Reinsurers on Canada’s Primary Market: Rate Spiral

As this year’s third-quarter financial results start to roll in, it’s clear 2007 isn’t going to be as sunny as the relatively catastrophe-free year of 2006. And yet, many in the reinsurance sector agree there remains enough capital swishing around in the market to sustain an ongoing softening market in Canada’s primary insurance sector for a at least a little while longer. The question now, however, is how soft that market might be, and to what extent such a market will tempt primary insurers away from the necessity of maintaining market discipline.

Francis Blumberg,

Head of Canadian Operations, PartnerRe

As primary insurers begin to leverage their capital for the purpose of gaining market share, reinsurers are bracing for downward pressure on reinsurance rates. This will be happening at a time, reinsurers note, when climate-change-related catastrophe risks seem higher than ever and insurance to value is something to be refined. Market discipline, more than ever, is something to be practised as as we approach the 2008 renewal season, according to nine reinsurance company CEOs who have given us their insights into what they believe are the top issues facing Canadian reinsurers going forward into next year. Their responses follow in alphabetical order by last name.

At a time when Canadian insurers are still playing catch-up with respect to insurance-to-value in both the residential and commercial property segments, some insurance companies prefer to focus on the total “premium pool” rather than trying to ascertain whether insured values and the premium rate are adequate when considered separately.

Whether or not this is an appropriate approach for an insurance company is not for us to say, but it is certainly essential for reinsurers to have appropriate value-at-risk information: it is the foundation upon which we ultimately rely for our cat analyses.

In the event of a catastrophe, the impact of inadequate insurance values becomes more visible. We saw examples of this with the surprisingly expensive finished basements in the Ontario storms of Aug. 19, 2005 and the expensive pool enclosures during hurricane Wilma in the United States.

The issue of insurance-to-value is particularly relevant in Canada, where housing prices have increased at tremendous speed, post-loss inflation (a sub-set of the insurance-to-value debate) is especially acute and where construction or contracting labour costs have become expensive even under normal circumstances.

One side-effect of not having up-to-date insured values, when combined with the phenomenon of widespread guaranteed replacement cost coverage, is the possibility of strongly underestimating the insured loss potential in the event of a major catastrophe causing numerous total losses. Existing estimates of damage losses due to a big earthquake in British Columbia or in Quebec — to name only two scenarios — should be looked at with extreme caution.

Although most insurers have been tackling this issue in recent years by enhancing their recourse to inspection, spreading the use of updated calculators and implementing systematic inflation factors, most companies seem willing to concede there remains room for improvement in this area going forward.

Christophe Colle

Branch Director, Chief Agent, XL Re America Inc. (Canada Branch)

Looking forward, one of the continuing issues for the reinsurance industry in Canada, as in the rest of the world, is the aggregation of losses. In casualty, this includes “emerging liability risks” — i.e. nanotechnology, food, genetically modified organisms, pandemic, etc. — and class action exposures. On the property side, concerns have been expressed about terrorism and changing climatic conditions. Greater frequency and severity of weather-related losses, most of them not being modelled, can range from wildfires to severe winds to higher water damage losses. Urban densities and a significant increase in the cost of construction add to the existing exposures each year.

As a general comment, the quality of data provided by insurers to their reinsurance partners is extremely important. We have seen significant improvement over the past few years, but more data transparency is a strategic challenge in the near future. Insurers able to provide a better quality of data can best reap the benefits from pricing models.

Carol Desbiens,

Chief Agent for Canada, Paris Re

This year, a large number of hailstorms hit the Prairies; it remains to be seen if we are embarking on a new trend with respect to climactic events in the rest of Canada. All insurers in the Prairies have incurred losses to some extent, which in turn has affected some reinsurance programs related to catastrophe and crop. We continue working towards a better risk evaluation that must encompass modelling results, combined with an accurate evaluation of the non-modelled perils.

Consolidation of major programs continues. There are already indications that some insurers will consider buying more capacity while increasing their retentions. Although most of these insurers have incurred a loss stemming from the various hailstorms of 2007, the impact to their reinsurance program has been minimal. This may not have been the case, however, for some companies buying at a lower level or writing a more regional book of business. For reinsurers, the increase of a profitable premium income remains a challenge. The challenge is particularly great this year, given that the bottom line continues to be good for many insurers; this translates into an expectation of reinsurance price reductions for the upcoming reinsurance renewal.

The ongoing softening of price and conditions at the primary market level remains a concern and for now we see no relapse. The need for diversification continues to be a challenge for many insurers and we will continue monitoring this situation closely.

Andre Fredette

Vice President and General Manager, Caisse Centrale de Reassurance

From a catastrophe point of view, unless there are significant losses before the end of the year, it is most likely there will be some softening in terms locally even though there were a number of hail and rain storms in Manitoba and Quebec this year. (Canada tends to follow the world market.)

The biggest issue on cat losses in Canada is that there is very little slack in the construction industry. The Alberta economy is so hot that if there were to be a large loss in British Columbia (an earthquake) or Alberta (windstorm), the industry would find a steep escalation in rebuilding costs. The projected legislative changes for fire following earthquake in B.C. will only increase insurers’ exposures.

In non-cat areas, the biggest worry is the current drop in prices in the primary market. We have not yet seen the bottom of this soft cycle. We can only hope for a soft landing.

Overcapitalization of the insurance industry and future potential mergers will make it hard for any growth in the reinsurance industry. The main aim of most reinsurers is to manage the cycle and maintain profitability until conditions change for the better.

Auto excess reinsurance continues to be a problem class for many reinsurers, as primary companies are still slow to reserve to their ultimate payout exposures.

Enterprise risk management [ERM] will make further requirements on reinsurers’ infrastructure. Reinsurers will have to get better at managing these exposures.

“Plus ca change…plus ca reste le mme”

Jean-Jacques Henchoz

President and CEO, Swiss Reinsurance Company Canada

Last year, we observed that primary industry results in Canada were favorable and balance sheets were healthy, fueling growth strategies. This year, we can say essentially the same thing, but with different implications. True, results are still good, but margins are rapidly eroding, meaning some insurers may
look to expand their books of business in an effort to maintain their bottom line.

Actual growth is another story. Since Canada is a mature market, we note the obvious route to growing market share isn’t only through enlarging risk appetite, but also through transactional growth, leading to increasing concentration of risk in the hands of fewer carriers.

We noted last year that some reinsurers were looking to further diversify their portfolios following the hurricane losses of 2005. This year, as another benign catastrophe year may come to a close, reinsurance renewals will likely feature some interesting discussions as some insurers look for concessions on price.

For reinsurers, a longer-term view is essential to the industry’s stability. Yes, Canadian reinsurers also enjoyed a profitable year, but the industry needs to be able to produce such results in order to manage volatility over the long run. Intelligent cycle management continues to be a prerequisite for sustainable operational performance. Managing the cycle means communicating our underwriting appetite to our clients, proactively addressing emerging issues and stressing that Swiss Re will remain actively engaged in the Canadian market for the long term. To this end, consistent pricing and underwriting is required. When the market turns and capacity becomes tighter, our key clients will know we remain there for them.

Through the cycle, we believe one fundamental truth remains: the quality of reinsurance protection is more important than short-term concessions. Long-term, mutually beneficial relationships are where the foundation of the Canadian marketplace should rest.

Kenneth B. Irvin

President and CEO, Munich Reinsurance Company of Canada

Falling on the heels of record profits, the insurance industry is experiencing increased competition resulting in softening of original rates. To date, however, we have seen no indication that companies are willing to self-destruct to obtain a perceived market-share advantage.

The industry has performed well the past few years because we have exercised sound business practices; our risk/return balance was positive. I believe these skills are very much evident today and will serve us well in managing the free-market, cyclical nature of insurance.

This does not mean we are without our trials and tribulations. As an industry, we have certainly identified negative trends that demand self-discipline. The deterioration in original pricing in the Canadian market is the major cause for concern and must be addressed. The evidence shows that claims inflation is now outpacing premium growth, a costly and intolerable long-term condition.

While very big strides have been made in the insurance-to-value arena, more must be forthcoming. One only has to look at the rampant inflation in Alberta to realize we are not receiving the premium for the exposure assumed in at least one geographical area.

From a catastrophe exposure perspective, reinsurers have a vested interest in the outcome of discussions about the effects of climate change/global warming. The cause may be debated but the reality of increased frequency and severity of extreme weather cannot.

Normal event horizons do not exist for rainstorm, windstorm, hail, drought, wildfires and flood. Increasing economic values in urban areas, coupled with the aging infrastructure of cities, will generate a significantly higher level of claims when these events occur than we have ever seen before. It is imperative to assess and price for this increased exposure in both our insurance and reinsurance products.

On the casualty front, there has been a huge jump in the severity of bodily injury and general liability awards and settlements. These have doubled over the past three to five years to the high single-/low double-digit, million-dollar range. Lawyers successfully plead cases for very large lost income and future care awards in catastrophic injury claims. The pricing of these insurance products continually lags behind social inflation and must be redressed.

The foregoing issues are the challenges of a vibrant industry. There will be no complacency in addressing them, and with reason and diligence, few barriers to solving them.

Cam MacDonald

Vice President, Transatlantic Reinsurance Company

An ever-growing consensus of opinion suggests global warming is responsible for an increase in the frequency of large weather-related losses. Recent events such as the Ontario rainstorm remind us that we here in Canada are not immune to this phenomenon. As populations expand and property values escalate, the possibility of several large weather-related losses in a given year poses a real threat to the Canadian property and casualty marketplace. As primary insurers increase retentions, and move from pro rata to excess-of-loss covers, the aggregation of several large weather-related losses could have a significant impact on their net position. If these changing weather patters are indeed the “new normal,” companies would be wise to revisit their reinsurance program in an effort to better control this increased exposure.

Enterprise Risk Management [ERM] is more than a new catch phrase or “buzz word” in today’s marketplace. Extreme events management, internal controls, regulatory issues and emerging issues are but a few of the challenges facing our industry. On several levels, it is important to understand why and how we manage our business. Identifying and acting on major risks affecting an organization should be a priority for senior management and line managers alike. An effective ERM culture is one that exists throughout an entire company, noting everyone in the organization plays an important role in using effective ERM techniques.

As we move into 2008 and beyond it will be incumbent on companies to develop a comprehensive ERM strategy at all corporate and business levels.

Steve Smith,

President, Farm Mutual Reinsurance Plan

Fortunately 2006 came and left without the storm severity that had been predicted following the dramatic hurricanes of 2005. Reinsurers were all able to breathe a sigh of relief on Jan. 1, 2007, when all the predictions of a more severe cat year in 2006 failed to prove accurate. The reinsurance industry recaptured some of the lost surplus from the previous year, and 2007 reflected some stabilization following rate increases, lack of capacity and a transitional reinsurance market.

What we have seen so far in 2007 is a fairly active catastrophe loss year internationally, with losses far exceeding 2006. While Canada has seen some activity, primarily in the West, the real story will be the effects of global activity on the international cat market and available capacity. We have seen Caribbean hurricanes, Asian typhoons, European storms and severe flood damage in the United Kingdom. At the time of this writing, we are only partway though the 2007 fall hurricane season, with time to potentially realize further losses. Already this year, there have been two Category 5 hurricanes, supporting the consensus that storm severity is noticeably increasing.

Those who expect Canadian catastrophe rates to see some softening may prove to be disappointed.

Risk activity is reflecting an increase in severity on the auto/casualty side and, to some extent, both an increase in severity and frequency on the property business. The key issue here is inadequate primary rating in this continuous soft market. Unfortunately, this pricing weakness has been in place for the last couple of years and there does not appear to be any relief in sight for the foreseeable future. There continues to be a widening gap between insurers and reinsurers, as primary pricing deteriorates and loss severity increases. This strain will need to be addressed.

The market is overcapitalized and market share is the principal driver of primary business plans. It will be absolutely essential that insurers exercise a flight to quality
and focus on underwriting discipline, underwriting integrity and insurance to value. Basic fundamentals may never have been so important.

Matthew Spensieri,

Vice President and Chief Agent for Canada, General Reinsurance Corporation

As we near year-end, activity intensifies for most of us involved in reinsurance. So, too, does the speculation on market pricing and availability. This year is no exception.

Although there have been worldwide catastrophic events in 2007, the impact on reinsurers’ results has been modest. If the frequency and severity of catastrophic losses in the United States replicates what occurred in 2006, most global reinsurers will likely publish positive underwriting results for 2007, even if other lines of business are deteriorating.

Canada is not tied to U.S. reinsurance results, but the U.S. results do influence worldwide results — which in turn affect all of us. Canada, for the most part, and for many years, has been spared the huge cycle fluctuations that have occurred in other nations. These market swings have spawned alternative or non-traditional sources of capital or capacity in various jurisdictions. Although Canadian insurers generally purchase more treaty “catastrophe limits” than any other line, access to required or increased “traditional” capacity as of Jan. 1, 2008 will not be a challenge. While this line remains competitive, pricing is not expected to change.

With respect to insurance, while some might argue we are going into a soft market, others will suggest we have been there for some time. Regardless, this has translated into deteriorating results for the industry in the first half of 2007. One of the biggest challenges we all face is achieving underwriting profitability.

Those who expect Canadian catastrophe rates to see some softening may prove to be disappointed. There continues to be a widening gap between insurers and reinsurers, as primary pricing deteriorates and loss severity increases. This strain will need to be addressed.

– Steve Smith, Farm Mutual Reinsurance Plan