Sailing Through the Storm

Amidst the current economic turmoil, the Canadian property and casualty industry is stable, but not without its challenges, delegates attending the A. M. Best’s Review & Preview Canada conference in Toronto heard.

Charles M. Huber, a senior financial analyst with A. M. Best, presented his rating outlook for the Canadian property and casualty market at the conference. His analysis came a few days after insurer giant American International Group (AIG) announced its exposure to the credit default market, and subsequently received more than US$100 billion in loans from the U. S. Federal Reserve to forestall bankruptcy.

“In our opinion, the [Canadian] market is stable and the key to this stability is the strong capitalization in the industry,” Huber said. “We believe the industry is well-capitalized to withstand the many challenges in the underwriting and investment markets today.”

But expect capitalization to weaken (because of the somewhat-reduced profitability of underwriting income), as well as increasing net loss ratios that are expected to continue on all major lines, Huber cautioned.

Based on data A. M. Best gathered from approximately 220 companies, the industry’s 2007 net income was approximately Cdn$4.6 billion, marking a decrease of 3% or 4% over 2006, he said. “Through the first six months of 2008, however, the net income is only Cdn$1.2 billion, which is down 37% compared to the first six months of 2007.”

Huber attributed the significant decline to lower underwriting income and lower capital gains. “So, the not-so-rosy picture on the underwriting side is putting greater reliance on companies’ investment earnings.”

The volatility in the equity markets is going to challenge companies’ investment managers to better manage their investment portfolios, Huber said. “Lower underwriting earnings is also going to result in slower growth in invested asset bases,” he noted. “This is also going to hinder investment growth.”

Huber said the increasing cost of auto claims, the increased frequency and severity of storm activity, construction cost inflation and the continuing softening in commercial lines pricing will also pose serious challenges to the industry.

De-leveraging plays out

The economy is in the very early stages of a de-leveraging process that has yet to fully play out, conference delegates heard from panellist Michael Taylor, the vice president and associate director of fixed income product management with Wellington Management.

Leveraging is the degree to which a businesses or investors are relying on borrowed money or debt.

Taylor noted the de-leveraging process, in which insurance companies attempt to shed debt from their books, can be expected to generate volatility.

“How much volatility is generated by this de-leveraging will depend on its speed,” he added. “A gradual de-leveraging will allow the industry to earn its way out of its bad asset problem. A rapid de-leveraging will cause liquidity shocks that could ultimately lead even solvent institutions to experience the types of things that we’ve seen recently.”

Either way, moving forward, the cost of capital will increase and the availability of capital — even to credit-worthy borrowers — will be lower, he predicted. As a result, consumer spending and economic growth would both decrease.

Consumer-driven recession

Taylor observed the current economic recession is different from past ones. Previous recessions have been primarily investment-driven recessions, whereas this one is a consumer-driven recession, he said. Investment-driven recessions are typically cured relatively easily, by a change in short-term borrowing rates for companies. Lower interest rates will make projects more viable and spark an increase in investing. On the other hand, consumer recessions tend to feel much worse and they tend to be much more protracted in length, he said.

Taylor noted that today’s consumer tends to be over-leveraged, has not seen significant increases in pay in the past decade, is now experiencing no mortgage gains and has had his or her confidence in the financial markets shaken. That means they will be less likely to invest in markets or spend money, even with tax cuts and lower interest rates.

For Taylor, the good news is that nonfinancial companies are entering this slow-down in consumer spending in better shape than they would have in the past. “Leveraging of non-financial corporations is much lower,” he said. “They should be better able to withstand the higher cost of capital and the restraints of the borrowing environment.”