December 1, 2003 by Bob Tisdale, President and COO of Pembridge Insurance
For many insurance providers (agents and brokers), the market of “last resort” in the form of the Facility Association (FA) has become the “only game in town”. Based on this obvious capacity problem and the “red ink” flowing from the FA, it is fair to say that the property and casualty insurance industry does indeed have a problem!
The real question that needs to be addressed is just what is the FA? Why is the FA writing so much business? And, why is it often writing it at prices below those of the voluntary market? The FA is an association of insurance companies operating in a particular province or territory. These companies as a requirement of their license to operate must be members of the FA. They must therefore share the FA business (premiums and losses) based on their own relative percentage stake of that jurisdiction’s auto insurance marketplace.
In any market operating efficiently, product availability is never an issue. Prices may be high but someone will always sell it (supply). How many will buy it and at what price (demand) is another question. This is “basic economics” of how competitive markets work. Quite simply, an efficient market for automobile insurance (supply and demand) does not exist today.
In any market, capital is risked by investors looking to generate a return on investment. The “riskier” the opportunity, the greater the expected return. This basic principle applies to the insurance market as well. The greater the propensity for a claim, the greater the risk factor, consequently the higher the premium charged.
In this respect, insurers target different market segments. For example, risk averse companies target the “better” (standard or preferred) risks. In times when the market is functioning efficiently, these companies compete through pricing strategies, geographical preference, underwriting guidelines and marketing techniques. The goal of these lower risk markets is to obtain the business with the desired risk profiles that meet their risk threshold.
Conversely, companies with a greater appetite for risk target the mid to high-risk profiles. Through stricter underwriting guidelines and higher price strategies, these markets focus on the risk segments they believe will provide an adequate return for their increased risk taking. In doing so, these companies accept the fact that there is a greater likelihood of loss (frequency) and greater loss (severity). By charging higher premiums and applying stricter underwriting and claims interpretations, these markets attempt to capture the residual segment of the market.
The low-risk companies define the difference between the standard market risk profile and the residual market profile. Once the parameters of the standard market have been established, the residual market defines the balance of the competitive marketplace. When the market is competitive, risks outside of these two segments are left for the “market of last resort” – being the FA. When the overall market is operating efficiently and adequate underwriting returns are being made, the FA market segment tends to be small. This makes sense as the true high risk segment of drivers is much smaller than the standard segment. In fact, in markets such as the U.K. or in the U.S. state of Illinois, residual markets are almost non-existent. This is prime evidence that in markets which are not overly regulated, private market efficiencies will provide capacity.
When market “interference” takes place, market efficiency breaks down. Interference is usually noted by things such as inadequate or outdated legislation, cumbersome price-making mechanisms or social inflation. Evidence of these facts is prevalent in the massive FA increase in all jurisdictions in Canada where it operates. This interference causes new market dynamics to occur.
Competitors faced with these new dynamics look for alternative ways to segment their book of business. This is done usually through underwriting restrictions and volume controls. Risk appetite lessens, and the residual market begins to be populated by risks that were previously considered standard risks. Residual markets begin to see more middle market risks being offered to them. At the same time, more risks begin to populate the FA.
Market dynamics are constantly shifting due to continued market interference. This is especially true of auto insurance because of its significant political overtones. As auto insurance is a compulsory purchase, survey data tells us that insurance products – and therefore the companies that provide them – are unpopular with voters. By imposing so-called “consumer friendly” regulations on the players in the marketplace, governments influence the market’s efficiency.
The recent actions of political parties trying to “fix” the current auto insurance market problems, ignores some of the realities of the competitive market concept. In most jurisdictions in Canada, there are numerous insurers writing auto business. Each company looks to find its own niche in the marketplace. These markets could, if permitted, provide a fairly efficient marketplace.
However, market efficiency is not being permitted primarily due to political interference. Citing affordability issues, pricing and regulatory controls are often touted by politicians as the answer to control costs. Once political interference begins to take place, market efficiency breaks down. The best noted example of this is cross-subsidization of high risk drivers and artificially low prices in the FA.
With an increasing level of risks going into the higher price categories, and prices rising for the lower risks, a “breaking point” in the market emerges. While this is happening there is substantial market disruption (as noted today) and the majority of drivers will pay higher premiums than they would have in an efficient marketplace.
Under such circumstances, the FA then becomes an even bigger factor in the market. This is because it was created to ensure that “market availability” existed. In other words, to provide consumers with a market of “last resort”. Last resort means the ability to obtain basic coverage irrespective of driving record, age or gender.
Current market conditions have resulted in an increasing number of risks being channeled through the “market of last resort”, which the voluntary market members are called upon to replenish ever increasing FA income losses. Capital must flow from the voluntary market to offset the members’ portion of the FA loss. This reduction in capital causes market underwriting to be even more conservative. Less capital means less business which means less risk. In turn, more risks are exposed to the FA. This spiral increases until a point of crisis is reached. This moment is usually denoted by public outcry about rising insurance costs resulting in government intervention. Sound familiar?
What can be done to avoid this scenario? For one, in order to alleviate some of the stress on the voluntary markets, government and auto insurance regulators need to be more proactive. Regulators need to change the way the FA creates it rates.
To avoid the ongoing crisis cycle, regulators need to work with the voluntary markets to allow the FA to revert to what it was created for. To achieve this goal, the cross-subsidization of higher risk drivers by good drivers must stop. In other words, the FA must not compete in the marketplace. FA rates must always be the highest in the market. And, they should only be filed for risks that the voluntary market refuses to write. For all other risk, the FA rates should be a factor of the highest rate applicable in the voluntary market. For example, “company A” will write a specific risk for a rate of $800. The FA rate should then be set at $800 plus an established cost of capital and return on equity charge.
The voluntary market participants define and price specific risk profiles. The profiles and pricing are established by actuaries and submitted to regulators. Once these prices and profil
es are approved, it is not necessary to have the FA do the same thing. This is a duplication of effort and cost. If voluntary markets will write a risk then that risk should not find its way to the FA. Furthermore, establishing FA rates above the voluntary market gives the consumer an incentive to shop for the best available price. An FA quoted price will indicate to consumers that a lower price is available in the marketplace.
The simplistic reverse argument to this concept is that today there simply is no voluntary market available. The FA is growing because companies are refusing to write business. The real question is why are companies behaving like this? The answer is that insurers are not generating returns on their capital. To generate adequate returns, companies need legislation which slows or halts the rising cost of claims.
Removing the requirement for the FA to file rates that voluntary markets write gives the voluntary markets some degree of flexibility in establishing their own rate ceilings. They can do this without waiting for the FA to establish the price ceiling under which they must compete. In addition, FA rates must be established with a cost of capital and return on equity factor built in. How much the capital costs are should be determined by using the same capital tests voluntary markets face from the Office of the Superintendent of Financial Institutions (OSFI). Once the level of necessary capital is determined, an appropriate capital charge can be created.
Once the cost of capital is known, a ROE expectation that considers the higher nature of FA business can be established. Moving forward under this scenario would ultimately create a full user-pay system. It would lower the cost for the better risks, remove the FA as a competitor and still provide a market of “last resort”. For the majority of drivers, this would be a positive step forward. These drivers would receive a premium rate more reflective of their own inherent risk profile, without the extra cost of the cross-subsidization charge.
For other drivers, this method of pricing adequacy will create affordability challenges. This unsubsidized price shock will drive up the numbers willing to risk driving with no insurance. Governments will have to face this reality with more stringent fines and an efficient method of mandatory insurance enforcement.
Like any proposal, there are no doubt debates and arguments which could be made around this concept. The underlying principle though is that the FA needs to stop competing in the market and revert to being the market of “last resort”. This can be accomplished by creating markets that are more efficient in the way they operate.
It is clear that a solution to today’s problems is attainable. The solution is not having artificially low rates at the FA. The solution is less regulation and a willingness by governments to work with the industry to create a freer marketplace. This will result in greater road safety and lower premiums for the majority of consumers.