March 1, 2017 by Greg Williams, Senior Director, Property/Casualty Ratings Division, A.M. Best Group, Inc.
Over the past decade, Canada’s property and casualty insurance industry has been faced with numerous tests, including major catastrophe losses, the global financial crisis, regulatory changes and, more recently, uncertainty created by political events in the United States.
Despite the challenging operating environment, and as companies also navigate through a sustained period of low interest rates, Canada’s p&c industry has emerged relatively unscathed and remains in a position of financial strength.
As a result, A.M. Best continues to maintain a stable outlook for Canada’s p&c industry based on its solid risk-adjusted capitalization, long-term profitable operating performance, growing sophistication in underwriting technology and continuing attention to developing and enhancing risk management methods.
Despite the stable outlook, however, the extended pressures of diminishing investment returns and intense competition have the potential to erode industry fundamentals.
It is, therefore, imperative that Canada’s p&c market bolster its enterprise risk management capabilities and remain vigilant to existing and emerging threats that surely will test management teams over the near term.
EXISTING AND EMERGING THREATS
The balance sheet of Canada’s p&c insurance companies has been pressured for several years by low interest rates and volatile energy markets. The low interest rate environment has persisted for a much longer period than many observers had predicted, with a growing concern that this might be the “new normal.”
For Canada’s p&c insurers, low interest rates are primarily an investment concern. A high proportion of investments are in interest rate-sensitive assets, such as bonds, and that has resulted in a prolonged period of low investment returns.
In response, some Canadian p&c insurers are now more closely matching their assets and liabilities, taking on more credit risk or increasing duration.
At this point, the vast majority of investments continue to be of high quality and the slight reallocation is not a rating issue. However, the low interest rate environment remains a concern as there is the potential for the mispricing of risk and the creation of asset bubbles as investors reach for yield.
Inflation remains well-contained, which should allow the Bank of Canada to maintain its current accommodative monetary policy. It elected to maintain the current base lending rate of 0.5% at its recent meeting on January 18, 2017.
It is expected that interest rates will remain low in the medium term, likely through 2018, as slack remains in the economy and the Bank of Canada remains dovish on future rate hikes. The yield curve remains flat as inflation expectations moderate further and investors continue to hold safe-haven assets.
The belief is that even though low interest rates are expected to continue, insurance companies should consider how their investment portfolios would respond to a sudden interest rate spike.
The Bank of Canada noted in its January Monetary Report that its outlook is “subject to considerable uncertainty, given the unknowns around policy actions by the incoming U.S. administration, particularly concerning trade. These potential policy changes pose important risks to the current projections.”
Energy is a key component of inflation indexes. As a result, the recent low oil price has suppressed inflation in Canada, which has helped to perpetuate the low interest rate environment.
Roughly 10% of Canada’s gross domestic product (GDP) is tied to the energy industry and exports remain a key component of the Canadian economy. While oil prices did rebound somewhat to US$53 at year-end 2016 from the low of US$26 recorded in February of the same year, prices are still well below the US$108 recorded in mid-2014.
With the increased level of competition in the energy sector, underwriting margins also have been consistently squeezed, and the fall in the price of oil has further intensified the situation. Many projects have been deemed uneconomical and cancelled, while investments in new projects have been limited, especially in the energy-producing provinces of Alberta, Saskatchewan and Newfoundland and Labrador.
This is likely to further reduce premium volumes and place greater pressure on managing costs as companies rationalize the benefits of continuing to underwrite energy risks.
Given the prolonged interest rate environment, underwriting fundamentals have taken on an even greater importance in Canada’s p&c market. Insurers continue to retire legacy systems and invest in more sophisticated policy administration and claims systems.
Management teams across the spectrum also are attempting to leverage data analytics to stratify customers into ever-more targeted price groups.
The use of technology, as well, has spread into other areas of organizations, including claims and distribution. Companies that have not adopted these technologies effectively find themselves at a greater risk of being adversely selected against.
Usage-based insurance (UBI), or telematics, also has dominated technology discussions in recent years. The use of such real data analytics has resulted in, and should continue to lead to, more refinement in rate and underwriting decision-making.
Additionally, autonomous driving (self-driving cars) has begun to emerge as a more recent topic of great interest. Some industry experts believe that autonomous driving will lead to safer roads, less damage to cars and fewer injuries and deaths for drivers and passengers.
While this remains to be seen, the issue of insurance on such vehicles will need to be addressed on a worldwide basis. The anticipated savings in claims costs could result in lower premiums, to the extent that it may become even more difficult for auto writers to remain profitable.
While significant progress has been made to improve pricing adequacy in the property lines, there still appears to be additional opportunity to improve price sophistication and risk management. Further segmentation in pricing, in the form of expanded use of by-peril pricing algorithms and greater detail in deterministic modelling, will need to continue to evolve and gain greater traction.
Fuelled by losses from the Fort McMurray wildfire, insured damages from Canadian natural catastrophes in 2016 topped $4.9 billion, which easily surpassed the previous record of $3.2 billion set in 2013, the Insurance Bureau of Canada has reported.
While primary p&c companies within Canada’s market were able to absorb these losses because of their robust capital positions and comprehensive reinsurance programs, the record damage reported in 2016 is part of an upward trend that shows no signs of abating.
Given the increased frequency and severity of catastrophic events that many attribute to climate change, Canadian insurers will remain challenged to improve their Cat risk management systems and controls.
Proper coding of loss exposure is essential to ensure meaningful model outputs are developed.
While most Canadian p&c insurers utilize sophisticated catastrophe modelling tools to provide loss estimates, careful monitoring of zonal and other specific aggregates, including “what-if” scenario testing using severe events in areas with concentrated exposures, are expected to be critical to understanding maximum potential loss.
Furthermore, strong catastrophe risk managers should integrate exposure data directly into the underwriting process and underwriting decisions should include the latest aggregate exposure position.
Most insurance companies, at some point, will need to grow to remain relevant in the marketplace, meet shareholder expectations (in the case of publicly traded firms) and ensure they can absorb costs in the future. However, prospects for growth in the Canadian market are limited as it is highly competitive and awash with capacity after several years of strong operating performance.
In order to achieve organic growth, some large insurers in the p&c market have broadened their distribution channels by introducing separate brands that write direct to the market, rather than through brokers. The intent is to reach a broader audience that is more tech-savvy and may not feel they need the involvement of a broker in their insurance decision-making.
Thus far, brokers seem to welcome the competition, provided that the direct writers market under different brands than those sold through the broker channels. Brokers also seem to realize that they need to provide some value-added services and make themselves more available to policyholders than in the past.
Nevertheless, mergers and acquisitions (M&A) remain the obvious route to growth. The desire to achieve scale or additional distribution channels continue to be driving forces of M&A activity within the Canadian marketplace.
Activity has been rampant in the broker segment as well, as brokers look to diversify their books, gain more geographical spread and increase their writings in a more efficient and rapid manner, while also finding synergies and improved scale in operations and common ground with former competitors.