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Insurance risk management

By the very nature of an insurance contract, there is uncertainty as to whether an insured event will occur and the amount of loss that would arise in such an event. In the course of these insurance activities, there are several risks the Company must address by applying appropriate underwriting and claims policies and processes. The following discussion outlines the most significant insurance risks and the practices employed to mitigate these risks.

(a) Underwriting risk

Underwriting risk is the risk of adverse financial exposures arising from various activities integral to the underwriting of insurance products, including: product design, pricing, policy issuance, risk acceptance and claims settlement. The Company’s exposure to concentrations of insured risks is mitigated by the use of segmentation, policy issuance and risk acceptance rules, individual limits and reinsurance.

The concentration of written premiums by line of business and geographical region are as follows:

2016 Written Premiums by Line of Business
  2016 2015
Personal auto 44.1% 42.8%
Personal property 19.1% 19.4%
Commercial auto 13.7% 13.2%
Commercial property and liability 23.1% 24.6%
  100.0% 100.0%
2016 Underwriting Risk
  2016 2015
Ontario 59.1% 57.4%
British Columbia 13.9% 14.8%
Alberta and Prairies 13.6% 14.5%
Atlantic 6.7% 6.8%
Quebec 6.5% 6.3%
Out of Canada 0.2% 0.2%
  100.0% 100.0%

A financial loss occurs when the liabilities assumed exceed the expectation reflected in the pricing of an insurance product. The Company prices its products by taking into account several factors including product design and features, claim frequency and severity trends, product line expense ratios, special risk factors, capital requirements, regulatory requirements and investment income. These factors are reviewed and adjusted as needed to ensure they are reflective of current trends and market conditions. The Company endeavours to maintain pricing levels that produce an acceptable return by appropriately measuring and incorporating these factors into its pricing decisions. Pricing segmentation and risk selection are used together to attract and retain risks at acceptable return rates. The process of calculating pricing involves the use of models, which exposes the Company to model risk in the event that actual results differ from those modelled, due to model limitations, data issues or other factors.

New products are subject to a detailed review by management, including the Company’s actuarial specialists, prior to their launch in order to mitigate the risk that they are priced at an inadequate level. The performance and pricing of such new products are regularly monitored and corrective action is taken as considered necessary, including re-pricing of the products and the use of reinsurance.

To minimize the risk arising from underwriting, the Company has policies that set out the underwriting risk appetite and criteria, as well as specified tolerances for maximum financial risk retention. The Company utilizes reinsurance in order to manage its exposure to insured risks. Once the retention limits are reached, reinsurance is utilized to cover the excess risk. The Company reviews the adequacy of its reinsurance programs, at least annually, to ensure sufficient reinsurance protection is in place at an appropriate cost.

To minimize the risk arising from claims settlement, the Company attempts to reduce its exposure to unpredictable future developments that could negatively impact claims settlement by promptly responding to new claims and actively managing existing claims, thereby shortening the claims cycle. In addition, the Company’s regular detailed review of claims handling procedures and frequent investigation of possible fraudulent claims attempts to manage the claims risk exposure of the Company.

Quality review procedures exist to ensure that the Company’s underwriting and claim activities fall within established guidelines and pricing structures. Head Office and field level reviews are conducted on a sampled basis. The results of these quality reviews are shared with the appropriate field management staff to ensure any issues identified are remedied.

In the normal course of business, the Company may from time to time be subject to a variety of legal and regulatory actions relating to its operations. In addition, plaintiffs continue to bring new types of legal claims against insurance and related companies. Current and future court decisions and legislative activity may increase the Company’s exposure to these types of claims. This risk of potential liability may make reasonable resolution of claims more difficult to obtain.

The Company uses reinsurance to manage its exposure to insured risks. Reinsurance coverage risk arises because reinsurance terms, conditions, availability and/or pricing may change on renewal, particularly during times of high levels of catastrophe events, either in Canada or globally, or as a result of higher than expected claims activity on the non-catastrophe reinsurance treaties. In addition, reinsurers may seek to impose terms that are inconsistent with corresponding terms in the policies written by the Company. Ceding risk to reinsurers does not relieve the Company of the obligation to its policyholders for claims. The Company works only with well-established and financially secure reinsurers that have extensive experience in the P&C insurance industry and a strong understanding of its business and the Canadian environment. Senior management reviews the Company’s reinsurance program to ensure its cost effectiveness and that adequate coverage is obtained, reflective of the Company’s risk tolerances and financial strength, and in compliance with its reinsurance and capital risk management policies.

The P&C industry is subject to significant government regulation. As a result, it is possible that future regulatory changes or changes in interpretations may limit the Company’s ability to adjust prices, adjudicate claims or take other actions that would enhance operating results. The Company seeks to mitigate this risk through regular discussions with regulators and P&C industry groups to ensure the Company is aware of proposed changes and by providing feedback to regulators on proposed changes. The Company monitors compliance with relevant regulations and considers the implications of potential changes in regulation or interpretation on future results. Note 18 provides information on regulatory capital requirements. Note 19 provides additional details on rate regulation.

(b) Claims reserving risk

Claims reserving risk represents the risk that the Company’s estimates of claim liabilities are insufficient to cover future insurance claim payments. The Company’s underwriting profitability depends upon the ability to accurately assess the risk associated with the insurance contracts underwritten by the Company. The Company establishes claim liabilities to cover the estimated liability for payment of all claims and claims adjustment expenses incurred with respect to insurance contracts underwritten by the Company. Claim liabilities do not represent an exact calculation of the liability. Rather, claim liabilities are the Company’s best estimates of the expected ultimate cost of resolution and administration of claims. The process of calculating claim liabilities involves the use of models, which exposes the Company to model risk in the event that actual results differ from those modelled, due to model limitations, data issues or other factors. Expected inflation is taken into account when estimating claim liabilities, thereby mitigating inflation risk.

Claim liabilities include an estimate for reported claims as established by the Company’s claims adjusters based on the details of reported claims, plus a provision for IBNR.

Individual claims estimates are determined by claims adjusters on a case-by-case basis in accordance with documented policies and procedures. These specialists apply their knowledge and expertise, after taking available information regarding the circumstances of the claim into account, to set individual case reserve estimates. The IBNR provision is intended to cover future development on both reported claims and claims that have occurred but have not yet been reported. Uncertainty exists on reported claims in that all information may not be available at the valuation date. Uncertainty also exists regarding the number and size of claims not yet reported as well as the timing of when the claims will be reported.

The valuation of claim liabilities is based on estimates derived by geographical region and line of business using generally accepted actuarial techniques. Numerous individual assumptions that impact average claim costs or frequency of late reported claims are made for each line of business. The principal assumption in the majority of actuarial techniques employed is that future claims development will follow a pattern similar to recent historical experience. However, there are times where historical experience is deemed inappropriate for evaluating future development due to recent judicial decisions, changes to government legislation or major shifts in a book of business. Such instances can require significant actuarial judgment, often supported by industry benchmarks, in establishing an adequate provision for claim liabilities.

As the outstanding claim liabilities represent payments that will be made in the future, they are discounted to reflect the time value of money, effectively recognizing that the bonds held to support insurance liabilities will earn a return during that period. The discount rate used to discount the actuarial value of claim liabilities is based on the fair value yield of the Company’s bonds that support the claim liabilities (note 5). In assessing the risks associated with investment income and therefore the discount rate, the Company considers the nature of the bond portfolio and the timing of claim payments and their matching to investment cash flows. Future changes in the bond portfolio could change the value of claim liabilities by impacting the fair value yield.

The following table presents the interest rate sensitivity analysis for a 1% change in interest rates on the net claim liabilities:

2016 Written Premiums by Line of Business
(in thousands of dollars) 2016 2015
Impact on: +1% -1% +1% -1%
Net claim liabilities $ Loss: (67,320) $ 72,293 $ Loss: (67,282) $ 72,463

Establishing an appropriate level of claim liabilities is an inherently uncertain process and is closely monitored by the Company’s corporate actuarial department. The sheer volume and diversity of considerations makes it impracticable to measure the impact on the Company’s insurance contracts resulting from a change in a particular assumption or group of assumptions. The analysis below demonstrates the impact of changing assumptions for all lines of business and geographical regions in such a way that the average claim severity and frequency is altered materially. The analysis below also isolates the impact within the average claims severity of a change in internal claims expenses on claim liabilities. The impacts below are on the reported claim liabilities as at December 31.

2016 Written Premiums by Line of Business
  2016 2015
Impact of change in net claim liabilities due to: +5% -5% +5% -5%
Change in average claims severity $ 115,051 $ Loss: (115,051) $ 111,891 $ Loss: (111,891)
Change in frequency on unreported claims $ 9,007 $ Loss: (9,007) $ 8,313 $ Loss: (8,313)
Change in internal claims expenses $ 6,779 $ Loss: (6,779) $ 6,566 $ Loss: (6,566)

Assumptions and methods of estimation have been used that the Company believes produce reasonable results given current information. As additional experience and other data become available, the estimates could be revised. Any future changes in estimates would be reflected in the consolidated statement of comprehensive income in the year in which the change occurred.

The following table shows the development of claims over a period of time. The table reflects development for net claims, which is gross claims less reinsurance recoveries. The triangle in the table (“Estimate of ultimate claims”) shows how the ultimate estimates of total claims for each accident year develop over time as more information becomes known regarding individual claims and overall claims frequency and severity. Each column tracks the claims relating to a particular “accident year” which is the year in which such loss events occurred, regardless of when they were reported. The rows reflect the estimates in subsequent years for each accident year’s claims. Claims are presented on an undiscounted basis in the triangle. “Cumulative claims paid” in the table presents the cumulative amounts paid for claims for each accident year as at December 31, 2016.

The claims development table excludes the FA, RSP/PRR and the effect of discounting (including PfAD), which are shown as separate reconciling items below the table.

Claims development table, net of reinsurance:

2016 Claims Development, net of Reinsurance
Accident Year (in thousands of dollars)
  2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Total
Estimate of ultimate claims
At end of accident year $ 1,295,586 $ 1,473,388 $ 1,401,630 $ 1,198,256 $ 1,129,584 $ 1,058,577 $ 1,224,981 $ 1,258,496 $ 1,273,526 $ 1,425,491    
1 year later   1,280,821   1,432,320   1,352,544   1,085,810   1,038,734   1,005,550   1,211,859   1,241,147   1,248,044        
2 years later   1,264,745   1,422,564   1,349,179   1,086,656   1,031,543   1,003,497   1,211,541   1,238,117            
3 years later   1,265,880   1,410,738   1,368,331   1,088,028   1,050,942   1,003,389   1,225,102                
4 years later   1,264,813   1,427,118   1,367,656   1,099,605   1,047,484   1,010,459                    
5 years later   1,273,663   1,427,746   1,364,157   1,097,641   1,045,845                        
6 years later   1,275,879   1,421,896   1,352,093   1,090,703                            
7 years later   1,268,970   1,413,038   1,343,588                                
8 years later   1,257,162   1,405,486                                    
9 years later   1,251,602                                        
Favourable (unfavourable) development recognized in the year, undiscounted   5,560   7,552   8,505   6,938   1,639   Loss: (7,070)   Loss: (13,561)   3,030   25,482     $ 38,075
Unfavourable development recognized from 2006 and prior accident years                                           Loss: (1,808)
Favourable development recognized from FA and RSP/PRR ceded and assumed in the year                                           3,840
Total favourable development recognized in the year                                         $ 40,107
Reconciliation to the consolidated balance sheet
Current estimate of ultimate claims $ 1,251,602 $ 1,405,486 $ 1,343,588 $ 1,090,703 $ 1,045,845 $ 1,010,459 $ 1,225,102 $ 1,238,117 $ 1,248,044 $ 1,425,491 $ 12,284,437
Cumulative claims paid   1,227,530   1,366,348   1,277,473   1,017,112   952,166   876,606   1,000,108   926,665   855,118   705,600   10,204,726
Current unpaid and unreported claims before discounting   24,072   39,138   66,115   73,591   93,679   133,853   224,994   311,452   392,926   719,891   2,079,711
Current unpaid and unreported claims before discounting pertaining to 2006 and prior accident years                                           69,818
Impact of discounting (including PfAD)                                           101,397
FA and RSP/PRR ceded and assumed, unpaid and unreported                                           50,094
Unpaid and unreported claims, net of reinsurance                                         $ 2,301,020


(c) Catastrophe risk

Catastrophe risk may arise if the Company experiences a considerable number of losses due to man-made or natural catastrophes that result in significant impacts on claims costs. Catastrophes can cause losses in a variety of different lines of business and may have continuing effects which, by their nature, could delay or impede efforts to accurately assess the full extent of the damage they cause on a timely basis. Although the Company evaluates catastrophe events and assesses the probability of occurrence and magnitude of impact through various commonly used, industry-wide modelling techniques and through the aggregation of limits exposed in each geographical territory in which it operates, such events are inherently unpredictable and difficult to quantify. In addition, the incidence and severity of catastrophe events may become increasingly unpredictable as climate patterns change, and severe weather caused by climate change will likely continue to affect the P&C industry and result in higher claims costs.

The Company manages its catastrophe events exposure through the deductibles charged to policyholders, by limitations on policies, by purchasing reinsurance, and monitoring the impact on capital position and overall risk tolerances. The Company currently purchases reinsurance to provide coverage for catastrophe events.