May 1, 2004 by Brian Gray
How bad can a 5% rate reduction really be? The first issue is leverage. Imagine a mythical commercial lines insurer operating with a 10% margin. For every $100 in premium, the combination of underwriting and investment income, net of operating expenses, is enough to generate $10 in earnings before tax.
We are not trying to evaluate whether this is a good or a bad return, but to use a relatively plausible scenario. At the end of 2002, underwriting leverage (earned premiums to equity) for the Canadian primary property and casualty industry was a little under 140%. So a 10% pre-tax return on premium equates to a little under a 14% pre-tax return on equity (ROE). If income taxes are 34%, this generates an after-tax ROE of a little over 9% – clearly better than actual 2002, and in the same range as actual 2003 results.
Now suppose our distribution network is able to convince us that market pressures are such that we need to reduce prices by 5%, so that we do not risk losing the business. What happens? Roughly, we cut our earnings in half. Five points out of our 10-point pre-tax margin have disappeared – not 5%, but half.
This is, of course, an over-simplification. First, some costs (notably commissions and premium taxes) also fall as premiums reduce, so the full impact does not flow through to the bottom line. Conversely, the lower premium means a smaller investment base, so the investment margin is cut, amplifying the problem. Finally, income taxes absorb roughly one-third of profit, so only two-thirds of the reduced return is absorbed by shareholders. There are some additional feedback items not discussed here, as their impact is small.
Adjusting for all of the impacts, we estimate that the sensitivity of ROE to rate change for the Canadian p&c industry at the end of 2002, was about 72%. In other words, our hypothetical 5% rate reduction would have cut the industry’s after-tax ROE by about 3.6 percentage points. The figure was slightly lower for reinsurers (who had a higher percentage of costs linked to premium), and slightly higher for primary carriers. For 2003 and 2004, with risk-free lower investment yields and a higher dependency on underwriting returns, we believe the sensitivity is slightly higher.
I am not sure how easy is it for most managers to explain to their shareholders that they have decided to reduce their ROE by 3 or 4 points. Which takes us to the second issue – historic context.
For years, many investors seemed to accept the variability inherent in Canadian p&c market cycles because, over a reasonable period of 10 years or so, the total return was somewhat acceptable. Not spectacular, but acceptable. It was worth staying in for the slightly softer times, because overall, the result was okay.
However the world continues to evolve. The stresses of the last three years (well-documented by many) have decimated numerous players and soured the investors’ enthusiasm. It seems unlikely that a quick hard market with one or two good years will suffice to satisfy capital providers this time.
Perhaps of significance is that, much more than in the past, the investors no longer need to be satisfied. Today the transparency of results is much better than a decade ago. If results look like they will be weaker in a region or a line of business for a two- or three-year period, it is much easier than in the past to re-direct the capital elsewhere. Capital mobility is increasing. A large part of the market is now provided by global providers who, increasingly, know when a soft spot emerges, and can adjust. Managers are much better at measuring the profitability of the business we are writing today (via good underwriting year data that reflects current prices), rather than waiting one to two years until the GAAP earnings emerge. Actuaries continue to improve their estimates further, with greater recognition of current price levels, allowing for cycle-dampening earlier identification of ultimate results.
This increased market efficiency is a gradual process, of course. The good news for agile, well-run companies is that there are still likely to be cycles, even if their amplitude gradually shrinks. These ongoing market inefficiencies will continue to provide ample opportunity for differentiation between those who think 5% makes a difference – and those who don’t.