Tuesday, 27 August 2013

FSCO Lowers ROE Benchmark to 11%

When approving filed auto insurance rates from individual insurance companies FSCO has allowed a reasonable rate of return. In his 2011 Annual Report, the Auditor General of Ontario discussed the changed economic environment since 1996 when the return on equity (ROE) benchmark was last updated and recommended that it be reviewed. The Ontario Government endorsed the recommendation in the 2012 Ontario Budget.

 FSCO selected two consultants (Dr. Fred Lazar and Dr. Eli Prisman of York University) to conduct the ROE review for automobile insurance. The ROE review included consultation with stakeholders and is now complete and is posted on the FSCO website.

FSCO uses an after-tax , return on equity ( “ ROE ”) benchmark in the rate review process for rate filings by auto insurance companies in the province. The benchmark was initially established at 12.5% in 1988. In 1996 the ROE benchmark was reduced to 12%. The ROE benchmark is one of many variables used in the rate review process .

Three other provinces (Nova Scotia , New Brunswick and Newfoundland and Labrador) use an ROE benchmark ranging from 10% to 12%.

In carrying out their review of FSCO’s ROE benchmark the consultants examined various approaches and settled on the Capital Asset Pricing Model (CAPM) , which is a widely accepted methodology for estimating a company’s cost of equity capital

The consultants concluded that the current cost of capital for insurers is below FSCO’s current 12% after-tax ROE benchmark. They noted , however, that the current risk-free rate is abnormally low as the Bank of Canada deals with the aftermath of the 2008-9 economic and financial crisis and likely underestimates what the risk-free rate might be under more normal economic conditions.

Consequently, the consultants concluded that it would be inappropriate to apply the CAPM simplistically, noting that if it had been applied continuously from 1995 with appropriate risk-free rates and market risk premiums, the resulting ROE would have moved sharply from year to year, in some cases changing by more than 150 basis points. To address the volatility in the application of the CAPM model, the consultants proposed moving to a 5 or 10-year rolling average for the ROE benchmark, utilizing the CAPM results calculated in the report 

If a 10-year rolling average were used to determine the ROE benchmark, for 2013 the benchmark would be between 11.20% and 11.28%. If a 5-year rolling average were used , the benchmark for 2013 would be between 10.40% and 10.56%.

 As a result, FSCO has determined that it will now be using an 11% ROE as a benchmark for Automobile Insurance rate filings, effective immediately.

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