A Mixed Bag

This article is an excerpt from the Q4/2007 MSA/Baron Outlook Report, which was released in April 2008. For information on the full report please visit www.msaresearch.com

Industry results at the end of 2007 confirmed our readings at nine months, with two main storylines emerging amid apparent healthy returns.

The first story is that companies exposed in any meaningful way to Ontario auto saw their results deteriorate in 2007. In fact, the direct accident-benefit loss ratio for Ontario cracked 102.9% in 2007, up more than 20 points over the 2006 figure, which stood at 82.3% for the same population of companies. This story is addressed in detail by Barb Addie’s article, ‘As Goes Ontario Auto…’ published in the third-quarter 2007 issue of the MSA/Baron Outlook.

The second story relates to the commercial lines arena, which is in the midst of cutthroat competitive pricing. Despite the plummeting pricing, underwriters have yet to bear the consequences due to relatively benign claims activity in the year. In the absence of these consequences, the soft-pricing saga is expected to go on for a while yet, to the dismay of brokers and underwriters alike.

THE BIG PICTURE

Before addressing these two storylines, let’s examine overall industry results. At first bush, they appear to be quite strong.

Figure 1 includes information on reporting entities as of Mar. 24, 2008 (excluding Lloyd’s and Genworth). The same population of companies is shown for prior years. To eliminate survivorship bias, the chart also includes historical data for primary companies that ceased writing business in 2006 and prior.

Premium growth in 2007 has (barely) kept pace with inflation at 2.7%; net claims, which benefited from Cdn$1.5 billion on prior-year releases, nevertheless grew at a rate of 5%. This, combined with a ramp-up in general expenses of 8.5%, resulted in a 24.5% drop in underwriting income on a calendar-year basis. A 7.1% up-tick in investment income buffered the bottom line, which dropped by about 4% over 2006.

OVERCAPACITY STILL A PROBLEM

Despite more than Cdn$3 billion in capital outflows via dividends and home-office transfers, industry capitalization continued its steady climb, reaching Cdn$30.8 billion at year-end 2007 versus Cdn$28.5 billion for the same companies in 2006 (refer to the green line in Figure 1). Minimum Capital Test (MCT) levels remained more or less stable at year-end. An abundance of capital, combined with a slight drop in income, conspired to lower the industry ROE to 14.7%, down from 16.9% in 2006 and 18.3% in 2005.

Overcapitalization is continuing to undermine underwriting discipline in Canada. As of the end of 2007, the industry (excluding Lloyds and most reinsurers) held more than Cdn$7 billion in excess capital, enough to comfortably support an additional Cdn$11 billion of net premium writings. Or enough capacity to write a replica of Canada east of the Ontario-Quebec border (Quebec and the Maritimes), plus another Manitoba and another Saskatchewan. For those who are Starbucks fans, we refer to this situation as “A vente in a tall cup.”

In Figure 2 (see page 28), we see overcapacity is present in the commercial lines arena (see FM, Northbridge and Chubb) as well as in the personal lines segment where, for example, Wawanesa has enough capacity to write more than Cdn$1 billion of additional business. Aviva and ING, on the other hand, are exhibiting tighter capital management by running on lower MCTs.

All in all, the capital bloat has been reduced by about Cdn$1 billion over 2006. The reasons for this include higher dividends, lower profits and the change in accounting standards. The direction is constructive, but the quantum of lazy capital in the industry remains remarkably high.

LOOKING AT LOSS RATIOS

For commercial writers as a whole, the net loss ratio improved by 3 points to 54.3% in 2007 from 57.3% in 2006. This is predominantly thanks in part to an eight-point drop in liability losses, to 53.7% in 2007, due to considerable favorable loss development (the 2007 accident-year liability loss ratio for commercial writers was 61.4%)

Although liability losses for commercial players were moderate in most regions, large spikes were witnessed in Nova Scotia and New Brunswick due to reported losses by Lombard, GCNA, LIU and RSA. Furthermore, hail and storm losses pummelled some commercial insurers in the prairies.

Results in British Columbia took a turn for the worse in virtually all lines. Auto results show a miniscule improvement, but these results do not include ICBC’s data, which will only be available later. Property results deteriorated, albeit more moderately than in other western provinces. In addition, Liability loss ratios in B. C. deteriorated by 16.4 points in 2007, bringing them very close to the national average of 56.6%, though from a very low base.

Similar deterioration was seen in PEI, New Brunswick and, to a lesser degree, in Nova Scotia.

Those looking for good news will find it in Quebec. Insurers there experienced improved results in property lines as well as in liability lines during the year.

Personal lines companies saw their overall net loss ratios deteriorate by 2.7% — to 67.1% in 2007 from 64.4% in 2006. This deterioration was most pronounced in the auto line, where the accident-benefit loss ratio ramped up 14 points to 94.4% in 2007 from an already troubling 80.5% in 2006. This is a result of the troubled auto regime in Ontario, coupled with curtailed rate growth.

There is little solace in looking to adverse prior-year development as the culprit (the running rate): the fresh 2007 accident-year loss ratio stood at 96.6% indicating that in fact the 94.4% calendar-year ratio actually benefited from slight favorable prior-year development. In addition to the AB run-up, personal and multi-line companies saw deterioration in commercial property, auto physical damage, liability and surety.

CLOUDY OUTLOOK FOR 2008

We expect results in most regions and lines to deteriorate during 2008 for the following reasons:

• Extremely inclement weather in heavily- populated regions of Canada during 2008 Q1. The impact on insurers will be seen when results are released in mid-May.

• The Feb. 8, 2008 decision by Alberta Court of Queen’s Bench Justice Neil Wittmann, which struck down Alberta’s minor injury Cdn$4,000 cap on nonpecuniary damages, has retroactive as well as prospective financial implications for auto insurers operating in Alberta. If the decision is upheld, additional unrecoverable claim costs will adversely impact results for insurers operating there; rates for compulsory coverage will need to rise substantially. It will also embolden challengers in Ontario and Atlantic Canada, causing financial as well as political travails for the industry there as well.

• Absent substantial rate-taking, we expect Ontario auto results to continue their downward drift in 2008. Furthermore, personal-and multi-line insurers looking to offset weak auto results will continue exerting downward pricing pressure on commercial lines. Cheap reinsurance capacity is also reducing discipline in the commercial arena.

• Volatility in financial markets will present insurers with further stresses.

Rest assured, we will be following these issues closely as the year plays out.