Year 2005: End of the Hard Market

Year 2005 clearly marked the end of the hard phase of the insurance cycle in Canada’s property and casualty market. Direct writings for the carriers included in this survey were essentially flat, coming in at CD$35.3 billion in 2005 versus CD$35.1 billion in 2004. Underwriting expenses, led by claims and acquisition costs, were up 4.7% to CD$28.8 billion in 2005, over CD$27.6 billion in 2004. General expenses were down 4.9% over the same period, however, indicating that expense management, consolidation and investments in technology are beginning to pay off (and not a moment too soon). The above factors resulted in an 18% decline in underwriting revenue, yielding a combined ratio of 92.4% for 2005 compared with 90.5% for the same population of companies in 2004.

Despite declines on the underwriting side, a modest 8% increase in investment income and outstanding growth in recognized capital gains (up 84%) propelled the pre-tax income up 4.1% over last year – to CD$6.2 billion in 2005 from CD$6 billion in 2004. Net after-tax income was up 2.5% to CD$4.5 billion as compared to CD$4.4 billion a year earlier. The overall ROE, however, declined to about 18% in 2005 from 21.1% in 2004, reflecting the larger capital base.

Capital outflows to shareholders and returns of funds to home offices rose 79% in 2005 to a record total of CD$2.6 billion, while inflows declined 58% to CD$409 million. These numbers are skewed somewhat by movements in vested excess funds for Lloyd’s; such funds accounted for over half a billion dollars in 2005. Excluding Lloyd’s, outflows rose 61% to $2.1 billion. Lloyd’s repatriation of funds was the largest one reported. However, several other companies returned significant amounts of capital. The largest are included in Figure 4 (Page 36)

Despite these outflows, overall capital in the Canadian market rose 10%, to just above CD$26 billion, translating into a still-rich MCT score of 249 in 2005 versus 238 at the end of 2004 (but down from 256% midway through 2005).

BREAKING EVEN

As anticipated in Barb Addie’s article, ‘PfADs or PfATs,’ which appeared in Q3-2005 MSA/Baron Outlook Report, reserve adjustments were generally positive. The overall industry, excluding Lloyd’s, registered CD$943 million in favourable development on an undiscounted basis. This translates into about 3.2 points on the combined ratio. Without the positive reserve development, the industry’s combined ratio in 2005 would have been around 95.6%. Unless further releases of this magnitude are in the offing, the starting point for 2006 combined ratio forecasts should be around 96%. This is getting awfully close to the break-even point on the underwriting side, considering price softening and claims inflation and projected increases in auto claims frequency.

EARNINGS PIPELINE: ALL INDICATORS NEGATIVE

MSA’s earnings pipeline chart, which graphs net written premiums as a percentage of net earned premiums, shows that all major lines of business are in the ‘softening range.’ That is, fresh premium writings, which will be earned over the next 12-18 months, scarcely replace current earnings. In the wake of the premium rollbacks mandated – and un-mandated – by regulators in most provinces, auto writings are showing the most pronounced degree of ‘softening’.

Commercial lines also show weakness, though the earnings pipeline chart for ‘commercial writers only’ shows a measure of hardening in commercial property premiums – perhaps in reaction to the large claims experienced both in Canada and the United States last year and their attendant reinsurance charges. The fact that commercial property shows weakness in the ‘industry total’ chart indicates the large multi-line writers may be undercutting their pure commercial competitors. Casualty pricing is also entering a softening phase, reflecting the current competitive environment.

In conclusion, all things being equal, we believe this softening phase will continue into 2007. We also believe that the softening will much more muted this time around, for the following reasons:

* Declines are starting from a higher base than any time in recent memory.

* Interest rates remain low.

* Increased consolidation and increased local financial market awareness of the P&C industry.

* Lessons learned from the previous soft market (for what that’s worth).

* Increasing catastrophic frequency and severity.

* Expected increases in auto claims frequency.

* Hardening in the reinsurance market, at least on the cat side and

* Rating agency pressures.

The above article is excerpted from the Q4-2005 MSA/Baron Outlook Report

Logjam: Mergers and Acquisitions

Dividends notwithstanding, the industry is sitting on excess capital of between CD$4.7 billion (at a target MCT of 200%) and CD$6.7 billion (at a target MCT of 180%). With the obvious target companies now gone – The Citadel to Axa and L’Unique to La Capitale – the question ‘Who’s next?’ is uppermost on industry watchers’ minds. Three or four years ago, you couldn’t give companies away. At that time, buyers weren’t to be found and their spending ability was curtailed by financial stresses in Canada and overseas. Now the reverse is happening: large buyers with unprecedented access to capital are having a hard time finding meaningful acquisition targets at reasonable multiples. For example, Axa purchased The Citadel, a modestly attractive target, at approximately 1.5 times book. More appealing targets are demanding multiples of 2 times or higher. Asking prices are unlikely to come down any time soon, unless sellers run into serious difficulties or the market turns abruptly soft.

This makes for difficult purchasing decisions, because the acquired ‘goodwill’ will inevitably drag down the buyer’s ROE for a while. At the same time, sitting on a pile of excess capital for long doesn’t do any good either. Strategic long-term decisions may be taken despite medium-term economic disadvantages. Those that benefit immediately will be the sellers and perhaps other players who can pick off chunks of brokered business previously directed at the acquired company (assuming the target is a broker company).

Having successfully absorbed Allianz, ING is turning its attention towards further growth through acquisitions. At year-end, ING was sitting on about CD$500 million of excess capital. In addition, last September, ING filed a short form base shelf prospectus allowing it to raise up to $1 billion in additional capital (via common stock, pref shares and/or debt). That’s a lot of ammo.

ING’s excess capital, growing by the day, cannot be easily stowed for long: it is a drag on their ROE. And unlike other foreign players, ING cannot temporarily return the capital to its parent, since 30% of any upstream dividend will have to be paid out to its TSX shareholders. ING will likely bite the bullet and make an acquisition, even at an un-accretive price, in order to pursue its long-term growth objectives and to solidify its leadership position. The perception that ING will move at these prices is grist for the M&A mill, playing into sellers’ hands.