Honey, I Shrunk the Market

Global and domestic natural catastrophes are expected to catch up to the Canadian reinsurance market as of the January 2012 renewal season, when primary insurers may potentially see catastrophe rate increases for the first time in a few years.

The global and Canadian reinsurance markets may see capital shrink somewhat in 2011, hammered by record-setting global catastrophe losses in the first two quarters and at least two or three major claims events in Canada over the past year – including the May 2011 wildfires in Slave Lake, which have cost the country’s insurance industry up to $700 million, according to recent figures.

These events have caused Canadian reinsurers to contemplate rate increases in catastrophe and retrocession lines of cover – ‘retro’ cover is when reinsurers purchase insurance from each other – for the next major renewal in Canada, which is Jan. 1, 2012.

And if reinsurance capital hasn’t shrunk as a result of these disasters, the number of major players in Canada’s primary market certainly has. Most recently, Intact Financial Corporation announced its acquisition of AXA Canada in late May 2011. This follows the acquisition last year of GCAN by RSA Canada. The much-anticipated consolidation of several large primary insurers in Canada has finally taken place. Theoretically, this would mean the number of reinsurance buyers has shrunk. But paradoxically, reinsurers also see consolidation as an opportunity to expand their reinsurance businesses.

Canada’s Reinsurance Market

It should be noted this is not a Chicken Little, ‘the-sky-is-falling’ story. Despite many catastrophes that have taken place in the world and within Canada over the past six months, no one is predicting a sudden, drastic turn towards a hard market in Canadian reinsurance.

Canada’s reinsurance market – which provides insurance to the country’s primary insurance companies – has remained steady and solid since 2006. With a comparatively small reinsurance market, Canada has been blessed recently with the perception of being a good place for global reinsurers to park their capital, knowing that the country is relatively safe from major catastrophic loss exposure (earthquake risk in B.C., Ontario and Quebec notwithstanding).

Canada’s reinsurers have not seen a lot of growth, writing roughly between $1.5 billion and $2.2 billion in premium each year over the past decade. But claims costs have been steady as well. Net claims costs for the 12 full members of the Reinsurance Research Council (RRC) are roughly the same in 2011 Q1 ($149.2 million) as they were in 2010 Q1 ($150.6 million), according to data from Canada’s solvency regulator. Generally speaking, Canada’s reinsurance market has been relatively “soft” over the past three years, meaning primary insurers have received more reinsurance premium rate decreases than increases, largely because capital has been plentiful.

“At face value, our data shows that licensed reinsurers in Canada had about $3.2 billion in capital at the end of 2010,” says Joel Baker, president and CEO of MSA Research Inc. “They wrote $1.3 billion of NPW [net premiums written] on this capital. It is conceivable that they could grow their assumptions by $700 million to $1 billion without requiring much or any additional capital.” However, Baker cautions, “precisely measuring excess capacity in the Canadian market is not possible, as the capital reinsurers place in Canada can grow if opportunities present themselves.”

To put the $3.2-billion number into perspective, Canada’s largest claims event – the 1998 Ice Storm in eastern Ontario and Quebec – cost the insurance industry somewhere in the ballpark of $1.8 billion, based on damage to 660,000 properties. Relative to this record-setting disaster, $3.2 billion in capital seems like plenty.

The Quarters from Hell

In fact, as recently as Jan. 2, 2011, risk management firms and analysts made frequent reference to excess capacity in the global re/insurance marketplace as well. Advisen reported in January the global marketplace could sustain a $74-billion hit before pricing decreases might turn into increases. And reinsurance broker Guy Carpenter said back in November 2011 that it would take $150-billion worth of loss events to turn the global reinsurance market. At the time, these numbers seemed laughably large. It seemed a remote possibility that they might be attained in a year – much less in a financial quarter.

But along came 2011 Q1. It started with a Magnitude-6.3 ‘aftershock’ earthquake that hit Christchurch, New Zealand on Feb. 22, 2011. This quake was less powerful than a Magnitude 7.0 earthquake that hit the same area in September 2010. But it did more insured damage because of the weakened state of some of the buildings following the September event. Catastrophe modeling firms estimated damages from the September 2010 earthquake might result in insured losses of up to $4.5 billion. For the February 2011 quake, the same modelers predicted a further $8 billion in insured damages.

About two months later, a Magnitude-9.1 earthquake hit Honshu, Japan. The earthquake triggered a 37-metre-high tsunami that swept through Sendai and other Pacific coastline areas, killing tens of thousands of people. Catastrophe modelers EQECAT, RMS and AIR Worldwide all showed initial insured damage estimates in the range of between $22 billion and $39 billion arising out of the Japan quake and tsunami.

The second quarter of 2011 started much like the first. Suddenly, the winds started to blow in the United States. In late May, extremely powerful thunderstorms and tornadoes ripped through several areas in the southern United States. Catastrophe modelers counted the damage as a result of these May storms to be between $2 billion and $7 billion. Overall, Aon Benfield reports, these and other severe weather losses in the United States over the past two months have totaled $15 billion.

And the ground in Christchurch shifted once again in June. This time, cat modeler EQECAT said the damage would be between $3 billion and $5 billion. Some reinsurers dispute this claim, it should be noted, because of the difficulty in sorting out what counts as damage done in June and what was done in previous earthquakes. Nevertheless, EQECAT stands by its numbers.

Tallying the estimated insured damage caused just by these global events alone (there have been others), the total is somewhere in the range of $48 billion to $67 billion. And that’s before the start of the 2011 hurricane season. Suddenly, the $74-billion to $150-billion figures seem to be well within reach.

Impact on Canada

The key question is: with global reinsurers having to pay off all of these big global catastrophe losses, will Canadian reinsurers be raising their rates in order to adjust?

The short answer is, theoretically, yes. “Buying cat cover is a global business and it’s going to be affected on a global scale,” says Henry Klecan Jr., managing director of SCOR’s operations in the Americas. “If you address cat cover on a local basis, you’re never going to get those cats paid off in a million years. Forget about it. So it’s going to be represented across the board on a global basis. In some areas, it may be more. In some areas, it may be less. But to say it won’t have an effect [in Canada] would be a simplification. I would expect some sort of repercussion.”

Andrew Aldwinckle, senior underwriter of casualty reinsurance at Ark Syndicate Management Limited, a Lloyd’s syndicate based in London, elaborates. “Reinsurer risk appetites are being re-assessed,” he notes. “Many parts of the world  – Canada, New Zealand, Australia and to a lesser extent Japan – are all seen as diversifying exposures to the peak zones within the United States. As such, alongside the mantra of the losses of the few are paid fo
r by the premiums of the many, Canadian portfolios will be helping to cover the cost.”  

But buyers might not be noticing it right away. “What we’ve seen to date is that the Canadian market is still insulated in the context of these global events,” says Sharon Ludlow, president and CEO of Swiss Re in Canada. “What I mean by that is, there is no direct correlation between a catastrophe in another jurisdiction and Canadian pricing.”

Reinsurance purchasers have noticed reinsurers are inquiring more pointedly about their clients’ global exposures. And quoted (as opposed to bound) reinsurance rates are less frequently decreases. Still, the impact of global catastrophes hasn’t filtered down into the Canadian reinsurance market in the form of dramatically increased pricing.  

“Because of the recent catastrophes, we don’t see as many reductions,” said Charles Paré, chief underwriting officer of Zurich Canada. “But it’s not like we are seeing double-digit increases either. A lot of reinsurers are still quantifying their losses, particularly on the global side. We’ve seen some impact in terms of reinsurers asking more questions and not quoting rate reductions anymore, but it’s not a drastic shift.”

This tepid market response is partly explained by the fact that Canadian reinsurance doesn’t renew in mid-season.

“There’s very little reinsurance renewal activity between now and January 1st., so I don’t think we’ve seen the impact in any significant way,” says Lambert Morvan, senior vice president and chief agent in Canada for Odyssey Reinsurance Company. “But there are a lot of discussions on how the market is going to react. I think there is going to be some reaction, but the magnitude of it will be dependent on whether there is any significant U.S. hurricane activity in the third quarter. If it’s quiet there, maybe it will be a bit calmer and we will see less of an impact in Canada.”

In the Bermuda reinsurance market, during mid-season renewals, reinsurance catastrophe and property cover increased by as much as 10% to 15%.

In Canada, insurance companies can likely expect to see modest premium increases on catastrophe lines of business during the January 2012 renewals, according to most Canadian reinsurer executives contacted for this story. “My own thought is, those treaties that have been hit with losses will definitely get a price increase,” says André Fredette, senior vice president at Caisse Centrale de Réassurance (CCR). “Other ones, probably zero to 5%.”

Reinsurers say they expect retrocessional cover will increase by approximately 5% in Canada. “There’s no question that retrocessional pricing is being impacted because of global events,” says Ludlow. “But that doesn’t necessarily mean all of the trickle-down pricing is changing at the same time…. In the best of all worlds, you would have the immediate correlation in pricing at the primary, reinsurer and retrocessional levels.”

But capacity remains abundant in the Canadian market, many observe. Pricing in Canadian commercial lines remain soft at the primary level, and primary companies are still retaining a lot of their own exposure, electing to keep operating costs down by purchasing less reinsurance. Some analysts say such capital abundance means the need to raise rates is debatable.

Fredette doesn’t subscribe to that way of thinking. “I’m saying, ‘Yeah, but the reinsurers don’t want to wait until they’ve used up everything in the kitty,'” he says. “They’re going to start to react before that. You’re not going to wait until the bank is dry before you start doing something. So I think there will be a tendency towards cat rates going up. And remember, we haven’t even had the hurricane season yet.”

Canadian Catastrophes

Canada has also seen its fair share of catastrophes thus far. “Aside from some fairly significant man-made losses, some of what we refer to as climatic losses have not gone unnoticed,” Klecan says. “Slave Lake [in Alberta] was quite a substantial fire. It will leave a fairly good dent in the market. Floods have been a real problem in this particular year, in various places in Quebec and Central Canada.”

Slave Lake Wildfires

Dry conditions and very high winds contributed to wildfires converging together outside of Slave Lake, Alberta in May 2011. The winds caused the fire to jump a fireguard and descend upon the town of 7,000 residents in just two hours. Insurers arrived quickly on the scene, and damages are still being estimated. Data from PCS-Canada, a catastrophe information service, suggests damage due to the wildfires in the Slave Lake area might be as high as $700 million.

Overall, will Slave Lake have an impact on reinsurance pricing in Canada? Yes, but perhaps on a qualified basis.

“I think with Slave Lake, some of the impact will be regional,” says Caroline Kane, senior vice president and chief agent at Toa Reinsurance Company of America. “So you may have some smaller regional companies whose cat programs have been hit, where they are also buying reinstatement covers. I think the pricing will go up on some of those programs. It’s more experience-driven, though, as opposed to exposure-driven.”

Slave Lake may in fact re-kindle a debate about guaranteed replacement costs. A similar discussion began when several hundred homes burned down in Kelowna, B.C. in 2003. “We do this crazy thing in Canada, we give out guaranteed replacement costs without a cap on it,” says Fredette. “I know in California, at State Farm, they cap it at 25%. And so, if you had $400,000 on your house, [State Farm would] give you another 25% or $100,000 more. You’d get $500,000 back to rebuild your house.

“It puts some onus back on the client and on the broker to make sure those values are kept up to date and they are sufficient. When you have a catastrophe like Slave Lake, where you now have to import contractors and house them, if there’s no cap, [then] we’ve given a blank cheque out there to rebuild no matter what the cost. Remember how in Kelowna those $500,000 homes cost about $800,000 to rebuild? I imagine you will see the same numbers [in Slave Lake].”

Slave Lake may also have reinsurers paying more attention to the economic ‘boom towns’ that are developing alongside Canada’s economic hot spots. “Slave Lake as a town had a lot of recent development, mainly as a result of the oil sands,” says Morvan. “We have to think about that, too. Are there other towns in the country that have seen a lot of housing and business development in what are called unprotected fire areas? Maybe we need to pay a bit more attention to that.”

Severe Weather Events

Last year at this time, Calgary endured a major hailstorm that caused record-setting insured damages of $500 million. This year, water damage remains at the forefront of concern for Canadian reinsurers. For example, a record-setting rainfall struck parts of Ontario and Quebec on March 5 to 7, causing about $50 million in damage. This damage was spread about equally between the two provinces, according to PCS-Canada data, as reported by the Insurance Bureau of Canada.

Man-Made Catastrophes

And it’s not just natural disasters at work, according to reinsurance industry executives. Canadian Natural Resources Ltd. reported an oil refinery fire at its Horizon oilsands site in January 2011. The fire injured five workers and halted production, which averaged 83,700 barrels a day. The company issued a press release in February 2011 saying the damage to repair the equipment itself was not anticipated to cost more than $250 million. But this doesn’t include potential business interruption losses. “Canadian Natural maintains a US$2-billion umbrella insurance package for the Horizon facility, which should cover a substantial portion of the cost to repair damaged parts and equipment and which provides business inte
rruption insurance to effectively cover ongoing operating costs incurred on the site after 90 days,” the company reported in January.  

One reinsurance agent in Canada said the oil refinery fire prompted some queries from Canada’s solvency regulator, the Office of the Superintendent of Financial Institutions (OSFI), about reinsurers’ capital positions. Such an interest after a specific event is “unusual,” the source said, and reflects OSFI’s general focus on the overall state of Canada’s reinsurance marketplace.

Certainly paying for all of these claims events comes at a time when reinsurers are still suffering from the ill economic effects of the global recession in 2008-09. “I think the losses are compounded by the redeemed investment returns,” says Steve Smith, president and CEO of Farm Mutual Reinsurance Plan Inc. “I think the reinsurers are really going to be struggling to make sure they get any sense of return at all. So they are going to have to get the rates up to offset the compounded effect of losses and loss of investment return. I think we’re certainly going to see a flattening [of rates]. You’re not going to see any potential decreases at all. I think there’s going to be marginal increases.”

Honey, I Shrunk the Market

On top of all this, market consolidation has finally become a reality for Canadian reinsurers. Canada’s biggest players started to make major acquisitions in 2010-11, strengthening their share in the marketplace. RSA Canada bought GCAN Insurance Company and its parent, Glenstone Capital Incorporated, from the Ontario Teachers’ Pension Plan Board in October 2010 for approximately $420 million. The deal moved RSA up to the fourth-largest general insurer in Canada, and was projected to increase RSA Canada’s premium base from $1.9 billion (based on 2009 figures) up to $2.2 billion.

Intact Financial Corporation followed suit in May 2011, announcing it was buying AXA Canada for $2.6 billion. That deal solidifies Intact’s Number 1  position in the Canadian market, giving Canada’s largest insurer a 16.5% market share.

How does market consolidation affect reinsurers generally?

Most say consolidation can be viewed as a glass that is both half-empty and half-full. “Intact’s acquisition of AXA creates challenges and opportunities for the local reinsurance market,” Baker says. “As Intact grows, it will be able to retain more risk and cede less to the reinsurance market. However, AXA Canada tended to use global facilities for much of its reinsurance needs. With the acquisition, much more of the business will be ceded in the local market. In addition, Intact might decide to buy additional covers due to elevated concentration risk in some regions as a result of the purchase.”

Canada’s reinsurers each note the paradoxical effects of consolidation.

Frank Rueckert, senior vice president of the Canadian treaty department of Hannover Re, describes the glass-is-half-empty concept without necessarily subscribing to it. He noted merged companies typically have bigger balance sheets as the result of a merger and therefore will be able to retain more risk exposure. As a result, they will less likely call upon reinsurers for lower layers of excess-of-loss insurance. (When primary insurers buy excess-of-loss insurance coverage, reinsurers start to pay claims when the primary company’s insured losses reach a certain level “or layer.”) By definition, lower layers of reinsurance cover claims events that aren’t as large, unpredictable or volatile as risks covered by the upper layers. For Rueckert and others, a long-term concern about consolidation would be as follows: if Canada’s consolidated primary insurance companies get bigger and retain more exposure, would global reinsurers be squeezed into the higher, more volatile layers of excess-of-loss cover, thus dampening their interest in the Canadian market?

But consolidation might also suggest a glass half-full. “At the end of the day, both insurance and reinsurance markets need fewer participants in order to reduce capacity and therefore see the pricing discipline returning,” says Ardwinckle.

Also, such deals create new opportunities for reinsurers.

“I would say that Intact and AXA are very, very adept at their risk management, and so they are going to be looking at their concentration when they put their two books together on a combined basis,” says Ludlow. “They’ll do their own assessment as to whether they have the right reinsurance coverage once they have that consolidated view. And that often will lead to a different solution than what they have today. Does that mean that there is opportunity? Absolutely. Are pieces of it likely to shrink? I think the answer is yes. But are there opportunities there as well? I think the answer is yes there, too.”

Specifically, Klecan notes Intact’s purchase of AXA “may be a little more interesting, because AXA wasn’t a buyer [of reinsurance] in the Canadian market. Most of it was placed by their parent [located it France]. So this may provide an opportunity for the Canadian market to step up, when Intact absorbs everything.”

Also, by getting bigger, Intact now has more risk exposure spread across the country – and thus more reinusrance might be an option. “Typically you would see a high risk retention or cat retention with a lot of mergers,” says Smith. “But I think in this particular case, what you are seeing is higher collective cat exposure – especially with the West Coast and Quebec business [that Intact has assumed]. Both of those are subject to earthquake exposure.”

More generally, Ludlow sees opportunity in using reinsurance to unlock capital for a company to explore a future acquisition. “There is always the opportunity for an acquiring company to look to a reinsurer to support M&A as well,” she says. “For [primary] companies that perhaps don’t have as easy access to capital in the market, I can see that M&A or consolidation can provide opportunities for reinsurers to support the transaction as well as the ongoing protection.”