Precarious Optimism…

With a return on equity (ROE) of just over 18%, negative claims cost growth, nearly an eight percentage point reduction in the combined ratio to 90.7%, and a healthy boost to companies’ surplus coffers, the Canadian property and casualty insurance industry has many reasons to be pleased with its 2004 performance. In fact, based on direct written premiums, the industry expanded from writing about $23 billion in business for 2001 to last year’s phenomenal $56 billion in business (based on company data collected by the Office of the Superintendent of Financial Institutions).

Why then is there lingering concern on the part of the rating agencies regarding the future prospects and stability of the industry? A recently issued A.M. Best report titled “Sustainable Improvement is Key to Upgrades” regarding the North American insurance industry indicates that the rater does not plan on rushing ahead with company upgrades based on 2004’s financial returns. “It would not benefit the companies or the users of ratings to upgrade a company based on the most recent three years of performance, only to follow shortly after with a downgrade due to the lack of sustainability of the improved performance as the market deteriorates,” the report observes. The rating agency says it is skeptical of the industry’s performance beyond 2005 as insurers become increasingly challenged by price deterioration. And, the report points out, the industry is still facing an overall reserve deficiency estimated at about US$59 billion. A Standard & Poor’s report notes that the industry’s surplus growth began tapering off last year to 15% from 2003’s 20%-plus growth rate. While weaker investment performance plays a factor, the rater says the decline in surplus growth is also due to reduced parent company contributions and higher shareholder dividend payments.

Even the Insurance Bureau of Canada’s (IBC) chief economist Jane Voll – who recently presented an overview of the industry’s financial results at Swiss Reinsurance Co. Canada’s annual “Statistical Breakfast” (see MarketWatch of this issue for further details) – holds a wary view of the industry’s future performance. Despite the fact that Canadian insurers’ financial return for 2004 was on par with other financial institution players, she expects the current year will witness significantly reduced premium growth, deterioration of the combined ratio, and an overall decline in ROE.

The precarious nature of the industry’s earnings performance is clearly illustrated by its past. Voll notes that, over the past 27 years, the industry has experienced four national earnings cycles lasting an average of seven years. The most recent “down cycle” began in 1997, she adds, resulting in six years of declining earnings. This was followed by two years of the ‘hard market” which brought about abrupt recovery (market indicators suggest that the hard market peaked last year and is now into the next downward cycle curve). Clearly, the cyclical nature of the p&c insurance industry cannot be denied, nor its erratic performance. As Voll observes, cyclical trends are not uncommon in most business sectors – from mining and construction through to insurance. So, it is not surprising that insurer talk of “breaking from the cycle” and even “cycle management” is being taken by industry analysts with a pinch of salt.

To further illustrate the precarious fortunes of insurers, Voll presented a “high road’ and “low road” outlook of the industry’s potential earnings performance for 2005. The “high road” scenario assumes premium growth of about 9% (Voll does not expect this will be achievable), little or no growth in claims costs (again, she expects the loss ratio to rise), no change in investment returns, and a minimum historical tax rate of 26.6%. Under such conditions, the industry will likely produce net income for 2005 of $4.9 billion – representing about 22% year-on-year growth in earnings. The “low road” scenario assumes a 10% reduction in auto premiums (excluding Quebec), a rise of 10% in auto claims costs and a 40% hike in liability claims, a rise of 2% in interest rates (which would impact bond values), and a maximum historical tax rate of 48.1%. The outcome for the industry would be net income of about $2 billion – resulting in a 50% year-on-year decline in earnings.

And, Voll notes, there are many unknown variables currently in play in the marketplace. The liability class is still operating at a 100%-plus combined ratio while the overall Ontario market (from which nearly 50% of total premiums are derived) is hovering at just below a 100% ratio. There also remains a significant difference in performance of commercial and auto writers countrywide, she observes, with the top ten commercial carriers having notched up an ROE of 16.2% for last year whereas the top ten auto companies came in with a much poorer 7.4% return. Seen on its own, the auto line casts the biggest shadow of uncertainty with insurers waiting to determine the true cost cutting effectiveness of the provincial auto reforms. Notably, Voll says accident benefit (AB) claims in Alberta began rising sharply from October of last year – a signal the industry can ill afford to ignore.