Insurer Strategies for 2001: balancing the BooksT

Following a grueling year of devastating performance across the various areas of business – weak rates, rising claim costs, higher expense ratios and volatile investment returns – Canada’s property and casualty insurers may have perhaps turned the corner for the better based on industry results for the first half of the 2000 financial year. Specifically, the turnaround in the industry’s figures for the first six months of this year has been driven by real growth in net written premiums – indicating that the long-awaited, but until now elusive upturn in the insurance price cycle may be taking hold. However, in looking ahead, company CEOs concur that 2001 will not be a year of “easy sailing” as they navigate their business strategies around the hidden reefs of investment market uncertainty and the stubbornly persistent rise in claim and expense costs. CU surveys senior insurer management to identify the likely business approaches to be taken in 2001.

The Canadian property and casualty insurance industry notched up a 7.6% return on equity for the first six months of this year – a significant rise on the 6.5% achieved for 1999, according to preliminary figures released by the Insurance Bureau of Canada (IBC). The first half of this year also saw net written premiums rise by 5.5%, producing the first signs of real growth in pricing for a long time.

In fact, according to projections by Ted Belton, author of the Belton Report, the rise in Ontario auto premiums for this year could be as high as 10%. The bad news, Belton comments, is that the market’s claim costs will most likely be up by 18%.

The improvement in the results of insurers for this year has been entirely due to strong investment performance, the IBC’s chief economist Paul Kovacs notes. So much so, that the contribution of realized gains to the income statements of insurers for the first half of this year amounted to more than that made for the whole of 1999. However, should investment gains remain robust into next year, and the rise in premiums continue, next year could well prove to be every insurance company CEO’s dream.

However, closer analysis of the numbers suggests at caution. As Kovacs observes, the underwriting loss of $554 million recorded for the first half of this year is more than 37% higher than the loss reported at the end of June 1999. This translates into claims growth for the first half of this year of 4.45% which significantly outpaces the 2.9% increase in net earned premiums recorded for the same period. Although the growth in net written premiums is so far almost double that of earned premiums, the benefit of this will only be felt next year due to the time lag of the business (ranging from 12 months on personal lines to 18 months on commercial).

And, while insurers earned a healthy $479 million in investment gains so far this year, there remains a great deal of skepticism over the longer-term buoyancy of the investment markets. “The [industry’s] increase in [net] earnings [for the first six months of 2000] is almost entirely attributable to recovering investment gains,” Kovacs notes. The significant jump in this year’s realized gains is mostly due to an earlier in the year surge in Canadian blue chip stocks which, as insurers tend to maintain set portfolio weightings of their various investment holdings, led to a liquidation of some of these equity assets. Whether the investment environment remains bullish into next year will have a defined influence on the financial performance of insurers, Kovacs believes.

However, as Kovacs sees the business landscape unfolding, the actions taken by insurers will have to be on several fronts. “The financial 2000 year won’t show growth. Everyone has been wondering when we’ll turn the corner, and next year might be it. I think we will see some signs of recovery next year, but this will depend on companies taking decisive action. Essentially, I think insurers will be taking a number of smaller actions rather than one large thrust – this will mean tightening up on claim costs and looking at reducing fraud-related costs. But, there’s no question that the really big issues of next year will be rates and reducing the expense ratio.”

Belton is also glum of the yearend performance of the industry for this year and into 2001. “It appears highly probable that 2000 will repeat the unsatisfactory return on equity that 1999 produced. Given the time lag between written premium increases and the impact on earned, there is not much likelihood of a pronounced improvement in 2001…auto insurance is where the big correction is needed.”

Furthermore, Belton remains dubious of the potential corrective actions insurers will be able to take in order to boost their returns on equity with the ongoing excessive level of capital floating in the industry. “The equity of primary insurers now totals $17 billion which, at a conservative premium-to-equity ratio of 2.5:1, produces capacity of $42.5 billion. Actual net written premium at June 30, 2000 was $18 billion which generates a capacity utilization rate of 42%…The surfeit of capital is a factor driving the hyper-competitive marketplace.” However, Belton expects 2001 will be the year when major shareholders of insurance companies will react and demand action from management. “I think the message will be, ‘we’ll rather lose the business than the earnings’.” Overall, Belton expects to see some minor underwriting improvements in next year’s numbers, but this is unlikely to produce a satisfactory gain in net earnings.

CEOs less-than-optimistic

In terms of the broader earnings picture, “I really think that we’re looking at a three year horizon before we see real improvement,” comments Judy Maddocks, CEO of Kemper Canada. She expects the industry’s return on equity for this year and 2001 will be around 7% to 7.5%, largely due to a more aggressive investment management approach by the larger companies. As such, she sees the investment side of the business playing a significant role in supporting insurer earnings in the short-term.

However, Maddocks is not overly optimistic on the investment outlook for next year. “We can’t rely on investment income to ‘pull the profit rabbit out of the hat’, so we’re going to have to get back to the fundamentals of the business.” In that respect, she is also wary of predicting a turnaround in underwriting for next year. “I think it’s still premature to assume that the pricing cycle has bottomed out…We still have the problem of too much capital [in the industry] and no way to effectively use it to write profitable business.”

Barry Gilway, president of Zurich Canada, also expects the industry’s return on equity for this and next year will be in the 7%-8% range. While investment performance will play an important role in bolstering earnings, investment returns for next year will probably not match the sterling performance achieved for 2000. The immediate action will be on rates, he predicts, but the lag between written and earned premium flow through will not provide much relief for the 2001 financial year.

The best way to describe the likely action of insurers next year is “battening down the hatches,” says CGU Group Canada president Mark Webb. “I think this year’s underwriting figures will show that we have been in a soft market for one year too long.”

Webb points to the exceptionally high underwriting loss ratios emerging from the Quebec market and Ontario’s auto. And, while insurers were able to support their earnings with realized investment gains for this year, this is not likely to be a “white knight” in the picture for 2001. Earnings growth next year will depend on actions taken this year on rates, which may feed through to the 2001 bottom-line, he surmises. He also predicts a return on equity for 2001 of between 8%-10%, with the lower figure the most likely outcome.

Larry Simmons, chief operating officer of Royal & SunAlliance Canada, takes a dour view of the “first half recovery” of this year, pointing out that the second and third quarters are significant seasonal business periods for the industry. In that r
espect, he notes that market indications for industry returns on the various areas of the business for the third quarter of this year are less than bright. “I don’t think that we can take it [the performance of the first half of 2000] as a guarantee that the p&c industry has moved into a growth phase of the business cycle.” As such, he also sees this and next year’s profitability being on a similar par.

“The uncertainty of the last quarter – which accounts for a significant portion of the annual business – does cast a shadow on whether or not the industry has reached a turning point in the price cycle,” says Janice Tomlinson, president of Chubb Insurance Co. of Canada. She concurs that net earned premium growth for next year is unlikely to breach a 10% gain, with added expense pressures likely to limit the growth in overall earnings. “This is a very good economy and this should feed back in premiums, particularly on the commercial side, but there is not a great sense of optimism that growth will be strong next year.”

Investment blues

Although the investment account will still play a crucial role in the unraveling of the industry’s fortunes, this side of the business cannot be relied upon for earnings growth next year, predicts Simmons. The second half of 2000 will likely show reduced realized gains, with the last six month period producing an overall lower rate of return, he says. “I don’t think we can rely on the investment side for profitability, we need to focus on the underwriting.”

This sentiment is supported by Gilway, adding “no, I don’t think that next year’s investment gains will reach the 2000 level. Although there is no reason to believe that investment returns won’t be ‘reasonable’ next year, they are likely to be around half of what we made in 2000.” A factor which could drive investment performance next year is the ongoing low return on equity rates of insurers, he notes. “When the return on equity is in the lower digits, insurers tend to be more aggressive in their investment strategies which could add a few extra points. However, I don’t think investment income will be a major factor in insurers’ strategies next year.”

Gregg Hanson, president of Wawanesa Mutual Insurance Co., observes “realized gains have been a big factor this year [2000]. In fact, our realized gains are up over 60% on last year, and are well ahead of the average of the last five years. However, next year I would expect realized gains to settle back down to a more normal level.”

In addition, Kevin McNeil, president of Gore Mutual Insurance Co., expects a more volatile investment environment for both the capital and equity markets in 2001. “We’ve had a good few years on the investment side, but next year I think it’s going to be a lot tougher. Our main area of focus will be on underwriting.”

Underwriting and claim costs

“The underwriting ratio for this year will be worse than 1999, and unless insurers want 2002 to be also screwed up, then they had better take action now,” comments George Cooke, president of The Dominion of Canada General Insurance Co. In addition to the substantial under-pricing of the Ontario auto product (believed to be about 15% below cost), underwriting losses on commercial books and increased storm activity this year will not make 2001 a good year. “There have been a lot of storm losses in 2000, and overall, next year looks like it’s going to be really crummy.”

Cooke points out that most major insurers have exposure to the Ontario auto market – which has caused the most bleeding on the personal lines book. Some insurers will be implementing price increases of 6% this fall, he notes, with further rate rises expected throughout 2001. “The IBC has sent off a report to the provincial government looking for legislative reform to the auto product. I’m optimistic that the government will be sympathetic to the situation. The [pricing] holiday is over.”

McNeil also believes Ontario auto will attract the most attention from insurers in terms of rate corrections. “Most companies will try to improve on auto as a priority.” However, with competition in Canada’s biggest insurance line remaining highly intense, the extent of a correction could be limited, he notes.

Maddocks also cautions against any dramatic rate adjustment in Ontario auto. “There’s a possibility that the regulator might intervene if they perceive any movement to be out of line. However, since the introduction of Bill 59, auto rates have plummeted to what many believe to be an inadequacy of 15%. Although insurers will not be able to bring this fully back, I think there will be several smaller increases filed during the course of 2001. We need to approach the market with a coherent, strategic approach.”

Simmons points out, “personal auto remains a sensitive area – we will be watching developments carefully. Given the market’s experience, I think it’s realistic to expect a broad upward price movement next year. A significant factor here is the medical cost component of auto related claims, and this is something the industry will have to move on.”

There are already signs of a market hardening on the commercial side of the business, comments Gilway. Some coverages have been raised by 20% to 30% this year, and next year will likely see pricing in the mid-market arena rising on average by 10%, he adds. As such, not all the news on the underwriting end is bad, however, the impact of stronger commercial market pricing will only feed through in the 2002 financial year.

Technology and expenses

Hanson sees next year as being the kick-start to a technology race between insurers. “I view it as a race for technology which is tied directly into streamlining distribution channels. Companies and brokers are clarifying and focussing their Internet strategies.” As a result, he expects this drive will continue to exert pressure on the expense ratio. “After Y2K passed, there was a lot of pent-up demand for systems projects to proceed. I believe most companies have now committed significant expenditure to technology.”

Webb concurs with this view, pointing out that some of the technology advancements already made by some of the larger insurers may feed through in cost-efficiencies next year. However, any relief on the expense margin will likely be offset by further infrastructural project investment, with Internet initiatives likely to be the central focus next year.

Tomlinson says insurers will have to play a delicate balancing act next year between maintaining an acceptable expense ratio whilst at the same time staying abreast with competitive advancements on the technology end. However, she observes, “we will be spending more on technology in 2001 than what we did this year. Quite simply, the old ‘stand alone’ systems of the past don’t work in today’s marketplace.”

Cooke also sees the Internet and the race to develop e-commerce type solutions and products as a significant factor influencing expenses next year. “I don’t think we will find any relief on the expense side next year. And, it’s going to take some time before the efficiencies achieved through technology investment finally feed through to the bottom-line.”