Is Profitability A Dirty Word in Insurance?

Catherine S. Swift, President, CEO and Chair of the Board, Canadian Federation of Independent Business and Director, The Empire Club of Canada; Reverend Canon Kimberley Beard, Rector, Christ Church, Brampton and Director, The Empire Club of Canada; John Chambers, Underwriter and Director, Non Marine Property, Aegis Energy Syndicate 1225; Jane Voll, Vice-President, Policy Development and Chief Economist, Insurance Bureau of Canada; Richard E. Clark, Partner, Stikeman Elliott; Julie Dickson, Assistant Superintendent, Regulation Sector, Office of the Superintendent of Financial Institutions; Nicholas Smith, Attorney-in-Fact in Canada for Lloyd's Underwriters; George L. Cooke, President and CEO, The Dominion of Canada General Insurance Company and Past President, The Empire Club of Canada; Loraine McIntosh, Partner, Deloitte & Touche LLP; Bryan Davies, CEO and Superintendent of Financial Institutions, Financial Services Commission of Ontario; Nancy I. Chambers, President, RIMS; and Kenneth.l. Mead, Executive Director, Guy Carpenter & Company Ltd.

Introduction by John Koopman

The ladies in our audience understand the difference between a man and a whole-life insurance policy. A whole-life policy eventually matures.

Solidarity is as old as mankind and it is at the core of insurance. Ever since mankind emerged from the darkness of unrecorded time, we have tried to soften the inevitable vicissitudes of life. Our ancestors understood that only through solidarity of the many could the unfortunate few be helped. Deuteronomy in 14:28 describes Moses instructing the people of Israel to contribute a portion of their produce for "the alien, the orphan and the widow." At the dawn of humanity, solidarity was limited to family and clan. Insurance is the extension of the solidarity principle beyond family and clan.

In ancient Babylonia, the Code of Hammurabai legalized insurance contracts on desert caravans. Prior to these first crude Babylonian insurance contracts a trader gave up his life and that of his family as slaves, if as the result of a desert marauder or other calamity the trader was unable to repay his lenders.

Until the beginning of the 16th century, people trusted St. Florian to protect their houses from fire. The Great Fire of London led to the creation of the world's first fire insurance companies. Soon after insurers discovered that it was in their own best interest to put out fires in buildings they had insured. Solidarity among insurance companies ultimately led to the creation of London's first true fire department and St. Florian was relieved of much of his responsibility.

Lloyds of London has its origin in the solidarity of the coffee shop. The coffee house that Edward Lloyd opened in 1687 near the Thames was a favorite haunt of risk-takers--men who would later be called underwriters. Its patrons assumed the risk of every conceivable contingency from the weather to the Queen's pleasure.

Lord Levene in the title of his address today asks: "Is Profitability a Dirty Word in Insurance?" The ancient Babylonian trader and the 17th-century London home-owner knew profit by the risk-taker was unequivocally a good thing. It meant that a caravan had not been attacked, or that a British merchant vessel had not been sunk by a Spanish "Man of War." The simple fact that this issue needs to be addressed suggests that though the contemporary world is more complex than that of our forefathers, it is not wiser.

Lord Levene has had an illustrious career. He is a life peer, a former Lord Mayor of London, and prior to becoming the Chairman of Lloyds he was among other things the Chairman of United Scientific Holdings, the Chief of Defence Procurement for the U.K. Ministry of Defence, and Chairman of Canary Wharf and Bankers Trust International. He was also an advisor to the prime minister of the United Kingdom for five years.

Ladies and gentlemen, please join me in welcoming Lord Levene, the Chairman of Lloyd's, to the podium of the Empire Club of Canada.

Lord Peter Levene

"The name Lloyd's of London is redolent with mystery and adventure. It suggests the tang of the sea and the aroma of coffee and tobacco. It denotes a fabulous phantom organization that pervades every sphere of life where risk is involved. It wagers with the whole world against every conceivable contingency from the vagaries of the elements to the Queen's pleasure."

So said Harold Lawson, former president of this distinguished forum, as he introduced Sir Walter Barrie, past Chairman of Lloyd's, to speak in 1960.

Almost 45 years later, the honour of speaking here is mine, and I am delighted to be here on my first visit to Canada as Chairman of Lloyd's.

In the intervening decades, much has changed both within the Canadian economy and within the Lloyd's market. However, it remains truer than ever that Lloyd's "pervades every sphere of life where risk is involved."

Today, Lloyd's is an international insurer and rightly known as the global powerhouse for specialist risk. But although we operate in over 190 countries and territories around the world, North America remains our largest market, and Canada is our largest source of overseas income after the United States, with business up 30 per cent in the first quarter of this year. Throughout the continent, our focus is on commercial insurance, and the security of Lloyd's runs like a thread through the economy; over 90 per cent of companies listed on the Dow are Lloyd's clients; and 10 of the 14 Canadian companies listed on the Fortune 500 have policies at Lloyd's.

However, in the past few years, the insurance environment here in Canada has been extremely volatile. And as availability of coverage and pricing of products have fluctuated, the industry has come under intense scrutiny and criticism, particularly here in Ontario where auto insurance has become a political issue.

Let me start by saying up front that the impact of this volatility on the insurance industry's customers and its investors alike is totally unacceptable. The customers feel themselves gouged. The investors feel cheated. In that context, I think it is fair and even necessary to ask: is profitability really such a dirty word in insurance?

Today, I want to cut through the headlines and the hype, and ask three practical questions. What are the facts about the financial situation in 2004--both for the insurance industry's customers and its shareholders? What is driving the current situation we have experienced? And what can we do to secure a more stable, successful environment for the future?

So let's start with the facts in 2004.

First, for consumers. There is no doubt insurance buyers of all shapes and sizes have been severely impacted by volatility in the marketplace.

Small to medium-sized businesses, which account for around 92 per cent of Canadian companies, have been hit particularly hard. The Confederation of Independent Businesses represents 100,000 companies across Canada, and their president said last year: "We were quite surprised when we did a membership survey at a time, when we were hit by SARS and BSE among other things, that 70 per cent of our members identified insurance as a top concern."

Now call me a cynic, but when someone I meet asks which industry I am in and I tell them insurance, they tend to yawn as their eyes glaze over, and wish they had never asked in the first place. So when 70 per cent of companies are spending more time worrying about the availability and the price of insurance than major economic threats to their business, there is clearly something wrong.

Consistency is something which insurance buyers desperately want. We know because they have told us so. In a recent survey which we conducted with North American risk managers, an overwhelming 84 per cent said that stability of coverage and pricing was not just important but very important for them.

A stable environment means that you can plan ahead and that you can transfer your risk in a predictable way, at a predictable cost, and manage your finances better.

At the moment, however, we have coverage and pricing volatility. Your CFOs don't like that, and your shareholders don't like that.

What, then, about insurance industry investors? If you believe the press, you would be forgiven for thinking that they must be more than content, raking in the profits from three years of price hikes.

But a quick look at the bottom line shows that couldn't be further from the truth. For the Canadian insurance industry, 2001 and 2002 are the worst years on record. Ever. In 2002, the return on equity for the industry fell to an all-time low, a miserly 1.6 per cent. So with a return on equity of just over 10 per cent in 2003 (when the arguably less risky banking and life insurance sectors are producing returns of around 15 per cent) it seems somewhat ironic that insurers making money should prove to be such a controversial story. Would investors in any other industry settle for such an unpredictable environment?

It seems, then, that no one (insurance buyers, insurers, or their shareholders) is happy with the current environment.

If that's the unhappy situation we find ourselves in, how have we got here? What are the drivers?

The first is one entirely of the insurance industry's own making. Poor management by the insurance industry of its core skill--underwriting.

It's been happening for as long as insurance has existed. The cycle starts with the insurance industry making a profit, and capital comes in to take advantage of the strong trading conditions. As competition increases, rates fall and the coverage is widened, this dual effect exponentially reducing the true price of what insurance should really cost. Only when something dramatic happens that makes the industry truly afraid to go on, do we finally confront our mounting losses and return to economic pricing.

It happened back in the nineteenth century, when insurers covered property close to home. Every fire was a reminder that their town, their assets, could burn next. And in the infancy of the insurance market, companies could not transfer their exposures so easily onto other markets around the world.

The trouble is that as the insurance markets have grown, those shocks which serve to bring things back into line are getting progressively bigger, the cycle is getting deeper, the swings are getting greater, and as a result, volatility is rapidly becoming unacceptable for everyone.

Those 19th-century fires which shocked the market back into sanity have turned into Hurricane Andrew in 1992; and 9/11 in 2001. If we allow the cycle mentality to continue, what will it be next time?

And that brings me onto the second driver. The cost of claims is soaring, and whether they admit it or not, insurers can no longer provide the coverage they used to at the prices they have been charging. The cost of risk has grown.

Take natural catastrophes. After a few years of benign loss patterns, we saw a rise again in the level of global catastrophes to US$16 billion last year, up from 11.5 billion in 2002.

Canada, unfortunately, mirrors the global trend. Hundreds of forest fires scorched much of British Columbia and burnt a C$250-million hole in the insurance industry's pockets; Hurricane Juan blew a further C$113 million as it ripped through the Atlantic coast; flooding, wind and hailstorms and the blackout also helped to make 2003 one of the worst loss years on record.

Unfortunately, all the evidence suggests this is no blip on the chart--neither for Canada nor the wider world. The long-term trend is clear. Over the past four decades, there has been an exponential increase in both the frequency and the impact of natural catastrophes.

If you compare the last 10 years to the 1960s, when Sir Walter Barrie was here, the facts are brought into sharp relief.

• The number of disasters has doubled.

• Economic losses have increased by a frightening factor of 6.7.

• Critically, insured losses have increased even faster--by a staggering 13.5 times.

We are now also witnessing a rise in the cost of man-made losses.

The growing compensation culture is one cause. Probably like you, we Brits used to see litigation culture as an American problem. But there is evidence that it is spreading to Canada and Europe.

While we haven't seen the class action activity here that we have in the US, it is firmly on the rise, and Canadian companies are beginning to find themselves targets for shareholder lawsuits--in both the Canadian and American courts. Nortel, it seems, is in the firing line again for alleged violation of accounting rules. Another is YBM Magnex International, (that's Magnex International not Magna International) which settled two class action suits filed by Canadian investors for $120 million. It had failed to notify shareholders that it was under FBI investigation for alleged money laundering--and the Toronto Stock Exchange took the decision to halt trading of the stock.

The auto insurance market provides a different perspective of the compensation culture. There, in the absence of injury claims reform, the residual market (which deals with auto risks the standard markets won't underwrite) recorded a loss of C$550 million last year. After the ice storm, that's the second most expensive insured loss ever experienced in Canada!

Add to this the increasing acceptance of contingency fees--with lawyers in Ontario increasingly operating on a "no win, no fee" basis, and we have a potentially explosive cocktail. Businesses and the insurance industry need to work and lobby together to ensure that Canada does not go down the road to a U.S.-style compensation culture.

So, what's the solution? I believe there are some very practical steps that each of us can take.

First, the insurance industry needs to take a more realistic approach to its underwriting. Only by doing so can it restore its credibility and establish stability in the market-place.

The truth is that insurance today costs about the same as it did 10 years ago. The recent price hikes are simply a necessary correction to the price decreases and extensions of coverage which spread through the insurance markets in the mid-'90s as competition increased. But with the volatility in coverage and pricing over the last decade, it isn't surprising that customers feel hard done by and are unable to plan their finances effectively.

As an industry we need to communicate better about the true cost of insurance, and explain why we take the actions we do. We need to look policyholders in the eye and tell them that there will be sufficient funds to cover claims should disaster strike. That means they can rest in the knowledge that their insurer is still going to be around in

Insurers must therefore get to the point where there is reasonable expectation of an underwriting profit, not just at the peak of the cycle, but every year.

Second, it means that government and regulators must display more realistic expectations of the role and economics of the insurance market. More then ever, businesses need insurance to take on new commercial challenges and to thrive.

The new, vibrant Canadian economy with leadership in everything from energy to engineering and technology to transportation is a solid testament to the spirit of the Canadian people. I wonder though: "How many of the global enterprises, fabulous new buildings, and world-class infrastructure projects that have been created here recently would have happened without insurance?" Few, I expect.

But regulators and politicians must remember that Canada is one of the most highly regulated insurance markets in the world, and any further attempt to stifle market forces will make it dangerously unattractive for businesses to operate in. They must also face the hard truth that auto premiums will continue to go up unless they implement reforms to set limits upon court awards and eliminate no fault benefits that lead to fraudulent claims. Ultimately, they must not put the financial health of the insurance industry--and therefore the consumers they represent--at risk due to the demands of politicians whose views may be clouded by the need to attract votes.

Third, it means that Canadian companies must take a more realistic approach to risk and face up to the changing risk environment.

In today's increasingly risky world, it is more important than ever that businesses have a holistic understanding of business risk, and that they set a strategy for dealing with disaster when it strikes.

Successful risk management requires implementation from the top clown. And that means greater attention to risk at board level.

The good news is that there is some acceptance of and commitment to risk management in Canadian companies. In a recent survey, no one said that their board was uncommitted to risk management. But at the same time, only 40 per cent said senior management commitment to risk management is excellent or strong.

I firmly believe that tomorrow's most successful, least crisis-prone businesses will be those whose boards show firm resolve and take decisive action. Effective, integrated strategies for dealing with tomorrow's risks require a change in culture at board level now. It means the cost of claims can be better controlled. And where claims costs can be controlled, so too can the pricing.

So, is profitability a dirty word in insurance? I believe that it shouldn't and mustn't be. But the incessant volatility that we currently suffer is, and it can only be corrected by a large dose of realism all round.

Not by rolling back prices unrealistically, defying the economics of investment and the changing risk environment, in order to appease politicians and consumer groups. The success of any such strategy will be short-lived. A sudden change in pricing policy will not result in improved relationships between customers and their insurers; or between consumers and their governments. It can only ultimately lead to another hard market cycle with double-digit rate increases further down the line.

Of course, history proves that insurance executives and underwriters have short memories. Almost as short as those of politicians. So is change, and a shift to a more realistic environment, possible? With resolve and determination I believe so, yes.

At Lloyd's, we are determined to get it right this time and we aren't taking any chances. We for one are not prepared to be in the position once again of trying to explain yet another painful cycle to our customers. We recognise that the old equation simply doesn't work any more and we are facing up to the future.

We have now taken some very decisive steps to change things as we enter the next stage of the insurance cycle. Just over a year ago, we began implementing a new franchise structure. Its key objective is to deliver consistent, strong financial performance, avoiding the staggering peaks and troughs to which we have become accustomed. After our first year of operating under this new structure, we are now confident that our plans for 2004 are now grounded in the reality of external market conditions.

Going forward, a willingness to maintain pricing adequacy and to make honest changes where necessary is critical to our future success.

So, let me be honest, pricing must remain firm. But if sense and economics are allowed to prevail, then we can avoid in the future the unpopular and unacceptable increases in premiums and fluctuations in capacity that we have witnessed recently.

The insurance industry has a critical role to play in the development of the 21st century Canadian economy. At the close of his speech 45 years ago to the Empire Club, the former chairman of Lloyd's said: "Looking to the future, which seems full of opportunity, I confidently believe that insurance has a great deal to offer by its ability to turn the wheels of commerce and encourage development throughout the world."

And he's still right. Without insurance, businesses cannot take the commercial risks they need to in order to grow and thrive. But the financially unstable environment we encounter today is unacceptable for all--customers and insurers alike. To recap, then:

• The insurance industry must take a more realistic approach to underwriting and communicate its actions better to consumers;

• Politicians and regulators must develop more realistic expectations of the insurance industry; and

• Canadian companies must take a more realistic approach to the range of risks they face and take risk more seriously at board level.

By doing so, we can achieve a more stable and successful environment for all, and profitability need no longer be a dirty word in insurance.

Of course, whatever tomorrow brings, some things remain certain. The special contribution of Lloyd's will always be its flexibility and adaptability. And our market's commitment to Canadian businesses will continue.

Thank you for listening.

The appreciation of the meeting was expressed by George L. Cooke, President and CEO, The Dominion of Canada General Insurance Company and Past President, The Empire Club of Canada.