December 1, 2003 by Vikki Spencer
From the investors’ perspective, the insurance industry is not looking like a “good buy” right now – neither in the primary nor reinsurance sectors. Despite the unprecedented rate increases and strict policy terms experienced by insurance buyers over the past two years, the industry’s health is still very much in question to those who might bolster its anemic capital, as well as regulators and rating agencies.
Speakers at the recent North American Insurance Conference in St. Pete’s Beach, Florida, say these tumultuous times have insurers questioning their own futures, asking what lines of business they want to be in and where is the appetite, if any, for merger and acquisitions. The biggest question of all is whether price competition will return to the marketplace.
Much has been written of the industry’s poor financial picture, which, although rosier than 2001/2002, remains dismal when compared to the returns posted by other industries. This picture suggests the natural response is a continuation of the strict underwriting that has characterized the past two years.
Certainly, companies have taken a stauncher approach to technical underwriting. “There’s been movement away from the ‘gentlemen’s agreement’ that we were all used to”, says Kathy Pryden, executive vice president with RBC Insurance. The industry’s focus is on underwriting and a higher degree of contract review.
This return to technical underwriting was precipitated by the investment market drought that forced insurers to turn a profit from their core business, rather than relying on investment returns. Investment returns remain “fairly flat” for the first half of 2003, although the stock market is unlikely to nosedive further, says Sean Mooney, chief economist for Guy Carpenter & Co. Inc. Premiums have risen again for 2003, although not to the degree seen a year earlier, and the industry’s combined ratio continues to decline. However, the returns needed to entice investors are just not there.
And, the industry remains plagued with issues, particularly for those companies facing legacy challenges, which are also turning investors away. Particularly troubling are reserving questions which have brought a negative spotlight on the industry and tainted its perception with regulators and rating agencies. In an attempt to restore investor confidence, Mooney predicts over the next five years companies will pursue increased segmentation. This may mean focusing on primary insurance and dropping a reinsurance operation, or sticking to specific lines of business. “Investors like to see a simple story.”
For this reason, Mooney expects “the next cycle will be line specific”. And one line insurers may pull back from is the troubled auto insurance segment. Of concern is the growth of residual markets and the introduction of “creative litigation”, such as the McNaughton vs. Co-operators class action suit to recover deductibles on total loss vehicle claims.
Despite these challenges, signs of increased competition are creeping back into the marketplace, although this is not unprecedented, Mooney notes. “The [hard market] cycle in the mid-1980s peaked in 1985, and one year later we were seeing price declines.” Companies need to start preparing for the soft market, he adds. “Set a bottom price for your product and be prepared to lose marketshare.”
Pryden agrees that insurers will have a difficult time sticking to strict underwriting and to the focused approach that has seen companies exit many lines of business. “The market analysts still look for top-line growth. It’s a difficult thing to do [strict underwriting, sticking to specific lines of business. There will be a need for companies [who are] trying to stick to their knitting to diversify.” She predicts companies will not be able to resist market softening and the desire to broaden their offerings.
Mooney notes that in the reinsurance market, rates are already backing off in lines such as property, with casualty/liability not expected to peak until 2004 due to concerns over exposures such as directors’ and officers’ coverage (D&O). “There is ample capacity for adequately priced business,” however, this could be thwarted by a mega-catastrophe or deflation in major economies (e.g. Japan, Germany), he adds. Other factors that could influence the next market turn are ratings downgrades and possible insolvencies, he says.
Rating agencies are coming under some fire for the spate of industry downgrades, Mooney says, and there is some question of whether these downgrades will become a self-fulfilling prophecy. As well, there is the question of whether high credit quality companies will accept being anything less than the sole or lead underwriter on business where lower-rated reinsurers are involved.
“How important are ratings? Because of the scrutiny companies are under, ratings are going to continue to play a part, particularly in terms of credit,” says Pryden. “Triple-A [rated companies] will be able to take the cream of the business.” The “A” rating, she says, has become a “magic line in the sand”, with companies reticent to do business with anyone below that mark.While the rating agencies have take a dim view of the insurance sector overall, their scrutiny has been especially harsh for those companies who announce mergers or acquisitions. Many merging companies have faced downgrades or a negative outlook from raters, admits Henry Witmer, senior financial analyst with A.M. Best Co. Raters have taken such issues as the late recognition or inadequate loss reserves to heart, and weakened insurer balance-sheets have reduced the number of potential acquirers. For this reason, the prospects for m&a activity are slow for the near term, he predicts, and will only return when the stock market rebounds and the industry’s financial health is strengthened.
In the current market, companies have to be careful about who they merge with or acquire, Pryden comments. “Companies need to ask themselves ‘does the company [being acquired] stand alone on its own merits’.”
One area the industry may see consolidation in the future is in Ontario auto, predicts Bryan Davies, Superintendent of the Financial Services Commission of Ontario (FSCO). There is no question the marketplace is troubled, and many companies are questioning their willingness to remain there, he observes.
Global players are making choices on scarce capital, says Davies. “That’s something we as regulators have to be aware of. We’ve had a significant number of policy interventions since the 1980s…very few people fully understand the product [Ontario auto].” Changes made by the previous Progressive Conservative (PC) government were an attempt to address skyrocketing healthcare costs associated with auto insurance and stem the abuse of the system by representatives of injured parties who “greenmailed” insurers into cash settlements with the threat of costly arbitration and mediation.
Statutory accident benefits (SABS) account for 40%, and bodily injury (BI) more than 30% of insurer costs – and both are growing at rapid pace (15% growth in SABS costs and double-digit growth in BI), despite a reduction in accident frequency, says Davies. “The only thing reasonably contained is property costs.”
“We’ve made foreign-owned and even domestic insurers skittish of the marketplace” with these kinds of cost increases, and the situation is bolstered by Atlantic Canadian auto complications, Davies notes. On the other side are “shocked and angered” consumers facing year-over-year rate increases.
Insurers are not blameless, either. “Not a lot of attention was being paid to underwriting when investment returns were coming in as they were a few years ago and insurers were chasing marketshare,” Davies comments. While changes by the former Ontario PC government were supposed to lead to a 10%-15% rate decrease, Davies admits insurers may see this as a stretch. The 1% reduction in premium taxes for a total $90 million savings was not yet in place, and the government also expected to see a $100 millio
n reduction in insurers’ administrative costs. “I don’t know how many companies had a plan to come up with their portion of that $100 million,” Davies says. But “hard” changes such as the reduction in healthcare fees and banning “greenmail” settlements for the first year after a claim were accomplished.
Now, insurers and regulators are waiting to see what the new Liberal provincial government will do. “The new incoming administration has a lot on its plate other than auto insurance,” Davies acknowledges, including a $5.6 billion overall deficit. While the Liberals promised and subsequently implemented an auto insurance rate freeze, the industry is unsure of how long it will ultimately last and if this will be followed by a set of cost-cutting initiatives. Plus, Davies wonders what will be done with the former PC government’s product reforms. “To the extent those are diluted, it becomes that much more difficult to find a 10% cost reduction.”
He also predicts the Liberals’ “optional coverage” campaign plan will be hard to implement, and may expose the cross-subsidization that exists in the system today.
Nonetheless, Davies tells insurers not to “act precipitously” because thus far the new government has been “very business-like”, and adds that he feels confident the premier and the finance minister understand that coverage availability is an issue and want to have an industry where companies can thrive.