1 C4-4 A PROPOSAL TO MOVE TOWARD REALISTIC PRICING FOR AUTO INSURANCE The effect of the March, 2013, cabinet orders fundamentally shifts the annual rate determination to a multi-year approach in an attempt to provide some smoothing or buffering to the actuarially indicated annual rate change. The Basic capital reserve is now a key component of the rate calculation, rather than a source of emergency funds to protect claimants from unforeseen threats to the program s financial forecast. This change, together with the annual rate change caps imposed on the B.C. Utilities Commission, makes the annual rate determination process much more complex than the system in place until 2013. It also calls into question the Commission s authority to provide an independent decision on the annual level of Basic rates. The change in the price of Basic insurance is the product of a number of variables. Income is affected by the number of policies, their average price (lower revenue from maturing drivers) and the amount of investment income. Costs are determined by the number of new claims, their average costs, the estimated cost of unpaid claims, the expense involved in claims administration, sales and corporate costs, and the cost of taxes and government mandated programs. The third key area is the change required in the capital reserve to maintain the appropriate level of equity available for short-term adverse impacts on the program s finances. The government, by reducing the commission s discretion on the size of the annual change in rates, has decided that the capital reserve will act as a surrogate banker, in effect providing short-term loans to policy holders to moderate significant rate increases (rate shock), with the expectation that the reserve will be replenished in future years. The rate change limitation, effective November, 2014, reduces the importance of the Commission s rate setting authority for 2014 ICBC could increase rates by about 3.5% and a further 2.0% in 2015 with little reference to the Commission.
2 The size of the capital reserve and the annual rate change limits are key components to the viability of the rate smoothing concept. To implement the new rate smoothing scheme ICBC requested (August, 2013) that the MCT capital target be revised from about $1.5 billion (some $500/policy) in 2013 to $1.7 billion (from a MCT of 130% to 150%). The extra $230 million rate smoothing buffer (about$75/policy) was to be phased-in over 10 years. In February, 2014, the government drew on the Optional capital reserve bank to add $113.1 million to the Basic capital reserve (OIC 55/14) which revised the MCT to 149% by December 31, 2013. In late 2012 the government directed ICBC to move $373 million of Optional capital to Basic to keep the MCT above 100% for fiscal 2012. 1. IS RATE SMOOTHING AN OVER REACTION? According to the ICBC legal advisors the Commission cannot question government decisions. However, because the March, 2013, cabinet direction represents such a significant intervention into the rate setting process (and the Commission s independence) a reasonable observer would wonder about the reason for such a change. Clearly the financial crisis of 2008 2010 caused an economic recession and a drop in interest rates. The decline in the economy is reflected in the decline in ICBC s earned revenue from 2009 to 2011 (together with a poorly timed 2.4% rate reduction in 2010). The decline in interest rates has had a negative effect on all insurance companies which hold a majority of their assets in bonds. As bonds mature new bonds are purchased with a lower dividend which reduces investment income. Lower interest rates reduce the discount rate on unpaid claims, which require more funding to cover the claims. A short-term benefit of lower interest rates is an increase in the fair market value of existing (now higher yielding) bonds, but this dissipates as the bonds mature. If the average bond maturity is closely matched to the average claim payment the increase in the asset value should eliminate most of the negative effect of the decline in the discount rate in the short term. Table I shows the change in dollars and percentage for major items. Clearly 2011 was a particularly poor financial year for the Basic program. ICBC did not request a rate increase in 2011, and the capital reserve declined from 153% MCT to 115% MCT. The rate shock came with the 11.2% 1 From 2010 to 2013 the Optional capital reserve has provided $914 million to the government, $485.7 million to the Basic reserve and $400 million ear-marked for major system transformation program.
3 increase in February, 2012. ICBC could have smoothed the shock if they had requested a price increase in 2011. The 11.2% increase of February, 2012, incorporated an increase to cover the prior rate deficit and a 12 month forecast. Rather than request an increase for February, 2013, ICBC timed their next increase for November, 2013, or some nine months beyond the last cycle. A further 11.5% increase was indicated, but this was modified to 4.9% after the government s March, 2013, rate smoothing intervention. The dollar changes for the key components shown in Table I can also be shown as the approximate change in the cost per policy, assuming some 2.8 million (12 month equivalent) policies in 2009 rising to 3.0 million in 2013. The MCT level excludes the 2012 and 2013 transfers from Optional. INCREASE / DECREASE FROM PRIOR YEAR Rate Change Invest. Income Net Income OCE MCT Fiscal Impact 2009 0 +$55 0 +$71 GAAP 2010-0.4% 0 -$43 +$23 153 2011-2.0% -$22 -$85 -$55 115 2012 +10.3% 0 +$21 +$17 101 2013 +1.7% +$50 +$47 +$30 107 The decline in net income and equity in 2010 and 2011 was the product of increasing costs, the lack of rate increases in 2010 and 2011, a 2011 reduction in investment income resulting from the drop in interest rates and the decline in the value of assets. There is no question that the 2008-2010 economic recession and the drop in interest rates were major reasons for the reduction in net income. The cabinet rate smoothing decision was made when the Basic program was experiencing a continued deterioration of its finances and reserve capital, hence the infusion of Optional capital and the desire to spread the indicated 11.5% 2013 rate increase over more than one rate period.
4 Recent rate changes impact ICBC s basic revenue over two fiscal years as shown in the table below. IMPACT OF BASIC RATE PERCENTAGE CHANGES BY FISCAL YEAR Policy Year FY2010 FY2011 FY2012 FY2013 FY2014 Nov/10-Oct/11 (0.4) (2.0) -- -- -- Nov/11-Oct/12 -- -- -- -- -- Nov/12-Oct/13 -- -- 10.3 0.9 -- Nov/13-Oct/14 Imposed -- -- 0.8 4.1 TOTAL (0.4) (2.0) 10.3 1.7 4.1 Nov/13-Oct/14 Indicated -- -- 1.9 9.6 TOTAL Indicated (0.4) (2.0) 10.3 2.8 9.6 MCT Reported 153 115 137 149 -- MCT Normalized 153 115 101 139 Average Basic rates declined 2.4% in November, 2010; did not change in 2011; rose 11.2% in February 2012; and rose 4.9% in November 2013. Had ICBC sought rate increases for November of both 2011 and 2012 the degree of volatility in the price change for Basic insurance would have been much less. ICBC should explain why they did not seek a rate increase during 2011, which would have lessened the financial deterioration that year and for 2012. Perhaps other timing considerations facing the government took priority in the summer of 2011, and again in the spring of 2013. It would appear that the
5 assumption by Ms. Clark of the premiership was an important factor in the deferral of price increases expected for November, 2011, while the increase anticipated for February, 2013 (a year after the last increase), might have become an issue during the May general election. THE EQUITY MARGIN FOR RATE DEFERRAL In their 2013 rate justification ICBC asked the commission to approve an additional 20% MCT capital margin in addition to the existing 130% MCT target. They distinguished the initial 30% margin as being necessary for DCAT justified unanticipated threats to the financial stability of the Basic program, while the 20% was to preserve the 130% MCT solvency target from the effects of the short-term underpricing of the true cost of insurance as a result of revenue deferral or smoothing. The resulting operating deficit would draw down the capital reserve in higher cost years. Basing the annual commission rates on the actuarially indicated cost forecasts is no longer applicable under a rate smoothing (or revenue deferral) approach. The focus of the discussion and analysis of future rate requests now shifts to changes in the capital reserve. During the 2013 rate review the commission asked if the existing 30% MCT margin was still necessary or could some of it be re-purposed as a rate smoothing reserve. ICBC replied that internal analysis confirmed that the 130% MCT was still reasonable (although the analysis was not filed). They conceded that the original 2007 DCAT analysis concern with a rapid increase in inflation was no longer applicable in the current low interest rate environment. However, ICBC asserted that volatility in the equity markets, concerns about unpaid claims (lower discount rates?) and different risks emerging from time to time required that the 30% margin be maintained. 2. In their response they featured four areas of concern; a decline in asset value (a capital issue not net income), increasing average claim costs (this is an annual occurrence and hardly qualifies as unanticipated); a possible increase in unpaid claims cost (a possible discount rate reduction), and inflation (they did not explain how a rise in inflation related to a possible decrease in the discount rate). 2 BCUC, ICBC 2013 Rate Request, BCUC 180.1 December 23, 2013
6 THE 2014/15 RATE REQUEST In essence, the 2014/15 request is to maintain the status quo. The initial 2013/14 forecast was reduced by 6.6% by government order and the structural shortfall is now in the current request at a reduced amount (5.1%). In their submission ICBC states that the rate smoothing framework has been effective in moderating the rate change from the 2013 to the 2014 policy year. 3 Another perspective is that the infusion of $ 485 million of Optional capital in 2012 and 2013 allowed the Basic program to attain a MCT of 149% in 2013. It was this subsidy by Optional policy holders that allows for the current request of 5.2% and provides a forecasted 145% MCT by late 2015. ICBC did not provide a multi-year financial summary of their forecast on a fiscal year basis. This makes comparisons with previous year actuals, the service plan and the 2014 second quarter actuals almost impossible. BASIC AND OPTIONAL CLIENTS ARE THE SAME PEOPLE What is sometimes forgotten in the detailed review of basic rates and no public oversight or comment on Optional rates is that some 96% of basic policy holders purchase Optional insurance, and some 86% buy the ICBC product. 4 The high participation rate is probably because the Basic limits have lost approximately 80% of their value since they were last increased. ICBC continues to over-charge for Optional insurance, and in 2012 and 2013 and $486 million of the resulting excess equity was used to build the Basic equity to higher than necessary levels. In effect, 86% of Basic policy holders paid to increase their own equity reserve (and to bolster the government s revenue). No reduction in Optional rates was announced the 2014/15 year, yet the government recently forecast that their skim of the Optional excess equity would be $111 million more for 2014/15 than the $252 million budgeted. 5 Thus, about 2.7 million of Basic policy holders (86%) will be paying an average increase of $42 per policy (excluding trailers) and see the government take about $41 per policy from 3 ICBC Rate Request, August 29, 2014, p. 2-8. 4 From ICBC s 2013 customer survey, ICBC Rate Request, August 29, 2014, p.10-4. 5 Ministry of Finance, 2014/15 First Quarterly Report, September 9, 2014.
7 their Optional reserve. The government forecast suggests another large Optional profit with the equity again well in excess of the already extreme 260% MCT Optional target. 6 MANAGING TO A MCT TARGET OF 100 PER CENT A more consumer friendly approach to achieving the government's objective, as expressed in their mis-guided rate smoothing intervention in the rate-setting process, would incorporate a more flexible attitude toward the minimum capital requirement of 100%. ICBC has always treated the 100% requirement as inviolate. Once ICBC secured the Commission's agreement in 2007 to 130% MCT target they have not made public any DCAT analysis based on current projections of inflation and other adverse scenarios. In fact, ICBC said they would not lower the 130% target without a directive from Cabinet. 7 In 2013 the difference between the 130% capital target and a 100% target was about $450 million, or approximately $150 per Basic 12 month equivalent policy, assuming approximately 3.0 million policies. In their 2013 rate submission ICBC refers to the 130% target as the solvency target, implying that anything less would put the solvency of the Basic program at risk. The issue of public auto insurance monopolies operating with capital less than a 100% solvency target was addressed by Marilyn McLaren, the former president of the Manitoba Public Insurance, during their 2012 rate request hearing. Ms. McLaren, in discussing the adequacy of the capital level (their rate stabilization reserve) stated that the talk of solvency is a little bit of a red hearing. It doesn't work." She stated that the key issue is with size of the capital reserve (where they were asking their regulator for an MCT of approximately 80% (excluding OCE). "This is about rate stability for Manitoba. if it s about solvency, absolutely we can run with negative retained earnings, both AutoFund and MPI Basic insurance - we've done that for a few years now and again through our forty (40) year history. You know, they don't come and -- 6 See Richard McCandless, ICBC Is Over-Capitalized, BCUC, ICBC 2014 Rate Request, Document C4-3.. 7 BCUC, ICBC 2012 Rate Request, IR 43.2 Response, February 2, 2012.
8 banks don't come and put padlocks on the door, the government doesn't shut it - it doesn't happen". 8 The rate stability scheme specified in the February, 2013, cabinet directive could be accommodated by managing around a MCT target of 100% over a two or three year forecast period. While ICBC focuses on a 12 month policy year, rate increases (decreases in rates are no longer permitted under the new scheme) based on a November 1st date take over two fiscal years to be fully incorporated in to earned income. The rate smoothing directive itself (OIC 152/13) contemplates the MCT falling below 100%, although the co-mixing of the concepts of setting rates to achieve a zero multi-year net income, and using the accumulated capital to moderate indicated rate changes, can quickly become confusing. The recent recommendation of the Saskatchewan Rate Review Panel is also instructive. Their actuarial consultants believe that the Saskatchewan Government Insurance, which manages their compulsory auto insurance, is overly conservative in setting the MCT target at 100%. See: http://www.saskratereview.ca/images/docs/sgi-2014/saf-2014-report-final-kw.pdf What is clear from the 2013 rate request material supplied, the response to the information requests and the oral hearing, is ICBC's continuing desire to increase the capital reserve. If ICBC now considers the new 145% MCT target as inviolate what has been gained (other than a further $225 million being added to the equity target reserve)? 9 Perhaps the government anticipates future capital transfers from the massive Optional reserve to subsidize Basic rates. This certainly will abandon the 2004 Core Review of ICBC funding principle of no cross subsidization; joining the previous discarded principles of low cost insurance, no transfers to government, and a depoliticized process for setting Basic rates. If the Commission adopted a MCT of 100% for Basic insurance and a 2014/15 increase of 3.7% (5.2 less 1.5%) policy holders would see little benefit in reduced rates because of the rate smoothing limits imposed in 2013. Assuming annual cost increases in the 4 to 5% range, and price increases at the lowest allowed level, it would take about four years before the Basic MCT approached the 100% MCT 8 Manitoba Public Utilities Board, Hearing on MPI Rate Request, September 250, 2012, p.269. 9 In 2013 the 100% Basic MCT equates to $1.15 billion, 130% equates to $1.5 billion and 150% equates to $1.73 billion.
9 level. Such a change, however, would be a positive step toward more realistic pricing of public auto insurance in British Columbia. It would also highlight the excessive Optional profits and may embarrass the government to direct ICBC to lower Optional rates and the MCT target. Richard McCandless September 10, 2014.
10 TABLE I ICBC BASIC INSURANCE ($=millions) Earned Claims Total Invest. Net Revenue Current Cost Income Income OCE Equity MCT 2013 2,357.1 2,175.8 2,674.0 437.4 3.0 327.8 1,716.10 149 2012 2,209.3 2,072.5 2,478.3 280.9 (133.1) 232.5 1,427.50 137 2011 2,081.7 1,941.5 2,435.6 278.4 (188.2) 180.8 1,129.70 115 2010 2,096.4 1,785.8 2,263.3 332.8 55.8 334.2 1,514.50 153 2009 2,093.4 1,716.1 2,133.6 339.9 175.5 262.5 1,596.90 162 2008 2,085.5 1,684.7 1,989.1 183.1 175.6 65.1 1,224.00 141 2007 1,993.2 1,706.2 2,031.4 408.7 290.0 186.4 1,169.80 136 PERCENTAGE CHANGE 8.8 6.7 4.5 7.9 55.7 100.0 41.0 20.2 2013 2012 6.1 6.7 1.8 0.9 41.0 28.6 26.4 19.1 2011 (0.7) 8.7 7.6 (16.3) (437.0) (45.9) (25.4) (24.8) 2010 0.1 4.1 5.1 (2.1) (68.2) 27.3 (5.2) (5.6) 2009 0.4 1.8 8.3 85.6-303.2 30.5 14.9 2008 4.6 (1.3) (2.1) (55.2) (39.5) (65.1) 4.6 3.8 Source: ICBC Annual Reports Notes: Rate Change = 2010 Nov (2.4%); 2012 Feb +11.2%; 2013 Nov +4.9%. RMC July, 21, 2014.