in which it exchanged the latter’s personal and small commercial lines renewal rights for its large commercial lines, the Allianz deal is an outright purchase with correspondingly more complex execution and integration risks. There is little doubt, however, that ING can pull it off with aplomb. We believe that further consolidation is likely to occur over the next 24 months as ING’s main competitors feel the need to bulk up and other under-performing players seek to exit as they sense the cycle softening.