CFO Perspective

Alex Vizer | November 9, 2009

• Usage Based Insurance
• Waiting for (Business) Intelligence
• CFO Perspective
• Capital Market Solutions for Catastrophic Exposures in Canada
• Long Tail Lines of Business
• Clarifying the Law for Director’s Duties
• Innovation at the Core
• The Role of Weather Risk Management

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Participants:

James Falle – Aviva executive vice president and CFO
Patrick Lemoine – AXA Canada executive vice president and CFO
Doug Hogan – The Dominion senior vice president and CFO

Q: How did the financial crisis affect your investment strategy over the past 12 to 18 months?

James Falle (JF): A decision was made to sell all of our equities in the fall of 2007. As a result a lot of the market corrections that happened in 2008, especially on the equity side, did not really impact us. I think our investment approach has been very conservative. We have a mix of Government of Canada bonds, provincial and corporate bonds. Through the market turmoil we’ve gone through in the last 12 months, that has stood us in good stead. We did stay the course but that being said there were opportunities to pick up some well priced assets in the market at the same time.

Patrick Lemoine (PL): We decided to diminish our portion of equities, so we sold about 60% of them and invested most of the proceeds in cash. Usually, we have around 10% of our assets invested in equities, and that has decreased to about 5%.

Doug Hogan (DH): Essentially our strategy has not been affected. With respect to our stock portfolio, which is significant and larger than the industry average, we’ve stayed the course and held on to our portfolio. With respect to our bond portfolio, we have actually taken advantage of the higher yield and lower prices at the beginning of the year and increased our mix of high-yield government and corporate bonds.

Q: The next 12 to 18 months?

JF: Notwithstanding the exuberance that we’ve all seen in the equity markets in the last several months, I think that is highly likely that there is going to be a significant equity correction before year-end. I think we are going to see more volatility than we’re used to in the equity markets in the foreseeable future, but more importantly I think we are going to see interest rates rise. At the same time I think you are going to see corporate spreads continue to come in.

PL: We believe that the volatility of the market is going to be high, so we do not intend to return to ordinary shares right now. What we fear is that it could be a “W” type of recession, so... we are being prudent.

DH: During the next 12 to 18 months we expect to continue our long-term strategy of investing most of our capital and surplus in common stocks. We think that corporate spreads have JFn—and their fair values have increased—about as much as they are likely to do so for some time. As a result, we might reduce the high corporate component of our fixed income portfolio over the next year and increase our mix of government securities.

Q: How difficult was 2008-2009 from the perspective of CFO?

JF: Is it the most difficult I’ve seen ever? Yes it has been, but we shouldn’t lose sight of the fact that there have been very significant events in the last 20 years, 15 years, five years in the way of market corrections. If you look at what happened to the equity markets in 2008 (17 times the market went up or down 5%) and then compare to the previous 50 years, where the market went up or down 5% only 17 times. I think the question we all have to ask ourselves right now from an equity perspective is: Is this volatility the new reality?

PL: We also had trouble, maybe even worse than today, during 2001 and 2002. At that time the P&C combined ratios were much higher, often more than 100%, which was not the case last year. On top of it we had a reinsurance market that was clearly damaged by 9/11, which caused reinsurers to increase their prices. At the same time, there was a big drop in the equity market and the IT bubble. That period was bad. The one that we experience today is also not easy, but the government response today is higher than it was eight to nine years ago.

DH: The stock market volatility last year definitely hurt our portfolio and our capital. Thankfully we’ve seen a relative recovery, but I would agree that the combination of the stock market turmoil and the underwriting challenges probably would be the worst conditions that we’ve seen in a long time. As a CFO, it typically always takes twice as much commentary to explain poor results as it does to explain good ones. There’s also been more intense monitoring of our investment portfolio and capital levels. Underwriting results, being as poor as they are, definitely exacerbate the intensity of risk management at the company. It’s a lot more work because there’s more risk.

Q: The P&C industry is known for being relatively cautious and conservative; did that help mitigate the damage the recession caused?

JF: I think that there is a perception that the industry is cautious. Looking back over the past year, I am not sure that this comment can be universally applied. It was surprising to see some relatively small companies with significant portions of their investment portfolio in what turned out, in the benefit of hindsight, to be very volatile investments. It calls into question the extent to which Asset Liability Management (ALM) has been embraced by our industry. ALM is something that is embedded into the fabric of the banking and life [insurance] industries and very much has a significant place in our industry. Companies that don’t look at it will find that they have injected a certain amount of volatility in their capital and earnings that they would otherwise avoid.

DH: Overall I think the Canadian P&C industry is a fairly cautious investor, perhaps a little too cautious. The Dominion is a more risk-taking investor than most. For investments underlying capital and surplus, we pursue the superior long-term returns generated by high quality common stocks. We necessarily carry more capital, to withstand inevitable crashes and corrections, but the additional capital is well-rewarded. For investments held in support of insurance liabilities, asset and liability matching appears to be growing in popularity with P&C entities. However, I believe that rigorous matching results in an unduly low investment return over time. Instead, we often deliberately mismatch by holding bonds with longer durations that our claims liabilities. This approach usually generates a higher fixed income return since normal yield curves reward longer durations with higher yields. We manage the resulting mismatch risk by maintaining sufficient liquidity. In my opinion, P&C entities that closely match are leaving too much yield on the table.

Q: How have you positioned your company’s portfolio given the current soft market?

JF: From a discipline perspective we need to make sure that we separate what’s going on in the investment portfolio from underwriting. We clearly understand that we are in the underwriting business, not the investment business. From an underwriting perspective, yes, we are in a soft market. Given the loss ratios incurred in the industry there’s no way that the pricing is where it should be. There’s some evidence that the market is starting to harden but there still is a lot of irrational behaviour from a pricing perspective in the marketplace. From our company’s perspective we are doing everything we can to stick to our pricing discipline including walking away from business that’s poorly priced. This isn’t about market share, this is all about being an excellent underwriting company and that’s what we aspire to be and making sure that we are going to make money for our shareholder.

PL: If you take hard market to mean higher interest rates, then we have several strategies in place. We are very careful with the duration so we try to lower the duration of the portfolio. Secondly, we try to shelter inside the provincial bonds more than the federal bonds, so we lower the portion of federal bonds to increase the portion of provincial bonds and we try to get some more safe corporate bonds. We are waiting for interest rates to increase—this situation cannot last for years.

Q: Reports suggest that reserve releases are using up money that would usually be invested?

JF: The reserves are not there to smooth earnings. The reserves are there to be an estimate as to what you believe the ultimate cost of settling the claims is meant to be. It’s not necessarily a bad thing to have favourable development emerge year over year. In fact, there are companies that plan for that. But when you see situations where the degree of favourable development is significantly higher than a normal period, I think we have to question whether or not there has been a drawdown on reserves.

PL: We are not going to play that game. When we have good news it’s because the reserves are settled down lower than expected. Sometimes you can release or increase reserves depending on legal decisions or inflation. When you have a slowdown in the economy, as it was at the end of 2008, inflation is going down and you can lower your reserves. On the other hand, when inflation is very high, you have to take that into account and increase your reserves. But these would not be large swings at all.

DH: Claims reserving is a challenge and requires discipline. We always try to maintain the same level of reserving conservatism through soft and hard markets. Neither shareholders nor policyholders are well served by large volatile swings in claims development.

Q: What else can be/was done when the economic crisis hit to mitigate the impact of the last 18 months of market volatility?

JF: Normally you would look at your portfolio and look to diversify, but what happened in the last 12 months is that everything moved in lockstep. We had equity volatility at a time when we also had significant volatility in the bond market, I’m not so sure that’s ever happened to that degree before.

DH: Well, besides being able to have seen it coming? I don’t really think there was anything significant. I think Canada is in a healthier position rather than say, the US financial system, and that has served us well. We are grateful to be Canadians in the Canadian environment that we have been operating in.

Q: Are you taking any steps to further “risk proof” your investment portfolio?

JF: No, I think we’re very happy with where we are. Whether or not we get back into equities time will tell. We really have not materially changed our investment philosophy when it comes to fixed income, going after high quality assets and making sure that we’re very happy from a risk return perspective. I think if anything through these very trying times it’s really validated our approach and that hasn’t led to any significant changes.

DH: No, instead of de-risking we actually increased risk by buying more corporate bonds as they were extremely cheap at the beginning of the year. That strategy has served us very well because as spreads have come down, the values of those bonds have gone up. We’ve had a very favorable unrealized gain on both the stock and the bond portfolios.

Q: How have you positioned your company’s portfolio given the current soft market?

JF: From a discipline perspective we need to make sure that we separate what’s going on in the investment portfolio from underwriting. We are in the underwriting business, not the investment business. From an underwriting perspective yes, we are in a soft market. There’s no way that the pricing is where it should be. There’s evidence that the market is starting to harden but there still is a lot of irrational behavior from a pricing perspective in the marketplace. From our company’s perspective we are doing everything we can to stick to our pricing discipline and walking away from business that’s poorly priced. This isn’t about market share, this is all about being an excellent underwriting company and that’s what we aspire to be and making sure that we are going to make money for our shareholders.

PL: If you take hard market to mean higher interest rates, then we have several strategies in place. We are very careful with the duration so we try to lower the duration of the portfolio. Secondly, we try to shelter inside the provincial bonds more than the federal bonds, so we lower the portion of federal bonds to increase the portion of provincial bonds and we try to get some more safe corporate bonds. We are waiting for interest rates to increase—this situation cannot last for years.

Q: How will this change if/when we move into a hard market?

DH: A hard market in and of itself won’t change our investment decisions. Our stock philosophy will likely continue as is. In our bond strategy, we may unwind as we see corporate spreads reduce and risk free rates increase but that’s really an investment decision. It does not have any relation to the underwriting cycle.

Q: Does an increasing loss ratio have an impact on investment decisions?

JF: You have to separate the two. When you price a product you make certain assumptions with regard to your investment yield and arriving at what you believe is an appropriate price for your product. What you should not be doing is changing the pricing of that product depending on how much capital gains you’ve generated from one year to the next. Again, we are in the underwriting business, not the investment business.

DH: In good times, from an investment point of view, the industry tends to allow the loss ratio to deteriorate because you are making up more than that loss by improved investment income. Now with the recent downturn in investment income, that part of your income that subsidizes your underwriting results is diminished. As a consequence, your overall results are deteriorating and now there is more pressure on companies to improve their underwriting results. I think that the economic downturn actually increases the pressure for a hard market to develop and for pricing to improve because as an industry, we now have much less investment income to subsidize our underwriting results. In a soft market the opposite happens, investment income is so good that you allow the loss ratio to deteriorate, because you know that as long as you are just bringing in the premiums, even if they’re a little under-priced, you are making it up on the investment side.

Q: Why is it so important to separate investment and underwriting decisions?

JF: There is an element of investment returns that you put into the price of your product; I’m not going to ignore that. But fundamentally you have to ask yourself: Are you in the investment business or the insurance business? If you are in the insurance business then your objective should be to price your product in a manner that allows you to make underwriting profits, and then you invest those profits to make an additional investment return. Policyholder funds, which creates the largest amount you have to invest with, is a product of all of those underwriting decisions. They should not be viewed as a fund from which to make investments. On the other hand, if you start reducing your prices you will find that you will lose money far quicker from an underwriting loss perspective than you would from an investment perspective, it’s very important to make sure that those fundamentals are clear.

PL: If you do this you are in trouble. Your pricing strategy will take years to get back to reality. With the level of combined ratio that we have within AXA Canada, we can potentially decrease the margins on some products, but certainly not go for an underwriting loss. We want to make an underwriting profit, and the investment strategy is not going to influence it because we have two separate items trying to make our insurance operations profitable.

Q: To what extent has the low interest rate environment impacted your investment strategy and portfolios over the past 18 months?

JF: If one assumes that on average, anywhere from 15 to 25% of a company’s fixed income portfolio matures in any given year, what we’ve seen over the last little while is bonds that would otherwise be earning 5-6% being reinvested at rates closer to 2.5%-3%. What’s that doing is decreasing investment income and putting pressure on earnings for companies. As interest rates rise going forward that would be better news from an investment income perspective, but it would cause the valuation of the bond portfolios to go down. Given the very large proportion of fixed income in anybody’s balance sheet, we are going to see capital pressures in the industry as a result of rising interest rates in the next little while.

PL: The fact that interest rates went down gave us relief in terms of solvency margins. It counterbalanced what happened on the equity side, as the equity drop damaged our solvency ratio. For the long term, if the interest rates are staying low we have an issue because we are in an industry where we usually have a positive cash flow, which we have to invest.  If interest rates are low we would invest at the lower level so the yield of the portfolio is going to decrease.

Q: What do you foresee over the next 18 to 24 months?

JF: I think we’re going to see continuing volatility in the markets. As far as growth for the economy, I do agree with some of the specials that have come out recently that we seem to be through the recession. Hopefully, what we see is modest growth in the next 12 to 18 months.

DH: I see investment markets stabilizing, and the reduced uncertainty will allow for better business planning. I also see a hard market developing, and the pressure points are deteriorating loss ratios. Ontario auto, being a quarter of the Canadian industry’s business, is in serious need of correction. The last three years of weather related water losses are very concerning because it now appears to be much of a trend than a blip. Although commercial property does not yet appear to be softening it has to happen and is simply a matter of time, and I foresee that happening within the next 12 to 18 months.