Reinsurance Outlook: Cultivating Capital

Canadian reinsurers are enjoying a rare moment in history when the financial state of the industry is living up to the Canadian stereotype of stability — and maybe even the reputation of being a little bit dull. “Dare to be dull, dare to be boring — but you make some money,” replies John Kartechner, senior vice president of reinsurance broker Aon Re Canada Inc., when asked if perhaps the Canadian reinsurance market might be a bit too quiet in 2006-07. In fact, at Cdn$483.2 million, Canadian reinsurers in 2006 posted their largest profit since the beginning of the new millennium. After paying out record losses in 2005 following several weather-related natural disasters and Cdn$1-billion for an explosion at the SunCor oil refinery in Alberta, the reinsurance industry had no major catastrophes to deal with in 2006 and consequently recorded a combined ratio of 86.8%.

To put this in perspective, the 20-plus members of the Reinsurance Research Council (RRC) in Canada, an organization representing the majority of professional property and casualty reinsurers registered in Canada, collectively posted a net profit of Cdn$239.7 million in 2005 (COR of 102.95%), Cdn$376.8 million in 2004 (COR of 92.4%) and Cdn$310 million in 2003 (96.38%). The Canadian reinsurance industry clearly has come a long way since its darkest days in 2001 and 2002, when it posted net profits on only Cdn$47.7 million (COR of 119.1%) and Cdn$52.9 million (COR 110.2%), respectively.

One happy consequence of the Canadian insurance industry’s relative financial stability is an influx of foreign capital. “There was a time when [the parent companies of] insurers [predominantly based outside Canada] were saying that maybe they would ignore Canada a little bit and put their capital elsewhere, because they were able to get a bigger bang for their buck,” Kartechner notes. “I do think there is a mentality among reinsurers now internationally that while Canada may not be the place where you’re going to have these huge, huge windfalls, at the same time, you don’t have these huge losses either. It’s a dare-to-be-boring kind of situation, where your customers rely on money in Canada.”

Jean-Jacques Henchoz, president and CEO of Swiss Reinsurance Company Canada, says there is ample capacity available in the Canadian reinsurance market. Once at Cdn$2.5 billion a few years ago, capacity has “adjusted a bit” to approximately Cdn$2 billion, Henchoz notes. “But there is still ample capacity,” he adds, especially considering the industry’s major losses in 2005.

The question now is: What are Canadian insurers and reinsurers going to do with all of this available capital and capacity?

DECREASED CESSION

Canadian reinsurers are continuing to monitor a long-term trend in the direct insurance market, noting that primary insurers in Canada, flush with capital, are opting to cede less of their valuable premium money — and therefore risk of exposure — to Canadian reinsurers. The theory behind this is that since the primary insurers have more capital available to them, purchasing reinsurance is less of a priority because the primary insurance companies can afford to retain more of the risk of paying out big losses themselves. “Due to very good results in the primary sector, insurers have substantially improved their capital strength,” Henchoz says. “In other words, they are able to take on more risk. They obviously feel at this stage that their risks are fairly priced. They increase their retention to increase their net [profit] and believe they are writing profitable business. I think the fact that they have more capital strength leads them to purchase less reinsurance and to increase their retention.”

David Wilmot, the immdiate past senior vice president and chief agent in Canada for The Toa Reinsurance Company of America, observes the increased retention of risk has primarily occurred in the area of ‘pro-rata,’ or proportional, reinsurance treaties.

In proportional reinsurance treaties, a reinsurer agrees to take on the risk for a negotiated proportion of a primary insurer’s book of business. A primary insurer might, for example, cede a portion of its auto, personal or commercial lines book of business to a reinsurer. In exchange for assuming the risk of the ceded portfolio, the reinsurer will receive the premiums the primary insurer collected for that portion of the business. Proportional treaties are distinguished from excess-of-loss treaties, in which primary insurance companies pay for different “layers” of reinsurance to cover catastrophic losses in excess of the company’s expectations. In effect, reinsurance treaties generally help “smooth out” any unexpected spikes in a primary insurer’s losses over any given year.

“We are seeing some significant jumps in retentions over the last renewal,” Wilmot says. “The impact of this is a dramatic reduction of volume of reinsurance being purchased. This coincides with marketing strategies, in which people writing pro rata business have said: ‘Wait a minute, this pro rata stuff is pretty attractive, good results, and maybe I don’t have to cede off as much.'”

Pierre Michel, the president and CEO of PartnerRe Canada, says the trend for primary insurers to retain their risks is not significantly more pronounced in the first part of 2007 than it was in 2006. He observes the volume of ceded licensed reinsurance in Canada in 2007 “is almost the same as it was in 2006, so predictions of shrinking volume have not materialized.”

In fact, Christophe Colle, the branch director and chief agent of the Canadian branch of XL Re Europe, says he wouldn’t describe what is happening in terms of retentions as a “trend” at all. “I would not say there is a trend to increase retention,” he says. “A trend means every single company is considering [retention] because that’s the fashion; that’s where the reinsurance industry and the strategy for buying reinsurance is headed. That’s not correct.”

According to Colle, individual primary insurance companies base their decisions to purchase reinsurance on five factors:

* individual business plans, which include whether they are quoting or writing new business;

* the company’s capital base;

* the risk appetite of the company’s shareholders;

* the price of the reinsurance; and

* the regulatory environment, which includes questions such as capital adequacy testing.

“I don’t like to be quoted about trends, because they can change overnight,” Colle says. “Yes, there are some companies that have increased their retention. Do I call that a trend? I would say, ‘No, it’s not a trend.’ It’s an individual strategy based on these five variables.”

Whether or not they count as a long-term “trend,” increased retentions by primary insurers remain something to watch over the long term, Michel says. “Just because it hasn’t happened in 2007 doesn’t mean it’s not continuing,” he says.

REDUCED PREMIUM BASE

One consequence of higher retentions is a reduced premium volume for Canada’s reinsurers. “Reinsurers should not be too bothered about the shrinking premium volume, but that’s within reason,” Michel says. Like most of his counterparts, Michel notes the Canadian reinsurance market becomes more competitive as reinsurers are forced to divvy up fewer reinsurance dollars in the overall pot. Theoretically at least, the situation could lead to market concentration, as reinsurers begin to target mergers and acquisitions as a means to achieve growth targets. Secondly, Michel notes, “reinsurance companies are only viable if they have a diversified book of business, meaning that the business comprises risks across various lines of business and various geographies. [Reinsurers] have to maintain a certain amount of volume, because volume is a reflection of diversification.”

Just how much of the reinsurers’ premium pie has shrunk in recent years?

Andre Fredette, vice president and ge
neral manager of Caisse Centrale de Reassurance, and RRC chairman, says premium ceded to reinsurers has dropped an average of 10% each of the past three years. “For the reinsurers, if you look at the RRC numbers, in 2004, the numbers reported by the local domestic companies here went down by 13%,” he says. “In 2005, there was a premium drop of 17%. Last year, I think it dropped about 2% or 3%. So you had over the past three years a drop of about 30% in premiums ceded to reinsurers.” Looking at the long term, approximately 15% of the primary insurers’ direct written premiums in 2001 were ceded to reinsurers, according to Henchoz. In 2006, the cession rate dropped to 10.5% of direct written premium.

But what goes up, because of the insurance market cycle, must eventually come down. Henchoz sees the market cycle acting as a brake on decreased cession rates, preventing increased retentions from dissolving the reinsurance premium pie to any dangerous degree. “I don’t think that this is a trend that is going to last forever, because it is related to the cycle,” he says. “Our [primary insurer] clients are very good at managing the cycle. Once primary pricing goes down, and therefore [business] will not be as profitable, you will see a reverse of this trend.”

One positive impact of increased retentions is “generally a more balanced and better-rated book,” notes Ken Irvin, president and CEO of Munich Reinsurance Canada Group. He observes that although primary insurers are ceding less premium on the proportional side, they are nevertheless purchasing more reinsurance at the top end [i.e. excess of loss treaties]. “They’ve bought more [at the top end] for various reasons,” Kartechner said, “including things like insurance to value, changes in the models people are using on the property side, claims activity, including on the casualty side…There have been a couple of recent court awards that have scared the industry a bit, so there is a reason for saying ‘We should look for more cover.'”

Like Irvin, Kartechner sees an opportunity for portfolio diversity despite — or more accurately, because of — the reduced premium volume for reinsurers. “I think what reinsurers have to do is start opening up their eyes a little bit and saying, ‘Well this is a risk we could do,'” Kartechner says. “The reinsurers just have to become more comfortable writing some business that they currently don’t have.”

Michel says primary insurers do need to consider whether they have purchased sufficient reinsurance. Also, several sources say, primary insurers need to keep in mind during their profitable years that reinsurers — since they exist as a backstop for insurance companies, acting to “smooth out” volatility in the primary insurance market — will generally not demonstrate a great deal of volatility in their pricing.

PRESSURE ON RATES

Maintaining adequate reinsurance pricing is crucial at a time when primary insurers are lowering their rates because of decreased loss activity in 2006, many Canadian reinsurers note. “The pressure [to drop reinsurance rates] is there because we had a very good year last year,” said Henchoz. “There is a misconception that because the prior results have been good, it should automatically lead to a reduction in pricing. This is an opinion coming from people who don’t know a lot about what reinsurance is all about…The best approach to providing long-term stability to the system is to provide adequate pricing. If there is adequate pricing in the reinsurance system, there will always be capacity available.”

In fact, 2007 is already looking somewhat more claims-laden than 2006, according to Steve Smith, president of the Farm Mutual Reinsurance Plan. That has reinsurers discussing whether or not their current rates should be increased.

One the key issues facing Canadian reinsurers going forward in 2007 is that there is a continuing large loss development, and the reinsurance premium base is not supporting the development in these large claims, says Smith. “We see large losses getting larger,” he says. “Combine that with what’s been a declining primary rating base, there’s been an expanding gap between the primary rates and the loss development, so that what you’re seeing is reinsurance premiums inadequate to support the claims.” Although catastrophe claims have been relatively quiet, Smith observes, the large losses have been associated with the auto and casualty lines.

A recent A.M. Best study of the Canadian market, Canadian Property And Casualty Insurers Should Heed The Past To Avoid Market Instability, appears to bear out Smith’s observation. The report notes that in auto lines, the Canadian industry’s loss ratio in 2006 increased to 67.7% from 64.6% in 2005. “This should signal to the market that further premium declines might not be prudent,” the report concludes. In addition, A.M. Best noted the rise in the auto loss ratio was due to a slight rise in the accident benefit costs: “In Alberta, for instance, the average accident benefit cost per claim rose about 7.1%, while in Ontario it rose 1.5% in 2006. The rise in accident benefit costs is somewhat concerning because one of the major initiatives from the auto reforms was to contain this rise through the adoption of evidence-based treatment for soft tissue injuries. The industry would be in serious jeopardy if accident benefit costs were to escalate as they did in 2001-2002.”

COURT AWARDS EXPANDING

Along these lines, Smith believes the increase in 2006-07 losses may be due in part to the Canadian court’s seeming expansion of the scope of the ‘Doctrine of Reasonable Expectations.’ Insurance defence counsel have noted for some time that the way the courts have interpreted this doctrine, policy coverage exists in those situations when a policyholder had a “reasonable expectation” that their loss would be covered. But “particularly with the Doctrine of Reasonable Expectations, coverage is being found that was never in the intent or wordings that supported the coverage,” Smith suggests. “Many times [the courts have] found severe or catastrophic-type losses that have resulted in reinsurance claims. I think that’s becoming a little bit unpredictable and difficult to underwrite against.”

Irvin agrees one issue facing Canadian reinsurers is the trend of dramatically increasing court awards in casualty cases. “Because of the inherent latency in the liability product, it is difficult to price today for the future societal behaviour of the courts,” he says.

Smith adds that, despite significantly reduced catastrophe losses last year, reinsurers are still suffering the “residual effects of Katrina, particularly in the retrocession market [i.e. in which reinsurers cover other reinsurers’ losses]. If there was a significant year of hurricane activity in 2007, we would certainly feel the dramatic effect of that in 2008, because that capacity [lost as a result of Katrina damage payouts] has not fully recovered.”

Despite this, some Canadian reinsurers observe catastrophe-related reinsurance pricing has come down slightly in non-hurricane prone areas. But a majority, however, feels that Canadian reinsurers have demonstrated a proper amount of pricing discipline in their catastrophe treaties. Irvin believes reinsurers “must eventually deal with the ever-increasing concentration of values that are significantly exposing catastrophe treaties at a much faster pace than the pricing for such exposures.” He adds there “are no models for weather-related events like the August 2005 Ontario rain storm — we just know more frequent and severe weather incidents in major urban and developed areas will cost decidedly more.”

Wilmot believes some current reinsurance pricing may in fact be too low — even though primary insurers, pointing to the absence of significant losses last year, might argue that their reinsurance rates should be decreased. “Despite the number of years we’ve had no-fault auto insurance in Ontario and some provincial government offices, it’s still fairly recognized that the deve
lopment of these losses is still very slow,” Wilmot said. “Some clients think they are paying too much for lower layers [of reinsurance] when in fact they may be paying far too little.”

Wilmot says the Canadian industry is now in a “remarkable situation,” in which the buyers and sellers of reinsurance have both shown a failure to understand pricing. “Imagine a Cadillac selling for close to $40,000,” Wilmot says, by way of example. “You have a buyer who thinks they should only be paying $20,000 for it and a seller who thinks it should be $25,000. They’re having an argument over $5,000 when the correct answer is that it should be sold for $40,000.

“Do you want the same story thrown back 35 years? Back 35 years ago, I was quoting casualty layers of $400,000 (coverage) in excess of $100,000 (loss). That’s how low it was. The going price [for the reinsurance coverage] was 90 cents for $1. And I always wanted $1.20 to $1.30. So I was quoting myself out of the business. I even had a broker once say to me: ‘Can’t you figure it out? You’re charging more than anybody else. You’re wrong.’ Well, it turns out I was wrong. All of those layers went for $4, they all burned at $4. The question is, 35 years later, has it changed?”

These discussions about reinsurance pricing should be kept in context, reinsurers note. Overall, there’s not much happening in the Canadian market in terms of any true volatility. “It’s been quieter than it’s been for a number of years,” said Wilmot. “I would say over the last 18 months, there’s not been major issues.”

REGULATORY ISSUES

If there have been any issues on reinsurers’ radar screens, they have generally tended to be regulatory issues. These issues represent the potential for instability in the market over the long term because of a lack of clarity around proposed legislation.

Take Bill C-37, for example, an act to amend the law governing financial institutions, which includes an as-yet-to-be-defined provision that seeks to clarify the application of Part XIII (Foreign Companies) of the Insurance Companies Act.

As noted in a 2006 bulletin posted online by Canada’s federal regulator of the insurance industry, the Office of the Superintendent of Financial Institutions (OSFI), Bill C-37 “clarifies, among other things, that Part XIII of the Insurance Companies Act only applies to foreign entities that insure in Canada a risk. In particular, the regulatory focus with respect to foreign companies will be on the location of insurance, rather than the location of risk. As this represents a material change for the Canadian operations of certain foreign companies, both these foreign companies and [OSFI] require time to adjust to these changes. Therefore, many amendments to Part XIII will be brought into force at a later date.”

What does it mean for foreign-based reinsurers “to insure in Canada a risk?”

“It depends what the rules and regulations are going to be,” says Henry Klecan Jr., president and CEO of Scor Canada Reinsurance Company. “This is what everybody is waiting for. That hasn’t become very obvious to any of us.”

Klecan says the new law might foreseeably allow an insurance operation based outside Canada to write a piece of business that’s inside Canada, but account for that Canadian business in its domiciled area without the oversight of OSFI. “OFSI has worked very diligently in providing regulatory oversight on behalf of the consumer, and possibly losing that over many years of working hard to get to that point is a bit daunting,” Klecan says. “We don’t know if there is going to be a double standard applied to existing reinsurers and a different standard to others. All of this is up in the air and we just don’t know which way it’s going to go.”

FIRE FOLLOWING

A similar problem concerning a lack of clarity concerns proposed amendments to the B.C. insurance act with respect to “fire following” coverage.

Fredette says a government White Paper on the proposed changes to the B.C. insurance act basically agreed that insurance companies could exclude coverage for terrorism absolutely — including an exclusion for any fire damage following a terrorist act. At the same time, however, the White Paper proposed that if a consumer has a fire policy, and if he or she experiences a loss from a fire following an earthquake, that fire would be covered under the fire policy and could not be excluded. “We’ve been arguing that you should allow us to put an absolute exclusion for the earthquake [in the fire policy], so that when the client wants earthquake coverage, then we provide them with fire coverage and shock coverage as a separate add-on.

“Right now, if they go through with what they’re proposing in the White Paper, some guy could have a house, and he has a fire as a result of an earthquake, and he looks up under his fire policy and sees he’s covered with a $500 deductible. His next-door neighbour bought the full quake coverage [including fire], but since he has a 5% client deductible, he might have a $30,000 deductible on his house. He bought the full coverage, so he’s going to have a $30,000 deductible, whereas the other guy had only a $500 deductible.”

Fredette says another danger with the “fire following” provision as proposed in the White Paper is that it might lead to a Hurricane Katrina-like outcome involving a confusion of coverage. For example, someone may receive insurance coverage for a fire to the kitchen following an earthquake; and yet, because they don’t have earthquake coverage, they would receive nothing if an earthquake shifted the house off its foundation by a foot. “You end up like Hurricane Katrina: ‘We cover the wind, but not the water,’ which I don’t think is good for the consumer,” Fredette says.

Perhaps these regulatory issues to do with the clarity of new legislation will result in future changes to the way reinsurance is transacted, priced and sold. But perhaps also they appear to be that much more prominent in an otherwise stable and quiet reinsurance market. Whichever it is, Canadian reinsurers are clearly at the top of the mountain – and the only place for them to look right now is at the vista. below.