Rocky Terrain

Industry results¹ for the full year of 2008 reflect a confluence of negative factors, many of which continue to plague the industry into 2009. The most obvious — and the most notable — of these factors are:

• the severe deterioration in underwriting profitability affecting both personal lines insurers and commercial writers;

• the market meltdown in 2008 Q4, which drove down industry capital and fair valued assets, and;

• historically low interest rates that constrain insurer ability to provide respectable returns without achieving combined ratios below 90%.

Underwriting results deteriorated across most major lines of business in 2008, most notably in property and auto.

Personal property results deteriorated in most of eastern and central Canada, while commercial property results were worse across the entire country (save for Manitoba). As reported in our Q3 report, personal property suffers from underpricing and inconsistent underwriting inputs, coupled with Guaranteed Replacement Cost (GRC) features. Commercial property results, although worse than in 2007, remain profitable overall.

Ontario auto was (and is) particularly dreadful; the overall direct Ontario auto loss ratio hit 84.4% for the year. The mandatory components, especially accident benefits, are running at loss ratios well in excess of 100%. The Financial Services Commission of Ontario (FSCO) issued its report and recommendations on Mar. 31, 2009. The report acknowledges the underwriting challenges facing insurers. However, taken in their entirety, the recommendations appear to fall short of addressing insurer profitability issues in a meaningful way. The upshot is that insurers in that market need to continue going for rate to stave off ongoing losses.

The 2008 combined ratio for the commercial writer population clocked in at 94.9%, climbing 11.2 points from the 83.7% COR of 2007. (See Figure 1 on Page 23.) If we strip out prior-period reserve releases, the result is grim: an AY-2008 COR of 102% for commercial writers. Results were worse across all major lines for commercial writers. The boiler and machinery (B&M) line was hit particularly hard: it saw its 2008 net loss ratio skyrocket to 84.4%. This is due largely to high losses in the B&M line for FM Global, the largest writer of this line in Canada. Still, we do not believe these results will usher in a robust hard commercial market. The reasons for this assessment are as follows:

• unlike personal writers, commercial writers are reporting wide variations in results across the spectrum; some companies continue to enjoy — or at least are appearing to enjoy — strong underwriting results. The lack of uniform misery in commercial lines means that although some players desperately need to raise rates, competition is keeping a lid on hardening;

• competition from multi-line insurers seeking relief from Ontario auto etc;

• aggressive battles for turf by some players; and

• recessionary pressures are limiting buyer ability to absorb significant rate increases.

The 2008 combined ratio for personal and multi-line insurers deteriorated less than that of commercial writers, but from a higher base, clocking in at 103.5% (up from 97.1% in 2007). (See Figure 2.) Again, stripping out prior-year reserve releases reveals a 2008 accident- year combined ratio of 106.4% for personal writers. This is an unsustainable run-rate in such a low-interest rate environment. Further, on a comprehensive income basis — after taking fair values of ‘available for sale’ instruments into account — personal line and multiline insurers posted a Cdn$800-million comprehensive loss at the end of 2008, versus a Cdn$1.7-billion comprehensive gain in 2007. Hardening is taking hold here, but it is far from sufficient.

Solvency Ratios Strong, But…

Thankfully, most insurers entered this tough phase in the cycle with strong levels of capital. The battering companies have taken on both the underwriting and investment fronts have caused most MCT and BAAT levels to decline; however, for the vast majority of companies, they remain at robust levels. Some companies, however, are susceptible to capital deficiencies. Presumably the regulators and the industry’s guarantee fund, the Property and Casualty Insurance Compensation Corporation (PACICC), are keeping a vigilant eye on these companies. There are some concerns about smaller provincial players that are exposed to unprofitable books of business, adverse reserve development patterns, limited pricing power and/or lack of access to external sources of capital.

2009: EYES ON THE WHEEL

We see little reason to expect things to get much better on an industry-wide basis in 2009 for the following reasons.

Ontario auto

We expect writers to continue bleeding here. As one CFO mentioned, if we were already living under IFRS, auto insurers in Ontario would have to book losses the minute they wrote an additional auto policy in the province. FSCO’s recommendations have not come into force yet; even when they do, they do not promise relief.

Uncertainty regarding judicial decisions on the constitutionality of minor injury caps in Alberta and Nova Scotia

Both lower court decisions are in appeal and will likely find their way to the Supreme Court. If the Alberta decision is ultimately overturned, a significant chunk of loss reserves will be released into income. If, on the other hand, the decision is upheld, insurers will find their reserves and rating models wanting. The lower court decision in Nova Scotia was in the industry’s favour. If that decision is ultimately overturned, insurers there will bear a reserve and pricing hit.

Commercial lines

Price firming is not yet taking hold. Competition is fierce. And with the implementation of Part XIII of the Insurance Companies Act scheduled to take place in 2010 Q1, competition is expected to become intensified, especially for larger risks.

Global firming in reinsurance pricing is happening and it is affecting Canadian cedants

We expect reinsurance will continue hardening for the foreseeable future as global players like Swiss Re, XL Capital and others seek to fortify their bruised balance sheets. We don’t believe reinsurance pricing is influential enough to make much difference in primary commercial casualty pricing at this time, but it may have some effect on catastrophe-exposed property writers.

FROM ORANGE TO RED

Netherland’s troubled ING Groep’s exit from Canada’s insurance scene in February of this year — with the distressed sale of its 70% share of ING Canada Inc. to the public and via private placement to institutional investors — heralded the birth of a domestic property and casualty industry leader under the new name Intact Financial Corporation. The management team remains under the stewardship of Charles Brindamour.

Intact2 was the largest property and casualty group in Canada in 2008, with direct writings of Cdn$4.1 billion and net earnings of Cdn$96 million. Like other insurers, Intact’s underwriting income and net income declined substantially as a result of underwriting conditions, lower investment income and investment losses.

Intact’s debut seems to have gone well, however. The IIC shares (soon to be quoted under the IFC ticker) held up and have gained substantially. (See Figure 3.) The institutional investors that got in on the $25 per share price of the private placement on Feb. 3 have since seen their shares gain 37.6% by April 21. The common shareholders that bought at a higher price (the bought deal was priced at $26.35) still have done very well since then. The upswing reflects the distressed pricing on ING N. V.’s exit and the March/April rally on the TSX.

The stock still faces some headwinds in th e form of the overhang of private placement shares that will only be able to be traded in June, as well as the general problems in the Canadian property and casualty industry from which Intact is not immune.

1 This survey is based on 204 reporting entities for which MSA Research Inc. had data at time of writing. These companies represent in excess of 95% of Canada’s primary insurers when measured on a net premium written basis. Excluded are most reinsurers whose filing deadline is mid-April, ICBC and MPI. Some of the exhibits in this study further exclude Lloyd’s Underwriters and Genworth Financial Mortgage Company of Canada due to the distortions they introduce.

2 We refer to the company as ‘Intact’ even though results for 2008 and prior were reported under the ING shingle.

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Taken in their entirety, FSCO’s recommendations for Ontario auto insurance reform appear to fall short of addressing insurer profitability issues in a meaningful way.