Swimming in Capital Again

The Canadian P&C industry (excluding ICBC and Lloyds) held approximately $22.8 billion in capital available to support its regulatory ratios at the end of 2004. This is up from $19.1 billion in 2003. MCT and BAAT levels in turn have increased from 227% in 2003 to 243% in 2004 to 256% as at June 30, 2005. The bare-bones regulatory minimum for these tests is 150%. However, OSFI requires insurers to set targets that are greater, typically 170%-210% (higher for reinsurers).

Regulators would be happy to have insurers maintain their ratios at these levels, but let us assume they would be satisfied at an average industry MCT/BAAT of 200%. Under this scenario, the industry’s excess capital more than doubled from about $2 billion in 2003 to $5 billion at Q2-2005. If the target were set at 180%, the excess capital at mid-2005 would exceed $7 billion. We expect capital to continue building through the remainder of 2005 despite the slowdown and the recent setbacks (Suncor, Katrina and Canadian storm activity).

Net dividends to shareholders and branch transfers to head office slowed during the distressed times of 2001 and 2002 and started ramping up in 2003-04. However dividend payout ratios (i.e. the ratio of dividends paid out to owners for Canadian companies, or net transfers to head-office for foreign branches, to net income) are at relatively low levels not seen since 1996.

The holdback in capital may be attributable to several factors. The most straightforward is the desire to rebuild battered balance sheets after the disastrous years of 2001 and 2002. Less obvious motivations include a desire to bulk up in advance of a slowdown. During the last downturn, some foreign-based parents suggested their Canadian subsidiaries should not expect automatic bail-outs, emphasizing that they should strive to solve their “Canadian problems” with their own resources. The most public occurrence of this was in early 2002 when Allianz A.G. announced that it no longer extended explicit support to its Canadian subsidiaries Allianz Insurance Company of Canada and Trafalgar Insurance Co. This resulted in rating downgrades of the Canadian subsidiaries and the eventual sale of these companies to ING. Management of other foreign-owned Canadian subsidiaries wishing to avoid similar fates may lobby to maintain elevated levels of capital in Canada in advance of softening markets to bolster their chances of successfully riding out the next downturn “on their own.” The strong Canadian dollar doesn’t hurt this argument either.

Canadian mutuals have little – if any – access to external sources of capital. Their accumulation of excess capital should be seen in this light. Canadian mutuals had an MCT of 302.6% at the end of 2004 (310% in Q1-2005). Assuming a regulatory acceptable target of 200%, the small clutch of Canadian mutuals led primarily by Wawanesa – and to a lesser degree, Economical Insurance Group (EIG) – are sitting on about $1 billion of “excess capital.” This situation presents them with serious deployment considerations. Attempting to organically grow market-share to leverage this capital would be inadvisable, as it inevitably would cause the rather disciplined softening that we are now seeing unravel. The M&A route beckons, but finding accretive acquisition targets is not simple in an environment in which there are more buyers than sellers; this results in rather unattractive multiples.

Although this is not on anyone’s radar at the moment, demutualization may be one answer in the long-term. Demutualization would allow the largest of these mutuals to operate on leaner capital while maintaining some flexibility to raise funds as needs arise. Successes on the life side with Manulife, Sun Life, Industrial Alliance, Canada Life and Clarica as well as the partial spin-off to Canadian public markets of ING Canada and Northbridge are surely not lost on the boards of Wawanesa and EIG.

As my old mentor, Don Smith of Canadian Insurance Consultants, says: “Beyond acquisitions, demutualization or returning capital to policyholders, there’s always the option of ‘doing nothing’ and accepting less than stellar returns on capital.”

Regardless of the reasons, the present industry-wide capital overhang of between $5 billion and $7 billion may prove hazardous to the market’s health by undermining underwriting discipline or stimulating a riskier investment stance.

ROOM TO SPARE

As the table below depicts, insurers have quite a way to go before the MCT/BAAT tests come under stress. In 2004, their investments attracted a capital charge equivalent to only 8.16% of available capital, down from 10.09% in 2003. The growth in (unearned) premiums and unpaid claims increased the nominal charge by slightly less than $1 billion, but the growth in available capital reduced the percentage charge for that element to 24.08% in 2004 from 24.67% in 2003. In fact, all elements, except for investments in fixed income instruments and reinsurance recoverables, attracted proportionately lower capital charges in 2004 over 2003.

All data sourced from MSA Researcher P&C 2005 Software www.msaresearch.com