The Thorn in Auto’s Long Tail

A rosier picture for auto insurance in key regions such as Atlantic Canada, Ontario and Alberta is masking uncertainties in the reinsurance marketplace, particularly when it comes to the excess of loss line of business. While consumer rates are coming down in most provinces and stability has returned in the form of improved loss ratios, several reinsurers point out that severe injuries, long-tail trends for prior accident years and reserving at the primary insurance level could create problems in the auto insurance market.

Auto insurance accounts for over one-half of the Canadian property and casualty market in terms of net premiums written, or well over CD$15 billion. Primary insurance companies rely on reinsurers to backstop auto coverage, particularly for catastrophic injuries that can end up costing well over CD$1 million.

While media attention has focused lately on natural disasters in the United States – especially after several devastating 2005 hurricanes, and what looks to be a difficult upcoming season – the Canadian market has not experienced severe catastrophic losses relative to what’s happened in the global market. Last August’s rainstorm in Ontario caused more than CD$500 million in insured losses and flooding in Alberta resulted in widespread damage, but there have been relatively minor rate increases for reinsurance catastrophe treaties. Where reinsurers are feeling the pinch is in the auto excess of loss line of business.

“Basically, our most challenging product line has been auto excess,” Andre Fredette, senior vice president of Caisse Centrale de Rassurance (CCR) Canada, says. “We regularly see claims from two to five years ago coming on the radar screen and hitting the reinsurance layers. If it was a CD$800,000 claim five years ago, it is CD$1.5 million today.”

Pierre Michel, Partner Re’s chief agent for Canada, says Partner Re has “seen a general increase in the number of claims exceeding thresholds such as CD$2 million, CD$3 million or even CD$5 million over the last 10 years.” Michel says there are inherent challenges in long tail pricing, because it is often difficult to predict accurately the future outcome of claims that have not yet occurred and that will remain open for years before final settlements are reached. David Wilmot, senior vice president and chief agent in Canada for The Toa Reinsurance Company of America, says Toa is seeing patterns of very late reporting of catastrophic injury claims. “And then after the reporting, even though they are recognized, they continue to develop quite seriously for years into the future,” he adds.

The implementation of caps on soft tissue injury legal awards for pain and suffering in Alberta, New Brunswick and Nova Scotia, and treatment frameworks in Ontario for whiplash-related injuries, appear to be keeping small claims under control. For example, the CD$2,500 cap New Brunswick introduced in 2003 has resulted in a 40% decrease in third-party liability bodily injury costs, according to one actuary. This trend has allowed insurance companies to reduce rates in virtually all regions.

But the reforms haven’t addressed the issue of catastrophic injuries and how they impact the industry. Many of the auto losses that hit reinsurance layers are severe injuries, particularly in Ontario, and serious trucking accidents in the U.S. Several reinsurers are asking questions about adequate claim reserving at the primary company level, late reporting of severe claims, the impact of medical/health care inflation on claims and the need for re-pricing in certain excess layers.

The auto market represents a double whammy for reinsurers in the current cycle. First, primary companies are reducing auto insurance rates, thereby lowering the premium base available for reinsurers. That means they have to get price increases on excess of loss from a smaller piece of the premium pie.

“The reform legislation in various provinces is pushing quite clearly towards more money going into larger claims,” Wilmot says. “This has an interesting effect on the excess of loss reinsurer. I have to charge more because the big claims are going to be bigger, but the subject premium on which I apply my rates has gone down.”

While many primary companies don’t agree with or understand why excess of loss rates are going up in a softer auto insurance market, Fredette says the reasons are compelling. “It is the old story of ‘Once burned, twice shy’ for reinsurers,” he says. “The typical two-year lag before companies recognize the true extent of their losses has given reinsurers the impression that they are only seeing the tip of the iceberg in the renewal submission. Consequently, they are pricing the product on exposure rather than experience.”

Even “normal” inflationary trends will naturally produce larger claims in the future, increasing the number of claims exceeding specific stated thresholds,” Michel notes. “Reinsurers must price for this increasing exposure, which is sometimes difficult to sell to cedents purely based on known past results. Ours is a prospective business and prices must reflect future risk potential.”

THE ART OF INFLATION

The “normal” medical inflation trends represent what Wilmot calls “a triangulation of development” for excess of loss reinsurers. “Let’s say the average claim that does exceed CD$1 million is CD$1.2 million,” he says. “If you take medical inflation, which is about 6%, and add that onto the CD$1.2 million, it quickly becomes CD$1.272 million. The rate of inflation for the ceding company is zero, but for the reinsurer, the inflation goes from CD$200,000 to CD$272,000, which is 36%. That’s the mathematics of being an excess of loss reinsurer.”

Precise statistics on severe injuries are difficult to carve out of general loss ratios and industry claims figures. The general primary insurance sector loss ratio for auto insurance has been declining in recent years – from 85.6% in 2001 to 65.1% in 2005. However, the average auto loss ratio for reinsurers for the past five years is about 93%. These numbers do not specify the type of claims, particularly for accident benefits and bodily injury.

According to Mark Yakabuski, the Insurance Bureau of Canada’s vice president, Ontario region, this lack of data will be addressed shortly through a new health claims database on medical/rehabilitation expenses. The government is expected to establish the database in the future. In the meantime, there are few concrete statistics available.

“We do not have the kind of data (on catastrophic injuries) that would be an immense benefit to primary insurers, reinsurers, government policymakers and health care associations,” Yakabuski says. “That leaves us with an intuitive sense of what is happening out there. There is no doubt the average cost of an AB claim has been rising, despite the fact that total medical/rehab expenses have been declining since 2003.”

CATS CONTINUE STRONG

Reinsurers have witnessed this development first-hand, according to Wilmot. “We have heard a lot about the reduced number of losses for smaller claims and fender benders,” he says. “As much as that is true, we are not seeing that in catastrophic injuries. These numbers are not decreasing.”

Fredette, Michel and Wilmot point out the experience in Ontario auto is particularly challenging: it is not uncommon for a single, severe injury to hit layers beyond CD$3-4 million. Frequently, the courts are called upon to issue determinations of catastrophic impairment and the consequent benefits available.

CAT IMPAIRMENT REDEFINED

Court awards, such as in Desbiens v. Mordini (2004), have expanded the definition of catastrophic impairment to include psychological disorders and pre-existing injuries. This important decision essentially provided guidance on how the catastrophic determination is to be made. And it has changed many of the approaches and rules that insurers, lawyers and independent medical examiners have been using when determining cat
astrophic impairment.

Traditionally, a severe or catastrophic injury has been defined as any impairment or combination of impairments that results in 55% or more impairment of the whole person, according to the American Medical Association’s Guides to the Evaluation of Permanent Impairment. However, the guide assigned no percentages to mental or behavioral disorders.

Phillipe Desbiens, who was seriously injured in a car accident, was not considered to be “catastrophically impaired” because he was assessed with a 40%, whole-person impairment. However, in his ruling, Ontario Superior Court Justice Harvey Spiegel said that psychological impairments could be given a percentage, in this case 25%.

“I find that it is in accordance with the Guides to assign percentages to Mr. Desbiens’ psychological impairments and to combine them with his physical impairments in determining whether he meets the definition of catastrophic impairment,” Justice Spiegel ruled. “The drafters (of the auto insurance legislation) clearly intended the definition of ‘catastrophic impairment’ to be inclusive rather than restrictive.”

Yakabuski notes there has also been an increase in applications for access to catastrophic benefits in Ontario. “This is something we have to monitor very closely,” he says. “We have suggested to the superintendent of insurance that an adjustment to the catastrophic impairment regulation would be appropriate. But I think the regulator would like to see more of a real indication that there has been a change in the pattern of catastrophic claims.”

It is also a concern for excess of loss reinsurers, who see the results of increased applications and revised catastrophic impairment definitions. “One of the difficulties related to writing this business is the changing court interpretation of injuries, coverage and expected response of the insurance policy,” Wilmot says.

“Recent court cases have revealed the potential for higher awards,” Michel notes. “Lawyers will continue to explore areas to increase claims amounts.”

To counteract growing claims costs, several reinsurers are moving away from lower layers to mid-level and upper layers. Whereas in the past it was relatively common to see CD$1 million in excess of CD$1 million, now there is a tendency to move to CD$3 million in excess of CD$2 million. Increasingly, reinsurers see auto excess under CD$3 million as “working” layers and are re-pricing according to the exposure, Fredette says. Wilmot adds that the rate adjustment in auto excess is not a pricing correction but an acknowledgement that the target is moving.

PRIMARY COMPANY REPORTING SCRUTINIZED

Many reinsurers are also closely monitoring how claims are being reported at the primary company level. “More and more, we are doing claims audits or reviews to go in and see the reserving practices at the companies,” Fredette says. “We need to get a sense if they are putting up an amount that shows the ultimate potential of a claim early on.”

Reserving by primary companies or putting estimates of all future claim costs that have not yet been paid, is a bone of contention with some reinsurers. While the reserve development for the insurance industry in Canada was favorable in 2005 (CD$943 million on an undiscounted basis), some of the under-reserving sins of the past are still being revisited upon reinsurers. In each of the years from 2001 to 2004, there was negative development on prior year claims, with insurers pumping CD$904 million into reserves in 2002 in particular, mainly for auto claims.

“Part of the problem was that companies themselves were not reserving correctly,” Fredette says. “Let’s face it, if the company tends to be slow in putting up adequate reserves, they end up with three or four years of cheaper reinsurance, because they presented a rosier picture for reinsurers than they really deserved.” Many primary companies have improved their reserving, he adds, while others are still doing “step reserving, which [means]: ‘Put up a bit now, and then put up a bit later when we are forced to.'”

Reserving for prior year claims is a challenging task insurers constantly address, according to Yakabuski. “There is no doubt that getting the reserving right is an art,” he says. “It is something that insurers have to be preoccupied with as they look at prior accident years.”

Some reinsurers, Wilmot says, are even walking away from auto excess business in general. “It is difficult to keep on writing this business and there are a reduced number of reinsurers doing it,” he notes. “There are many reinsurers who have decided it is too hard to do, too uncertain or too underpriced. We do write this line of business, but we find that we cannot always write it.”

Concern has been expressed about how changes in the auto excess reinsurance line will affect capacity in auto insurance in general across the country. Industry observers will be keeping an eye on this as consumer rates continue to come down and catastrophic injuries emerge from previous accident years.

“We have to be vigilant to manage effectively smaller injury claims, but we cannot lose sight of the fact that the severity of these claims is growing substantially,” says Yakabuski. “It continues to grow despite our ability to manage health care related claims. Ultimately, it has to be a matter of concern to policymakers if we are to maintain the goal of stability in the auto insurance system.”

Fredette notes that “some reinsurance brokers are worried there is shrinking auto capacity. There is capacity – but not at the old price.”

Like insurance, reinsurance is a cyclical business, Michel says. “Problems in long-tail business are slower to emerge, but corrections eventually take place. I think we all recognize which part of the cycle we are in today.”