Chapter 3 - Dynamics of the Insurance Marketplace

Introduction

With the complexity of the market, insurers play an important role in all segments of the economy. This section explores economic forces that influence the insurance industry and looks at how the industry impacts the greater economy. It begins by examining the question of whether insurance is a commodity.

Insurance as a Commodity

A commodity is a product used for commerce, and it has been typically distinguished from a service. Further, commodities are products traded on authorized commodity exchanges, or markets, where raw or primary products are exchanged in standardized contracts.

Is insurance a commodity? It is, if one has the view that insurance is a standardized product that is traded principally based on price. If the consumer does not differentiate one insurance policy from another based on coverages, exclusions, policy limits, deductibles, and service levels but purchases the policy solely based on price, then insurance is a commodity. When insurance products share similar or identical characteristics, it may prove difficult for the consumer to differentiate between them. If the consumer purchases a policy that meets their needs based on factors other than price—if they have looked at the whole insurance package offered—then insurance would not be considered a commodity here.

Consumers are becoming more sophisticated in their knowledge of insurance coverages, partly due to the interest being expressed in the media, industry education programs and events, the rise of plain language policy wordings, and online quoting tools and aggregators that deliver quotes to the consumer in real time. As consumers become more informed about what coverages are available that fit their needs and become more “hands-on” about securing insurance, and as insurance providers differentiate their insurance packages with more value-added services and customized benefits for consumers, it is likely that the argument that insurance is a commodity will diminish.

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The Theory of Supply and Demand

Consumer influences also affect the Canadian market, centring on the economic theory of supply and demand. This theory analyzes the way pricing is determined by balancing the amount of a product made available for purchase with the quantity required by consumers.

In a market economy, according to the supply and demand theory, more resources will be allocated to a product that increases revenue for producers—the ideal situation for a producer is to supply more of the products that they can sell at higher prices. Supply represents how much of a product producers are willing to provide at a certain price. The law of supply shows that the quantity of a product a supplier will provide is relative to the amount of payment per unit they will receive. The higher the price, the more the producer wants to supply. The correlation between price and the amount of product supplied is the supply relationship.

The concept of demand and the demand relationship concerns how much of a product buyers will purchase. The law of demand states that, if all other factors remain equal, fewer people will demand the product as its price rises. Conversely, the lower the price, the more demand there will be for the product. Therefore, sales volume is influenced by how much people are willing to pay for the product.

This economic theory does not strictly apply to insurance and does not apply to all types of insurance. Insurance that is mandated by law (such as automobile liability) or by lenders is not fully governed by the laws of supply and demand because these insurance products must be purchased, even if the cost is high. Consumers generally do not buy more than what is required to fulfill mandatory requirements when buying insurance that is imposed upon them. In this context, price does not govern how many policies will be sold. However, consumers may purchase higher limits of insurance or more options of coverage when pricing is affordable. By monitoring the trends in the growth rates of premiums and claims, and taking into consideration the relationship between supply and demand, predictions are made about the direction of future changes in the price of insurance.

Rate peaks and valleys associated with the insurance and reinsurance markets are generally caused by capacity
 (availability) limitations—that is, problems with supply rather than demand. In this context, capacity is synonymous with supply and reflects the financial strength of a company. Capacity is also tempered by a company’s willingness to take on particular risks. Consumers create demand for insurance, and this rises and falls based on the vibrancy of the economy. This is because the affordability of insurance affects consumer demand, as does the financial ability or willingness of the consumer to purchase the insurance they desire or require.

Economic Influences

Economic influences on the market include increased demands for insurance and reinsurance that result from a healthy economy. Economic growth puts more cars and trucks on the road and more cargo and travellers on the rails and in the air. As well, more construction projects are initiated and more manufacturing is carried out. Such increased activity creates the need for insurance, and this contributes to organic growth in premium income as opposed to premium growth through mergers and acquisitions. It also leads to more claims activity.

The influences of economic growth also manifest themselves in bull equity markets and in higher interest rates. Central banks tend to increase interest rates to temper a hot economy when3-5it gives rise to economic inflation. Economic inflation is a general increase in the prices of all consumer goods and services. The terms economic commentators use to describe the cycles of the stock market are bull market and bear market. A bull market is a market on the rise. During this cycle, there is strong demand for securities but a weak supply, which generally results in the rapid rise of share prices. When a bull market exists, investors are optimistic and have faith that the upturn in the market will continue. Characteristically, the economy is strong and the employment rate is high. Insurance companies do well as their investment returns increase.

The insurance industry is affected by economic forces including the cycles of the stock market.

A bear market is a market in decline. Share prices drop and investors believe the downward trend will continue. In faltering economies, investors who normally put money into equities move their capital into what they consider to be a safer investment—bonds. Bond markets, and particularly government bonds, generally perform well during economic downturns. For those who have them, this results in better investment portfolio returns. The reluctance to invest in securities, in turn, perpetuates the downward trend in share prices. Characteristically, when a bear market exists, the economy is sluggish and unemployment rises.

Most free or semi-free markets worldwide tend to become overpopulated by businesses as too many companies attempt to fill a market need. Insurance rates can quickly begin to fall as insurance companies vie for market share when, for example, booming equity markets provide capital to establish new insurance and reinsurance companies or to allow existing players to expand. Businesses can, in general, plan for insurance expenditures with a good degree of certainty in a stable insurance market. When the market is stable, business owners can go on running the other aspects of their enterprise, knowing that they can transfer their risks in a predictable manner at a predictable cost. Also, they can feel confident knowing that the insurance provider they are dealing with will be around for years to come, and most importantly, when a claim is presented.

In the insurance industry, when organic growth is more difficult to achieve, an insurer can grow by acquiring other companies. When cash is abundant, mergers and acquisitions are enabled. Mergers and acquisitions in the mid-1990s caused the demand for reinsurance to lessen. The newly formed, larger companies could either retain more risk or reinsure through internal programs. Mergers and acquisitions activity tends to increase capacity as larger companies with surplus capital expand their geographic scope and product offerings. Compared to their smaller competitors, larger companies have greater resources to draw from and use to compete for market share. However, another source of capital may shrink if investors reconsider the insurance industry as an investment choice and opt to put their capital in industries that earn more lucrative returns. In larger global operations, there are more complex choices for investors.

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Canada’s reputation as a highly taxed and highly regulated jurisdiction has probably led investors to believe that this is a place where capital can be tied up. This is not much of a problem when capital is plentiful and all the country’s requirements are viewed as simply the cost of doing business. However, when capital is scarce, the fees and paperwork required to invest in Canada may influence decision makers to invest elsewhere.

In the past, when investment returns for insurance companies have been high, companies have found that they do not have to report an underwriting profit to record a solid net income. They have managed to record reasonable profits primarily due to income from their bond portfolios. Profits have also been taken from stock holdings during bull market periods. Investment markets have played an enormous role in the amount of capacity that is made available to back risk. Overall, Canadian insurers as a group have historically relied on investment income to record a bottom line profit.

While positive conditions in investment markets can boost the bottom line of a company, negative trends can affect it just as dramatically. Starting about mid-2000, a bear equity market began that lasted close to three years. At the same time, interest rates in several of the strongest western economies hit record lows. This was one of the only periods in recent memory when the portfolios of investors (including property and casualty companies) weakened on the equity and bond markets. Insurers had no choice but to work toward earning underwriting profits. Those that succeeded in doing so were beginning to record better profits by 2003, and this was sustained through the 2006 underwriting year.

The Economics of the Industry

Traditionally, the results of the property and casualty (P&C) insurance industry have not tracked with those of businesses in general. That is, when the economy is faltering, insurers have often done well, and when the economy is strong, insurers have often done less well. Buyers of insurance also tend to be more cautious of their assets during economic downturns and, therefore, they tend to rely more on insurance.

Although government heavily regulates the P&C industry, there are few barriers for new entrants into the market except for licensing and capital requirements. This has contributed greatly to the abundance of companies serving insurance buyers. Therefore, it has also exacerbated the fragmentation and competitive nature of the marketplace. See In Practice—The State of the Canadian P&C Market.

The level of regulation governing an insurance company’s financial position has contributed to ensuring that the market is relatively conservative and stable. Stability makes the Canadian market an attractive place to do business, especially for foreign-owned companies looking to expand. This, in turn, has a positive effect on the market’s capacity.

Canadian insurers have worked together to accept responsibility for the state of the insurance market so that havoc-causing legislative ultimatums can be avoided. They have created residual market mechanisms in most provinces to ensure that mandatory automobile insurance is available, even to high-risk drivers. Similarly, the insurance industry has created the Property and Casualty Insurance Compensation Corporation (PACICC) to protect policyholders and the public against the collapse of a P&C insurer.

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In Practice

The State of the Canadian P&C Market

The Canadian property and casualty insurance sector has its historical roots in the United Kingdom, where business has mainly been placed through brokers. Although broker-based business remains an integral part of the Canadian general insurance market, direct writers also occupy a significant market segment. Banks are now competing in the P&C insurance sector mainly as direct writers. Some insurers support multiple distribution channels.

In the last two decades, there has been a surge in the growth of the wholesale market with the formation of more managing general agents (MGAs)
 and managing general underwriters (MGUs). These producers have contractual arrangements with insurers that provide them with delegated authority to act on the insurers’ behalf to place business that is often hard to place or niche. MGAs often specialize in a type or class of business in which a primary insurer either has no expertise or prefers to write only part of the risk. Additionally, MGAs often arrange insurance for new and emerging risks: one example of a new risk was the production and sale of cannabis in Canada following its legalization in 2018.

So, with the large number of entities participating in the insurance marketplace, it has become fragmented and competitive, which increases the opportunity for mergers and acquisitions.

It should be noted that catastrophic events in the United States triggered the creation of state-run insurers and reinsurers of last resort as well as regulatory action to discourage insurers from leaving the marketplace and not renewing policies. Such dramatic action came about to ensure that insurance remained available in high-risk areas. Canada might experience a similar result if a serious catastrophe occurred that negatively impacted the availability or affordability of insurance. In Canada, governments have previously imposed sanctions on insurance companies who try to exit a market.

The reinsurance side of the Canadian market affects primary insurers. The entire insurance industry feels the effects of rate increases in the retrocession market (in which reinsurers need reinsurance). Increased retrocession rates eventually pass to the primary side of the industry. Many large Canadian primary insurance companies have been able to reduce their dependence on reinsurance because of their strong capitalization and internal scale. However, reinsurance pricing continues to exert a strong influence on areas of the country exposed to catastrophic loss events, as well as on large commercial risk pricing and small to mid-sized companies.

Causes of Reduced Profitability

When investment portfolios underperform, reduced profitability is the result. In this situation, the cause of the portfolio’s lagging performance should be analyzed individually to determine whether poor investment decisions or falling stock prices (in a stagnant or receding market) are the cause. When interest rates fall, returns shrink on the money lent by a company. However, elevated interest rates do not always benefit insurers either: When interest rates rise, the value of fixed-income investments (which are generally bonds for insurers) falls. Also, elevated interest rate environments contribute to a volatile investment market.

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Sometimes, an insurance company miscalculates its anticipated claims outlays when it sets its rates. This results in premium revenue that is inadequate to cover claims.

If trends of social inflation (the increase in claims costs over general economic inflation) within the legal system seem to be swinging in the direction of higher and more frequent court awards for such things as products liability, insurers and reinsurers may opt to write less of a line (or stop offering it altogether) to protect their profitability.

Class action lawsuits, punitive damages awards, and other potentially volatile areas of litigation are threatening the profitability of insurers. Toxic mould, cyber risk, and tobacco liability are other emerging areas of concern. In the past, asbestos claims caused a significant drain on the insurance industry and they still continue to do so, as seen in Example—Environment-Related Losses.

Example—Environment-Related Losses

In the early 1980s, loss ratios in the United States on the liability side skyrocketed due to higher claims costs associated with asbestos and environment-related losses. The general trend in US courts was to award increasingly higher compensation to injured parties. Insurers increased loss reserves to compensate, and this led to a severe capacity shortage in the country’s insurance and reinsurance markets. Predictably, the shortage prompted a large increase in premium rates and the availability of liability insurance was restricted.

Asbestos losses increased significantly because of higher claims costs associated with asbestos-related treatment and removal.

Catastrophic events impair the industry’s surplus, thereby eroding its capacity. Catastrophic loss experience can have profound short- and even long-term effects. When a large loss or a series of large losses removes billions of dollars from the market, it affects whether a company can meet its statutory capital requirements; in turn, the capacity that affected insurance companies can make available is then reduced. Facing such losses, insurance companies may pull back or completely exit from writing certain lines of business or claims from certain geographic areas. Such conditions are a classic cause of the hard market cycle, as described in Example—Devastation 9/11.

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Example—Devastation 9/11

In 2001, hundreds of millions of dollars of shareholder capital were lost because of terrorist attacks on the twin towers of the World Trade Center in New York City and the scandalously improper accounting practices that occurred in corporate America thereafter. Although insurers and reinsurers in the US market were primarily affected by the severe claims filed, the Canadian market also felt its effects because it tends to react to the international market.

Dramatic natural catastrophes like hurricanes and earthquakes have precipitated the bankruptcy of some companies that insure property. Many more companies have simply refused to renew or write new business in heavily exposed areas, as seen in Example—Natural Disaster Exposures.

Example—Natural Disaster Exposures

Areas around the Gulf of Mexico have produced many of the largest global claims events of the past 20 years. In 2022, Hurricane Ian caused insured losses of US $60 billion.^[1] Hurricane Ian hit Florida following several consecutive years of large loss events, resulting in some US-based private insurers exiting the market.

Natural disasters, like Hurricane Ian, can have devastating consequences for insurers. Some insurers can be so heavily burdened that they exit markets altogether.

Reinsurers also determined they were vulnerable to Florida’s hurricanes and restricted or increased rates on much of their business in the area, making catastrophe reinsurance covers expensive for primary insurance companies.

Canada’s P&C market has not seen an insurer insolvency since 2003, with the closing of the Home Insurance Company by the federal regulator. If an insurer does fail, PACICC responds to policyholder claims since the corporation is concerned about the impact of catastrophic loss on the industry. It has stated that the Canadian P&C market can withstand a catastrophic event resulting in claims of $30 billion without leading to insurer insolvencies. For events resulting in3-10claims beyond that and up to $35 billion, PACICC estimates that the industry would survive but several insurers would become insolvent.^[2]

However, the good news is that PACICC has stated that no extreme weather event has caused an insurer to fail in Canada in the last 60 years. In fact, Canada’s worst year for insured damage was 2016 at $5.95 billion in claims, when the Fort McMurray wildfire accounted for nearly 75 percent of losses. The second worst year for insured damage was 2013 at $3.87 billion; the majority of those losses arose from flooding in Alberta and the Greater Toronto Area. The third worst year was 2022 with $3.1 billion in insured damage, which did not have a single cause. Eight separate events accounted for the majority of the insured losses, including the derechos in Ontario and Quebec; Hurricane Fiona, which hit Atlantic Canada; and other convective storms.^[3] So, a single extreme weather event costing $30 billion in insured losses in Canada may be unlikely. However, PACICC has cautioned that systemic risks such as earthquake risk,^[4] and climate change risk that leads to more natural catastrophes, should be addressed by both the industry and the Canadian government.

Obviously, when an insurance company becomes insolvent there will be one less insurance provider in the marketplace, but such an event also has a ripple effect on remaining insurance companies by shrinking the market and its capacity. Because Canada has created an association to deal with bankrupt P&C insurers, the effects of shrinkage are even more intense for other, healthy companies in the industry. When a property or casualty insurer becomes insolvent, each insurer that is a member of the association is called upon to pay its share of claims; this could potentially have a negative effect on profit levels.

The hardening of the insurance market is due to a cautionary reaction—a desire to pull back—on the part of underwriters when the future is uncertain and the extent of risk cannot be measured.

The gravest potential losses to be faced by the insurance industry in the future are likely to stem from risks such as natural catastrophic events, losses arising from climate change, cyber risk, pandemic risk, or a yet-to-be discovered loss situation. Many people also believe stricter corporate governance measures arising from investigations into industry practices have posed new challenges that insurers, reinsurers, and brokers will have to face. Improved discipline in underwriting practices is considered a prerequisite for the insurance industry to thrive.

1 Tom Sims and Alexander Hübner, “Hurricanes and Floods Bring $120 Billion in Insurance Losses in 2022,” Reuters, January 10, 2023, https://www.reuters.com/business/environment/hurricanes-floods-bring-120-billion-insurance-losses-2022-2023-01-09/ (accessed December 29, 2023).

2 Canadian Underwriter, “What to Tell Your Clients When Their Insurer Goes Bust,” August 13, 2021, https://www.canadianunderwriter.ca/insurance/what-to-tell-your-clients-when-their-insurer-goes-bust-1004211292/ (accessed October 3, 2023).

3 Canadian Underwriter, “Where 2022 Tallies for Insured Damages in Canada,” January 18, 2023, https://www.canadianunderwriter.ca/insurance/where-2022-tallies-for-insured-damages-in-canada-1004229754/ (accessed October 3, 2023).

4 Canadian Underwriter, “Which Peril Might Bankrupt the Canadian P&C Industry?” June 28, 2023, https://www.canadianunderwriter.ca/insurance/which-peril-might-bankrupt-the-canadian-pc-industry-1004235269/ (accessed October 3, 2023).

Introduction

The property and casualty marketplace in a free market system is known for its hard and soft market cycles. Extreme market cycle movement has had damaging effects on the insurance industry’s economic stability and reputation. This section explores what is meant by soft and hard market cycles. It also examines private automobile insurance and how its dynamics affect the insurance market.

Soft Market Cycles

Soft market conditions arise when there is excess financial capacity in the marketplace. The impetus for the soft market cycle arises from insurers’ financial results that demonstrate reasonable profitability and strong capital bases.

Typically, marketing efforts are intensified during soft market cycles because successful results encourage companies to gain market share. When growth goals are beyond the general economy’s growth rates, one way for a company to achieve its goals is to take business from its competitors. The highly competitive environment that results often drives underwriters to do the following:

• Reduce premium rates

• Relax policy terms and conditions

• Relax loss prevention and control measures

Other strategies for insurance companies to improve their market share in soft markets include creating new products with new demand, writing classes of business that they would not normally write, and expanding into new geographic territories.

After a few years of soft market conditions, underwriting results generally deteriorate. If the investment environment weakens during this time, the capital depletion of insurers worsens; this eventually invites a hard market.

Hard Market Cycles

Hard markets inevitably follow buoyant soft markets because risks underwritten at artificially low prices must eventually be offset with high enough premiums. Still, insurance companies tend to react very slowly in a hardening market because they do not want to be the first to move prices up in fear of losing good accounts.

When a company’s rate of return on equity drops to threatening levels, shareholders demand corrective measures. The market hardens when insurers adopt the following strategies:

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Approach each risk very cautiously before offering to insure it

• Set more exacting underwriting standards

• Give loss control and loss prevention measures significant consideration

• Tighten policy terms to limit exposures

• Make substantial rate increases

• Terminate relationships with brokers with unprofitable results or with only a small volume of business

• Withdraw from the jurisdiction, a class of business, or an individual risk when sufficient market share has not been gained or a portfolio or individual risk is not profitable

• Withdraw from the market altogether by selling the company to another insurer or placing it into what is known as run-off
  , which is when a company ceases to write new business and only services existing policies until their expiration dates

This can sometimes result in detrimental consequences for some insureds when, suddenly, they are unable to obtain insurance (a condition known as market dislocation) or are unable to afford large rate increases.

In the past, it has been rare for the industry to sustain satisfactory investor returns for any extended period. This is traceable by examining the return on equity recorded on insurers’ financial statements. Investors rate businesses as reasonably satisfactory only if they experience returns that reach at least the low double-digit range. In a tougher market, the higher single-digit range might be acceptable.

In general, the P&C insurance industry has enjoyed a surplus of financial capacity. This has led to investors consistently rating the insurance industry as a safe investment sector.

The typical insurance cycle has about a seven-year lifespan: Roughly four years of falling rates will be followed by about three years of increasingly weakening results, and then the cycle culminates when insurers make drastic changes to turn the tide of negative results. For some, changes must be made hastily to regain financial stability. If a company is unable to recover, it may have to sell part or all of its operation or close its doors. The industry in recent years has seen shorter cycles ranging from three to five years.

The free market system makes hard and soft market cycles a reality for the insurance industry. In fact, all market economies oscillate seeking equilibrium but inevitably move too far in one direction before making corrections, then move too far in the opposite direction. Financial pressures tend to be acute before the market conditions correct themselves and this leaves some companies in tenuous positions.

Causes of Hard Markets

Hard market cycles can be caused by a variety of factors. A hard market could result from limited market competition. For example, all participants in an environment supporting a relatively small number of market players could charge high premiums. However, it is more likely that competition among market players will be fierce.

When the government regulates premium rates, insurance companies may be unable to achieve premium levels necessary to make claim payments, cover operating expenses, and achieve reasonable profits. Insurance companies, under such circumstances, may adopt restrictive3-13underwriting practices that limit the type and amount of coverage sold. If they are unable to leave the market, they examine expenses carefully.

A hard market may arise when the demand for a new product grows faster than the number of insurance companies who sell it. This can create a hard market within a particular product line.

Differences in Market Cycles

Market cycles affect insurers, brokers, risk managers, consumers, and governments differently. In the following, the typical outcomes are noted for each party:

• Insurers begin to lose profitability when soft markets take hold. They aggressively look for new business and their existing business is under attack by competitors.

  • However, when the market is hard, insurers regain profitability but face the animosity of brokers and the insuring public when pricing increases are dramatic or the underwriters serving those parties are not willing to accept risks.

• Brokers enjoy soft markets because capacity is abundant, premium rates decline, and underwriters are less demanding. However, a decline in rates means a decline in commission income.

  • During a hard market cycle, brokers must labour intensively to find capacity for their clients’ needs; also, they must negotiate more diligently to exact reasonable prices. To the brokers’ benefit, commission income rises when premiums increase.

• Risk managers benefit from lower prices, easier underwriting, and less demanding loss control requirements in soft markets. Also, they attain their goal to deliver risk protection more easily.

  • During a hard market cycle, risk managers have to be more creative in offering options to deal with risk. Alternative risk financing propositions like captives
    , reciprocal exchanges
    , and other, less conventional ways to deal with risk such as parametric insurance
     are explored.

• When hard market conditions strike without warning, insurance consumers become wary, distressed, and often frustrated. Consumers are struck with premiums that are suddenly not affordable, insurance availability that is restricted, and coverage terms that are limited. Consumers are in a very awkward position when they cannot afford to buy insurance that is mandated by law; when this is the case, politicians inevitably become involved.

  • Conversely, in soft market conditions, consumers are simply more neutral in their reactions to the insurance industry.

• Governments often react to hard markets by imposing measures they believe will make insurance more affordable; often, they are especially focused on ensuring that mandatory insurance is available.

  • When certain lines of coverage become difficult to buy because, for example, the risk of catastrophic loss is too significant (for example, loss arising from earthquakes or severe flooding), governments can step in to establish backstops. Government-backed protection plans are advantageous to both the insurance industry and consumers because they put a cap on the amount of loss, ensuring that the insurance industry as a whole can survive a catastrophic event. For example, if a severe terrorist event were to occur, the government would be expected to participate in helping citizens to recover (see Example—9/11).

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Example—9/11

The events of September 11, 2001, triggered a worldwide crisis for coverage against terrorist attacks. The destruction of the airplanes and the World Trade Center in New York City wiped out billions of dollars of capacity. Markets worldwide put terrorism exclusions into place, forcing many insurance consumers to go without insurance. Construction projects and real estate transactions felt the repercussions: Builders found it difficult to get the financing needed to start or complete projects, and buyers of properties found it hard to complete transactions. The US government negotiated with the insurance and reinsurance industries and, as a result, the industry agreed to take on the lower layers of risk in exchange for a government-backed protection plan.

Exhibit—Market Cycles Affect Parties Differently summarizes how cycles affect hard and soft markets from the perspective of insurers, brokers, risk managers, consumers, and government.

Exhibit

Market Cycles Affect Parties Differently

Delivering Private Automobile Insurance

Automobile insurance forms the largest share of the P&C insurance industry. What happens when mandatory automobile insurance becomes less accessible to consumers because of high rates or overly stringent underwriting rules? It makes the news. Consumers pressure their governments to take action and, in response, governments impose regulatory sanctions. In some provinces, the government has created automobile rating boards or public utilities commissions to regulate automobile insurance premiums. While these measures tend to please consumers, from a private insurer’s point of view, price regulation is an unnecessary and expensive administrative burden. The free market system anticipates that a competitive self-regulating market ensures that prices reflect the true cost of doing business; rating boards and commissions only create imbalances in the free market pricing system.

Insurers must be cautious and prepare for the probable effects of newly enacted legislation that, while intended to help consumers, can hurt the industry. Some possible consequences are that the claims cost ratio will rise or that a satisfactory balance between income and expenses cannot be maintained.

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With private automobile insurance, there is also the danger that rates will not accurately reflect claims potential. When pricing controls result in inadequate prices, underwriters tend to avoid the risk of losing shareholders’ capital by choosing not to insure such risks any longer. When this happens, the market availability for the business decays.

Automobile insurance accounts for nearly 40 percent of the total insurance premium written in Canada, so any regulatory intervention—whether in pricing, coverages, procedures, or processes—will affect the operations and profits of insurers that deal in this division. When regulations are imposed, higher staffing requirements or different software applications to rate and report data might be required, and these increase the expenses the insurer incurs to support its automobile business. Increased operating costs and, perhaps, politically imposed premiums could reduce the insurer’s profitability and return on equity. Sometimes the insurance industry is left with little time to plan for contingencies when government sanctions are imposed, as shown in Example—Alberta’s Freeze of Automobile Insurance Rates.

Example—Alberta’s Freeze of Automobile Insurance Rates

In January 2023, the Alberta government announced that it would not approve automobile insurance rate increases for the rest of that year. The Alberta Automobile Insurance Rate Board, an independent agency established by the Alberta government that regulates automobile insurance rates, ensured that Alberta automobile insurers did not file or use increased rates for the year. At the end of the 2023 rate freeze, the Alberta government announced only rate increases for “Good Drivers” to a maximum of 3.7 percent would be approved (a percentage that matched the province’s annual general economic inflation rate). Insurers incurred significant expenses as they responded to these announcements: They needed to program new rate capping logic into their systems within a short period of time to meet the government’s requirements.

What might happen when a regulator disallows rate increases or rolls back existing rates to the point where they are insufficient to cover all costs of writing the business? Obviously, this is not a viable business alternative. To reduce negative effects in this situation, insurers may look closely at an area they can control to some extent: internal expenses.

If salaries decrease and bonuses are not paid because of cost-cutting measures, a loss of quality staff or an inability to attract new talent to the industry may result. If cost-cutting measures include a reduction in staffing, there is also the potential for poorer service that directly affects consumers. Cost-cutting measures can affect more than just salaries, staffing, and customer service. An insurer forced to cut back may find that the company’s functional competence suffers, questionable risk selection occurs, succession plans cannot be developed, and the company’s financial results are negatively affected.

When provincial governments take over all or part of a province’s automobile insurance, insurers are obliged to reassess any business plans they currently have. Insurers are made less certain of what to expect because the effects of government action—even action that is welcomed—cannot be fully known. Projections for premium, loss ratio, and return on equity made before the changes must be redeveloped. Some insurers may shelve business strategies to achieve organic growth or to expand territorially until the effects of government actions are made clear.

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Insurers anticipating government-imposed reforms but unsure of their nature or likely effects may consider withdrawing from their jurisdiction, adjusting marketing plans for the affected area, or reserving any final decisions until the regulator’s plans are announced. Automobile insurers may also consider withdrawing from the market at the time of an insurance crisis, anticipating legislative reforms to come. This, in turn, reduces automobile insurance capacity in the insurers’ jurisdictions.

Summary

The theory of supply and demand analyzes the way pricing is determined by balancing the amount of a product made available for purchase with the quantity required by consumers. Thus, if there is an increase of consumers buying online insurance, then that is the direction the insurance market is progressing toward.

Insurance differs from business in that when the economy is thriving, often the insurance market does not do well due to an increase of claims costs. When the economy falters, insurers often do better.

Bond markets, particularly government bonds, generally perform well during an economic downturn due to less risk being involved. Buyers of insurance tend to be more cautious of their assets during economic downturns and tend to rely more on insurance.

Catastrophes have been a cause of reduced profitability. Class action suits, punitive damage awards, and toxic mould, asbestos, cyber risk, and other emerging areas of concern are a drain on the insurance industry.

Hard and soft market cycles affect insurers, brokers, risk managers, and government differently.

Soft market cycles occur when there is excess financial capacity in the marketplace. Eventually the relaxed guidelines cause the underwriting results to deteriorate and, if the investment environment weakens during this time, the capital depletion of insurers worsens. This situation invites a hard market.

Hard market cycles begin with a cautious approach to new business and existing renewals. More exacting underwriting guidelines are set and rates increase. Relationships with unprofitable brokers are terminated. The insurer may withdraw from certain lines of business that are unprofitable or withdraw from the market by selling the company to another insurer or placing it into what is known as run-off.

The typical insurance cycle is seven years—four years of falling rates, followed by about three years of increasingly weakening results. The cycle concludes when insurers make drastic changes to turn the tide of negative results and reach stability in the market.

Automobile insurance is the largest share of the P&C insurance industry. It is mandatory insurance and highly regulated. When it becomes unprofitable, the rates increase. Consumers vent their concerns to the government and the government responds by imposing regulatory sanctions. In some provinces the government has set up rate control boards. Insurers may

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also consider withdrawing from the market at the time of an insurance crisis, anticipating legislative reforms to come. This, in turn, reduces automobile insurance capacity in the insurers’ jurisdictions.