Sputtering on All Cylinders

Joel Baker, president of MSA Research, kicked off the second annual National Insurance Conference of Canada (NICC) in Ottawa-Gatineau by likening Canada’s property and casualty insurance industry to a sputtering car. It’s the sound a car makes when it isn’t firing on all cylinders, noted Baker, the host of the conference.

Certainly, deteriorating loss ratios in the auto, property and commercial lines were a conversation piece for the NICC; if that didn’t prove enough, the sputtering U. S. stock market and the announced US$85-billion bailout of the American International Group (AIG) provided additional fodder for discussion during the conference’s many sessions.

Clearly the Canadian P&C industry has “issues,” many of which were openly debated at NICC in October 2008. Here is a sampling of what occurred.

THE FALTERING U. S. ECONOMY

Bailout isn’t enough

The US$700-billion bailout package the U. S. Senate passed on Oct. 1 will not solve the fiscal problems plaguing the U. S. economy, but it will help to some degree, Don Drummond, TD Bank’s chief economist, told delegates attending the NICC.

The question,’Will the bailout package provide sufficient liquidity?’ was posed to Drummond during a Q&A session following his presentation.

“What’s sufficient?” Drummond responded.

Although the US$700-billion proposal is not nearly sufficient to rid the United States of the nearly US$5-trillion worth of mortgage-related debt crippling the U. S. financial sector, its liquidity will nevertheless serve to “free up” some available credit in the marketplace, Drummond observed.

He further noted the U. S. bailout package does not remove the debt owed. It simply moves some of the debt over to the government books from the books of the financial services sector. “That’s easier for the markets to handle, but the economy still has a long way to go before recovery,” Drummond said.

Baker asked Drummond to comment on whether or not the current state of affairs south of the border will affect the United States’ AAA bond rating.

“If you look at the financial mess, then they don’t deserve to be called the financial leaders of the world,” Drummond replied. “I think that they could lose that ‘AAA’ rating, but on a narrow basis, it doesn’t do a heck of a lot.” He said it would take a downgrade down to a ‘BBB’ rating for any serious consequences to develop.

Given huge imbalances on its fiscal and trade sheets, and its dependency on foreign banks to “pick them up,” the United States “has phenomenal vulnerability right now,” Drummond said. And there are signs they still haven’t learned their lesson.

“I was thinking they’ll get a new administration that will begin to chip away at the fiscal mess, but then I look at what happened last night [when the U. S. Senate passed the bailout package] and, for completely unprovoked reasons, they added US$100 billion of tax cuts to this financial problem.”

OSFI defends stance against leverage

The Office of the Superintendent of Financial Institutions (OSFI), Canada’s federal insurance solvency regulator, made no apologies at the NICC for insisting on eliminating debt from the balance sheets of Canadian property and casualty companies.

It said its strategy to reduce leverage has allowed Canadian property and casualty insurance companies to weather the current financial turmoil in the United States.

“OSFI has faced criticism in the past for our stance against financial leverage in P&C companies, and we have been criticized by those who say we artificially add to the cost of capital, but despite the criticism we stand by our decisions,” OSFI superintendent Julie Dickson told NICC delegates.

On the basis of OSFI’s stance, Canadian property and casualty companies have the lowest operational leverage than at any time in the past 15 years,”and most likely in the last 30 years,” Dickson noted.

As a result, to date, no property and casualty insurers in Canada have been forced to take significant writedowns as a result of exposure to the financial turmoil currently gripping the United States.

“In Canada, we know that regulated P&C companies are not overly leveraged,” Dickson said, comparing the difference between the Canadian and U. S. property and casualty insurance markets right now. “Regulated P&C companies in Canada do not have debt on their balance sheet, nor are they generally selling products that require collateralization in the event of credit downgrades.

“Debt — and OSFI has been adamant about this — does not belong on the balance sheets of operating P&C companies.”

Further defending OSFI’s decisions on capital requirements, Dickson noted the regulator could not be too careful.

“We are in uncharted waters,” she observed. “The total losses that global banks and insurance companies have had over the past three or four weeks were on what until very recently were perceived to be low-risk, conservative debt instruments.”

AUTO INSURANCE LINE

Establishing new ROE targets

Insurers should reconsider their future return on equity (ROE) targets in light of the volatility existing in the Canadian private auto insurance markets, actuarial panelists told delegates attending the NICC.

“Return on equity: this is in my view a change in the landscape, and is an area or issue in which companies should be doing some soul-searching,” Richard Gauthier, a partner at Pricewaterhouse Coopers, said. “The auto market today is not the old product of Yore. It’s no longer an area where the level of certainty is sustained over time.

“Regardless of the equity that your shareholder demands, the case can be made that the auto product requires higher [ROE] returns and that will compensate for the volatility.”

The ROE is a calculation of a company’s net profit, divided by the company’s average shareholder equity (or net worth) over a certain period.

The moderator of the auto actuarial panel, Francois Boulanger, president and CEO of RBC General Insurance Co., noted the uncertainty around claims costs in auto potentially affects insurers’ predictions about how much of their reserve funds to release, which in turn affects their ROE and capital calculations. Higher ROEs would amount to leaving the company with more capital to pay for escalating costs, panelists noted.

The volatility affecting auto results is a consequence of higher loss ratios and a number of legal challenges to caps designed to keep insurers’ costs down, panelists observed.

In Alberta, the Court of the Queen’s Bench this year struck down the province’s Cdn$4,000 cap on auto insurance minor injury claims. An appeal has been heard and the ruling is pending.

While the outcome of the Alberta appeal is uncertain, trial lawyers have either launched actions or threatened to launch actions against minor injury caps in the Atlantic provinces.

In the meantime, Ontario lawyers have indicated they would be prepared to challenge the province’s verbal threshold for determining serious injuries, as well as the Cdn$30,000 deductible applied in Ontario to accident benefit claim awards of less than Cdn$100,000.

Ron Miller, principal of Baron Insurance Services, said if the caps in Alberta and the Atlantic provinces were to be permanently removed, insurers in Alberta will pay additional damage losses of up to Cdn$160 per car and Nova Scotia insurers could expect to see their losses climb by Cdn$250 per car.

In the Ontario market, the largest private auto insurance market in the country, if the verbal threshold defining a serious impairment and the Cdn $30,000 deductible were to be permanently eliminated, Miller said, additional claims costs to insurers would amount to Cdn$375 per car.

The Alberta Cap Appeal

Minor auto injury claimants suffering from temporary disabilities do not have the same “immutable” characteristics required to receive constitutional protection a
gainst discrimination, insurers’ counsel have argued on appeal in Alberta.

Alan D’Silva, a partner at Stikeman Elliott LLP, presented to the NICC the arguments the insurance industry has already made before the Alberta Court of Appeal.

The insurance industry is watching carefully the province’s appeal of an Alberta Court of the Queen’s Bench decision issued earlier this year. The court found the province’s Cdn$4,000 cap on minor auto injury claims was unconstitutional because it discriminated against whiplash victims.

The court found whiplash victims were labelled as “malingerers” who were faking the extent of their injuries for insurance purposes.

But “the claimants we are talking about seem to be people who have temporary disabilities,” D’Silva observed. “By definition, they don’t seem to fit into the category that Sections 15 [of the Charter] was intended to protect: people with immutable personal characteristics such as age, sex, ethnic background — things you can’t change.

“This group of people seems to be people who are either going to get better, in which case they are back to work, etc., or they could get worse, in which case they meet the test of a serious impairment and the cap wouldn’t apply.”

D’Silva cited a Supreme Court of Canada authority in which Canada’s highest court said characteristics engaging Charter protection had to be “immutable” in nature.

PROPERTY LINES

Insurance-to-Value (ITV)s

About 80% of Canadian houses today are undervalued by 27%, which hasn’t changed since 1995, according to Peter Wells, president of Marshall & Swift /Boeckh (M&S/B), a provider of building cost technologies.

In addition, 60% of commercial build- ings are undervalued by 40%.

In total, that would amount to Cdn$11 billion in lost premium for (re)insurers, based on the discrepancies between the reconstruction values of buildings and the premium collected to rebuild them (otherwise known as the insurance-to- value or ITV issue).

It’s a hot topic among insurers, brokers and insurance calculator providers, each of which blames each other for the problem.

(Re)insurers, in the meantime, are warning primary insurers that they might be in for a big surprise if they are suddenly required to insure the reconstruction of a large number of homes or businesses following any large-scale natural disaster in Canada on the order of the flood in New Orleans.

Diane Brickner, the president and CEO of Peace Hills Insurance Company, told delegates attending an NICC seminar on ITV that she blamed the insurance to value problem on three main factors:

• the inadequacy of cost calculators;

• brokers are not using cost calculators correctly; and

• insurers are not capping guaranteed replacement cost (GRC) policies, thereby failing to limit the amount by which policyholders may be underinsured. These and similar comments stoked the anger of many brokers attending the insurance-to-value seminar.

“Brokers are absolutely committed to fixing the ITV issue,” said Insurance Brokers Association of B. C. CEO Chuck Byrne. “We think we have the right leadership to do it.

“GRC is not the cause, it’s the symptom. What we have to change is ITV.

“We’ve got to make sure that brokers do not use ITV competitively; that they do train and use the tools properly.

“We’ve got to make sure that the tools are adequate. They’ve been woefully inadequate for a long time. And insurers must be a lot more consistent and disciplined in their approach to ITV.”

Wells noted insurance calculators in the United States have historically used square-footage models to determine the true value to rebuild homes. That has changed, and those changes have recently come to Canada, Wells noted.

M&S/B now uses a “total component underwriting” method for determining the cost of homes, which includes many more variables in its calculations.

But when brokers were using the cost calculator, some were turning off one or more of the variables, leading M&S/B to make changes that would make it impossible to turn any one of the variables off, Wells said.

Doing this significantly changed the calculators’ final results.

COMMERCIAL LINES

Iron-clad broker-insurer contracts

In order to achieve market stability, insurers and brokers should consider non-cancellable broker-partner contracts, Paul Martin, president and chief operating officer of KRG Insurance Group, told NICC delegates.

“In other words, if you’re going to write it today, I want you to write it tomorrow,” he said. “This will breed stability for consumers and raise the trust factor.”

Insurers should also guarantee price stability and availability in order to promote consumer financial stability and confidence, he added.

Martin spoke as a member of panel discussing the outlook for the commercial market.

Martin called on the industry to create non-cancellable broker contracts. “This does not mean that a company would not have the right to select the right distributor,” he said. “What it means is, I’m not sure anyone really understands the hardship that the client goes through when an insurance company and broker relationship sours and clients are thrown onto the streets.”

There should never be a cancellation due to a brokers’ volume of books changing or a change in a broker’s loss ratio, he continued.

Martin stressed the importance of solidifying the broker-insurer relationship as the industry prepares for a hard market looming on the horizon.