Grazing with Elephants

A Canadian reinsurance company shares a park bench with a large direct insurer, an elephant that retains a lot of premium for its lunch. The reinsurer looks longingly at the premium consumed by the direct insurer, but the hungry elephant isn’t sharing. As the elephant feasts, it becomes larger and larger, until its size leaves scant room on the park bench. What will the reinsurer do? One answer is to move to greener pastures, where premium dollars are more plentiful and accessible. In other words, the reinsurer could choose to seek premium sustenance in exactly the same place where the elephants graze – Canada’s primary insurance market.

GRAZING WITH ELEPHANTS

Ongoing consolidation in the Canadian primary marketplace this year has reinsurers pondering how best to adapt to the increasing number of “elephants” that are grazing in Canada’s primary insurance market.

Intact Insurance, for example, became an even bigger animal in May 2012 when it paid $530 million to purchase JEVCO Insurance Company from The Westaim Corporation. JEVCO provides specialty and niche products to individuals and businesses in Canada and wrote direct premiums worth approximately $350 million in 2011.

The JEVCO deal happened roughly a year after Intact Insurance announced it would be acquiring AXA Canada for $2.6 billion, a deal now closed.

RSA Canada also continues to be active in the mergers and acquisitions space. The company announced in June 2012 that it had agreed to acquire L’Union Canadienne from parent company Co-operators General Insurance Company (CGIC) for $150 million, pending regulatory approval. L’Union Canadienne is Quebec’s third largest intermediated personal lines insurer, employing more than 300 people across offices in Quebec City and Montreal. It distributes through a network of more than 150 brokers across the province.

The deal makes RSA Canada the country’s third-largest insurer. RSA Canada vaulted into fourth place last year with the $420-million acquisition of GCAN. That deal was expected to increase RSA Canada’s premium base from $1.9 billion (in 2009) up to $2.2 billion.

In addition to the aforementioned high-profile M&A activity, it remains to be seen exactly how Economical Insurance proposes to demutualize, with two options, including an initial public offering (IPO) and a “sponsored demutualization” that would see all or some parts of the company sold. The company will not assess which route it will take until after the federal government comes up with regulations allowing P&C insurers to demutualize.

Suffice to say, reinsurers have watched a number of primary insurers in the Canadian marketplace get bigger over the past two years. And they don’t believe the trend will soon end. The number of federally and provincially licensed insurers has dropped from 395 in 2002 to 316 in 2011.

“There is still more opportunity for some continued consolidation to happen in personal lines,” says Hervé Castella, head of Canadian operations at PartneRe. “There are still a lot of regional players that are viable targets for larger players. On the commercial side, it’s really a matter of competition, though I’m not sure how it will play out. Will some of the larger primary players come together or, like Intact and JEVCO recently, will some of the smaller niche players be acquired? Either way, I think consolidation will continue.”

PRO RATA TO EXCESS OF LOSS

As reinsurers’ clients get bigger through consolidation, what does that mean for reinsurers? For one thing, the type of business is changing.

Reinsurance companies are frequently defined as “insurers of the insurance companies.” They offer different forms of coverage, including:

• Pro rata treaties, in which premiums and losses are divided between primary insurers and reinsurers based on stated percentages.

• Excess of loss treaties, in which a primary insurer accepts losses up to a certain amount, and pays a premium to reinsurers to divide any losses exceeding that amount.

Pro rata treaties are typically associated with insurers’ casualty and property per risk business. Property per risk covers things such as single large commercial losses – for example, the Chapman creamery fire in 2009, sawmill explosions, mining losses, etc. Excess of loss treaties are commonly associated with large-scale natural catastrophe losses.

Reinsurers are looking for a well-balanced premium diet, including both pro rata and excess of loss business. “We cannot necessarily afford to reinsure only the top catastrophe layer,” suggests Frank Rueckert, senior vice president of the Canadian treaty department of Hannover Re. “We also need a bite from [primary insurers’] casualty writings or from their property per risk portion. And that is likely to slowly drift away from the reinsurance end because insurers are getting bigger.”

As the behemoths in Canada’s primary insurance market get bigger, they can afford to accept more risk, thus keeping more premium and paying more claims themselves. Their appetites for pro rata reinsurance and the lower layers of excess of loss reinsurance are therefore shrinking over the long term. There are signs of this already happening.

The Reinsurance Research Council of Canada (RCC) is an organization representing a majority of professional property and casualty reinsurers registered in Canada (it had 18 members in 2011).

Each year, RCC posts financial statistics for its members; collectively, they reported $1.99 billion in premium ceded from their primary insurance company clients in 2011. The assumed premiums were $2.1 billion for 2010, and slightly higher than that in 2009. Generally, the amount of premium ceded from primary insurers to reinsurers has declined by about $100,000 per year on a comparable basis for the last three or four years.

Premiums assumed by reinsurers are not only declining gradually, they are increasingly coming under the excess of loss category. This is often described as a “volatile” area of business. “An excess of loss treaty by its very nature tends to mean you have less premium, but you could be on a bigger loss,” notes Andre Fredette, senior vice president at Caisse Centrale de Reassurance (CCR). “The pro rata treaties we write tend to be a little less volatile, a little more balanced and have a similar loss ratio from year to year.”

Assuming larger companies can pay for more claims themselves, theoretically they do not need to share the risk with reinsurers in the form of pro rata treaties. “At the moment, companies have excess capital,” Fredette says. “That means they tend to keep a larger net retention. That translates into fewer pro rata treaties being placed. A lot of companies – not all, but the bigger companies – have cancelled their pro rata cessions and they’re just buying excess of loss, which means ultimately there is less premium for the reinsurance market.”

SUPPLY AND DEMAND

To some extent, the laws of supply and demand govern the reinsurance market. Recently the demand for excess of loss reinsurance has increased, while the supply of reinsurance capacity has decreased. Castella sees a gradual, growing imbalance between supply and demand in the Canadian reinsurance market. “Last year we saw the balance of supply and demand begin to shift,” he says. “It wasn’t very significant, but there was a noticeable increase in demand for excess of loss reinsurance, while the reinsurance market reduced its appetite for peak earthquake risks.”

INCREASED DEMAND

The increase in demand for excess of loss reinsurance was a byproduct of a record catastrophe year globally in 2011, causing catastrophe reinsurance rates to increase anywhere between 5% and 15% this past renewal, depending on the program and the primary insurer’s catastrophe exposures. Globally, research by Swiss Re notes that natural disasters last year – including earthquakes in Japan and New Zealand, and flooding in Australia and Thailand –
saw the highest economic losses in history, at $370 billion. Of this, $116 billion in damages were insured. Sharon Ludlow, president and CEO of Swiss Re Canada, notes that insurers are working with governments around the world to figure out a way to close the widening gap between economic losses due to natural catastrophes and insured losses.

Canada was not immune. The country’s property and casualty insurance industry paid out more than $700 million in claims for a wildfire that destroyed much of the Town of Slave Lake, Alberta in 2011. Hurricane Irene caused an estimated $6 billion in insured losses in the United States, and although it weakened to a tropical storm as it crossed through Quebec and the Maritime provinces, it still managed to knock out power and damage properties. A tornado destroyed much of the downtown area of Goderich, Ontario, causing upward of $75 million in damage. And hailstorms battered Saskatchewan and Alberta.

All told, Canadian P&C insurers paid between $1.5 billion and $1.7 billion in claims in 2011 – significantly higher than the $860 million they paid for claims in 2010, MSA Research Inc. president and CEO Joel Baker told the 2012 CIP Society Symposium in Toronto.

REDUCED SUPPLY

Demand for reinsurance – the excess of loss variety, anyway – may have increased last year, but the supply of capacity in Canada has decreased somewhat this year, reinsurers observe. Based on the significant global and Canadian loss events last year, global reinsurers faced some tough choices this year when determining where to deploy their capital. Anecdotally, reinsurers say, the argument for geographical diversification of risk didn’t favour Canada this past year, as it often does (and still does, to a degree).

“What really played a role [in obtaining pricing increases this past renewal] was the fact that capacity is becoming scarcer,” says Rueckert. “It used to be quite chic for U.S. players to say they should diversify into Canada. With cats happening on a worldwide basis in 2011 – New Zealand, Australia, Thailand – it became the top of the priority list to look at diversification. But all of a sudden you saw reinsurers saying: ‘Oops, it’s not only a nicely diversified premium, but now you are getting the losses from all sides.’ So it seemed like people were significantly reducing capacities in countries that are not their main priorities,” he adds.

Related to this observation, Farmer’s Mutual Reinsurance Plan president and CEO Steve Smith notes: “I think the big issue that’s still hovering out there is the cost of capital. I think [capacity] is withdrawing from the Canadian market for two reasons. One, it’s withdrawing because the cost of capital isn’t being supported – reinsurers can’t get the premium adequacy that they need. I think the other part of it is that they can’t grow.”

Smith says reinsurers typically look to write $2 or $2.50 for every dollar they have of capital surplus. In other words, for every $1 million of capacity a reinsurer brings to the market, it is looking to write $2 million or $2.5 million worth of premiums. But, as noted above, premiums ceded from primary insurers to reinsurers in Canada have remained flat – if not diminished – over the past three years. If reinsurers can’t get the premium adequacy they need to support the cost of capital, they might consider pulling it out of the Canadian market and deploying it elsewhere.

Smith further observes that if foreign owners of reinsurers are looking for a return on equity (ROE) of up to 15%, they need to be able to write enough premium to support it. But Canadian reinsurers are not getting that type of premium adequacy, Smith notes, citing casualty lines in particular.

“So if you’re a foreign investor and you’re coming into the Canadian market and can only get a 2% or 3% return, what’s the point?” Smith suggests. “When I have this conversation with other people, they say: ‘Yeah, right now it’s true for Canada, but the rest of the world is going to follow suit. It’s going to be the same globally.’ But I think what’s different globally is the ability to grow. In emerging markets, there’s ability to write more premium for every dollar of surplus.”

Castella sees the disparity between supply and demand getting slightly bigger each year, with a number of factors contributing to an increased demand for reinsurance capacity. For example, Canada’s solvency regulator, the Office of the Superintendent of Financial Institutions (OSFI), has made proposals recently that would effectively require primary insurers to assign more capacity for earthquake coverage. The proposals could potentially drive more demand for reinsurance, thus contributing to the current imbalance between supply and demand.

“There’s a growing imbalance in the marketplace between the need for capacity – for quake, for example – and the premium in the market,” Castella says. “Every year, the gap gets bigger, due to regulatory reasons and also due to consolidation, where the combination of substantial primary books leads to an increase in demand for reinsurance catastrophe coverage. At the same time, the reinsurance market is contracting as primary insurers retain more risk on non-cat programs.”

GREENER PASTURES

And so what do Canadian reinsurers do when demand for capacity is increasing

at the very same time the supply is shrinking? “If reinsurers are not able to diversify or get to the business that they need to write on the reinsurance side, you start becoming active on the primary side,” Rueckert observes.

For a reinsurer, that may mean establishing a property and casualty company in the primary insurance market. It could also mean acquiring or establishing a managing general agent (MGA), a type of brokerage that can help place business with the parent company’s insurance and reinsurance operations.

This is in fact part of a global trend, says Bob DeRose, vice president and head of A.M. Best’s reinsurance group. “Over the past five years, no question cedents have been retaining more for their own account, because they themselves have benefited from excess capacity,” he says. “So reinsurers’ opportunities have been declining. They haven’t had much opportunity to expand their writings. No question that they’ve gone to primary businesses.”

Canada has witnessed several examples of this phenomenon over the past five years. The Munich Re Group now backs Temple Insurance Company, a primary insurer that underwrites large industrial and commercial risk management accounts. Westport Insurance Corporation, a primary insurer that underwrites errors and omissions (E&O) business, is a member of the Swiss Re Group. Everest Re Group in 2011 acquired Premiere Underwriting Services, an MGA that specializes in entertainment, sports and leisure risks. Also, some hybrid global re/insurance parent companies have entered the Canadian primary marketplace, including Arch Insurance Canada and Axis Insurance.

Global reinsurers might adopt this strategy in part because of limits placed on their participation in a reinsurance program. A broker, for example, might limit a reinsurer to 25% participation in a primary insurer’s program so that the risk is distributed evenly among the reinsurers. In this way, it is easier to replace

a reinsurer that decides to drop from the program. Also, brokers have more control over the placements and the pricing of the program when a reinsurer doesn’t dominate the program.

But once reinsurers reach the proverbial “glass ceiling” of 25% reinsurance, they might turn to a primary insurance company as a supplement to the reinsurance they receive.

At first glance, this move by reinsurers into the primary insurance market appears to be counter-intuitive. In doing this, reinsurers might be viewed as competing for business with their clients, the primary insurers.

Rueckert says the aim is for the reinsurance-backed primary insurers to find niches in the primary market that are not cannibalizing business from reinsurers’ own clients. “Th
e last thing we want to do is to establish a relationship over decades with client XYZ and then turn around and start an insurance operation and take its business,” Rueckert says. “From what I understand, that is not the intention of the big players. You need another leg to stand on if your main leg, straightforward reinsurance, is starting to get cut over time. Reinsurers are trying to place themselves into niches in which primary insurers might not be interested.”

Thus far, the establishment of reinsurance-backed primary insurers appears to be the strategy of the larger global reinsurers such as Munich Re, Swiss Re and Everest Re. This could be for any number of reasons. Among them, larger reinsurers have the financial wherewithal to cover the costs associated with the strategy. For example, a direct company writing in the automobile space would be subject to the same “take all comers rule” when it comes to writing risks. Also, significant management and compliance costs are associated with establishing and maintaining an insurance operation.

A more cost-effective option may be to acquire or establish an MGA. An MGA is more of a broker operation for arranging a re/insurance placement, as opposed to a directly and wholly owned insurance subsidiary. The MGA might have agreements in place in which primary companies agree to accept certain insurance risks and then cede some portion of the insurance risk to the reinsurer. The reinsurer would have some flexibility in determining how much of that insurance it would accept.

The overall idea is that the MGA will actively solicit business specifically for the reinsurance-backed organizations.

One potential pitfall with MGAs is that they are loosely regulated, thus subjecting them to the scrutiny of insurance regulators. The Canadian Council of Insurance Regulators (CCIR) recently issued a paper with a number of recommendations for MGAs on the life insurance side, and it intends to follow up with a paper in the future regarding MGAs on the property and casualty side. Among its concerns, the CCIR cites contracts with MGAs that are too vague about the role of the MGA; inadequate supervision of MGA representatives; the potential for conflict of interest between the clients’ needs and those of the MGA; and regulatory responsibility for MGAs (“Who’s watching over MGAs?”).

Its recommendations include making life insurers accountable for their MGAs; supervising agents; doing regular market conduct reviews of MGA activities; and establishing a program for providing information about the MGAs to regulators.

It is unknown if an adaptation of these recommendations will be proposed for P&C MGAs and, if they are, what kinds of compliance costs they will entail. In the meantime, Canadian reinsurers expect the practice of getting into the primary market to be an attractive option in the future.

“There are very few ‘pure’ resinsurers in the market anymore,” DeRose says. “If you look at anybody that’s in Bermuda, most have insurance and reinsurance…. I think it’s going to play out through the market cycle. In periods in which reinsurance opportunities are shrinking, reinsurers will attempt to do more primary business. On the other hand, if there’s a major event somewhere in the world, if reinsurance capacity dries up all of a sudden and pricing goes through the roof, I think organizations will re-allocate some of that capacity back to reinsurance where they can make a more profitable return. I think it’s a matter of being nimble. It’s being nimble and allocating capital between primary and reinsurance, and it’s also being nimble in allocating capacity between property and casualty.”