Uncorrelated CaT capital “is the cheapest”

One of the reasons given by market participants for competitive pricing in the ILS markets is the lower cost of capital required by such instruments due to the uncorrelated nature of the underlying exposure with other classes. I previously posted on the lower risk return for an ILS fully collaterised portfolio against a similar portfolio written by a mono-line property catastrophe reinsurer. The ILS investor may be prepared to accept a lower return due to the uncorrelated nature of the exposure. It is nonetheless resulting in lower prices for risk which has always ended badly in the past.

Twelve Capital are a well known ILS investment manager and recently published a white paper on the impact of ILS capital on the reinsurance industry. I liked the way they described the lower cost of capital issue, as below:

“Equity is the most expensive form of capital for the (re)insurance industry. Thanks to its diversification benefits, ILS is the cheapest. The most popular form of investment for those looking to enter the reinsurance market was, prior to the birth of ILS, equity offered by traditional reinsurers. However, returns on equity are eroded by company management costs and the tendency of reinsurers to diversify into less profitable lines of business. In addition, financial market investments on the asset side of the balance sheet expose reinsurance shareholders to additional financial market risks. A listed reinsurance stock thus has the disadvantage of being highly correlated to equity markets in general.

So, what ought to be a fundamentally uncorrelated investment gets transformed into a correlated investment, and the diversification benefit is lost. The investor is also exposed to the risk that the management of reinsurance companies might not always act in the best interests of shareholders.

As insurance investors focus on those lines of business that are favourably priced and soundly modelled, reinsurance companies might end up losing their most profitable lines to the ILS market. And it is this source of profit that reinsurers have traditionally relied upon to support and cross-subsidise substantial volumes of business that generally only break even. With profitable lines taken away by more efficient investors, reinsurance companies are left with business models that cannot sustain conventional cross-subsidisation.”

The comment on reinsurer’s management is a bit below the belt! The impact of the loss of the low frequency/high severity business to the traditional market is a valid one though. However, the long histories of the largest tier 1 reinsurers with large diverse portfolios and the ability to provide products and services across most business lines and jurisdictions indicate more robust business models than the commentary suggests in my opinion.

My previous post looked at the capital return of a fully collaterised provider such as an ILS fund against a mono-line catastrophe provider such as a property cat reinsurer. To see if the commentary above on a correlated investment is reflective of actual experience, the graph below shows the S&P500 against the share prices of the property catastrophe reinsurers Renaissance Re, Validus Re, Montpelier Re and Platinum Re since late 2002. Excluding Montpelier Re, which obviously had some company specific issues after the 2005 wind losses, the R2 for the other firms is remarkably similar around 65%. This suggests investing in the equity of these firms has indeed been a correlated investment in the past.

click to enlargePropCaT Reinsurers correlated to SP500

It emphasises that the traditional reinsurance market needs to focus on reducing such correlation, whether real or wrongly perceived, to compete better for this cheap capital.

The fascinating case of Betfair

With the ending of the World Cup, my attention turned again to my attempts at understanding the issues facing the betting and gambling sector. For the sake of full disclosure, I am a novice on the sector (I am not a gambler if investing and the odd poker game are not included as such) and have no positions in any betting or gaming stock. My ramblings here, and in previous posts, simply illustrate my attempts to satisfy my curiosity about a sector that is at a fascinating point of change.

In a previous post, I highlighted the changes that the internet has had on the betting and gaming sectors. At that time, I thought the impact of the disintermediating betting exchanges on traditional business models could provide interesting insights into other disintermediating businesses in the financial sector. However, as I have found out more about the sector, such as the results of the traditional betting firms in the UK as per this post, there are a multitude of issues facing the sector such that a review of the impact of the betting exchanges in isolation is not that informative and (frankly) outdated given current developments. Recent developments include regulatory changes such as those in the US which has prompted the purchase of the largest online poker firm Pokerstars by approximately $5 billion by Amaya Gaming and new online taxes such as the forthcoming UK point of consumption (POC) tax of 15% due in December.

As the graph of Betfair’s share price since its floatation in late 2010 shows, the betting exchange model clearly has not had much of a disruptive impact on the traditional business models in recent years.

click to enlargeBetfair historical share price

Rather than go over Betfair’s eventful past in detail here, I will focus on current issues. Niall O’Connor in his blog, bettingmarket.com, has a number of informative articles on the history of Betfair, including this one. Below, I show a graph of Betfair’s profit before tax against the other UK betting firms which illustrates its difficulties in the recent past. The 2012 results (which are Betfair’s YE 2013 results as their year ends in April) exclude some write-offs and adjustments as a result of Betfair’s turnaround plan (which are included in the dotted line). The plan involved refocusing on sustainable geographical betting markets with accommodative regulations and developing a fixed odds betting business alongside the exchange to optimise the liquidity advantages of each model.

The new plan, in effect, admitted that the stand alone betting exchange model was flawed and that some markets “may not have sufficient liquidity to offer an optimal betting experience, notably in ante post and ancillary markets“. The firm estimates its share of the sophisticated bettor market of £150 million at 60-70% but its share of the recreational and occasional bettor market of £500 million at less than 10%. This market is where they see growth and Breon Corcoran, previously Paddy Power’s COO, was brought in as Betfair’s new CEO in August 2012 to execute on the new direction. The most recent results show that the new strategy is delivering better results.

click to enlargeBetfair 10 year Profit Before Tax margins

The focus on sustainable betting markets and cost cutting whilst increasing marketing spending (Betfair were high profile in recent World Cup advertising) can be seen in the graph below. Product development in features such as cash out and price rush (automatically gives the best odds from fixed odds and exchange) are being heavily pushed, particularly in the growingly important mobile market.

click to enlargeBetfair Revenue & Expense Breakdown

As mentioned in the previous post, there is a vast body of academic research on the gambling market and with the wealth of data that Betfair offers, the betting exchange market has been no exception in the studies. The Institute for Strategy and Business Economics in the University of Zurich in particular has some interesting papers. This one, for example, contends that there is a growing body of evidence that exchange markets “exhibit high prediction accuracy as they regularly outperform non-market forecasting methods”. The well-documented long-shot bias where the tendency to overvalue underdogs by fixed odd markets “is less pronounced in person-to-person betting” and this can be used by traders on the betting exchange to arbitrage price differences.

There is a particularly interesting paper by Egon Franck, Raphael Flepp and Stephan Nüesch in the University of Zurich from December 2013 on the importance of liquidity in determining price competitiveness which the authors offer as one of the reasons behind BetFair’s move into fixed odds online betting. Other arbitrage opportunities indentified by research include bookmakers actively shading prices in the presence of a partly irrational betting audience in order to increase their profit (e.g. sentiment bias in football games by the home fans) or the movement in odds prior and during games with the growth of in-play betting.

The development of sports investment funds was previously highlighted in a Bloomberg article and despite an early hic-cup with the collapse of a fund called Centaur there are many now developing predictive algorithms which try to take advantage of arbitrage opportunities. BetFair is consistently looking at how it can optimise its pricing (on the exchange it earns its commissions on winnings by a sliding scale on volume) in different geographical areas and sports to maximise its commissions, despite an outcry from a pricing charge change a few years ago.

Although BetFair face considerable challenges (e.g. I estimate that 95% of BetFair’s sustainable revenues are concentrated in the UK and the firm disclosed that the POC tax, if implemented as currently envisaged, would of cost them £36 million for their 2014 year, one with £61 million of operating profit!) in the short to medium term, one of their strengths is the balance sheet with a net asset ratio of 55% and a cash pile of over £200 million and a strong cash generating business. In their latest results Corcoran commented that “the flexibility we retain through our strong balance sheet provides a competitive advantage during uncertain times for the gaming sector. We will continue to review our balance sheet on a regular basis.” Although Betfair are a fascinating case to keep an eye on, the uncertainties on the POC tax issues outweigh any positive investment case for now.

In my attempts at understanding the sector more, these comments led me to look at some other models (and possible acquisition targets) in the other publically traded online firms, mainly on the gaming side. Names that I have looked at include 888, BWIN (currently looking at strategic options!) and 32Red. I am also intrigued by the software gaming firm Playtech which provides the underlying software to many firms in the sector. I will follow-up with a post on further musings.

US Hurricane Follow-up

Following up on the topic of the last post, I previously discussed the importance of looking at historical experience adjusted for today’s exposure. Roger Pielke Jr is one source that has looked to “normalise” historical hurricane insured losses through the prism of today’s building types and densities and I highlighted Pielke’s work in my June 2013 post.

Another market expert is Karen Clark who used to work for one of the main catastrophe modelling firms, AIR Worldwide, and who now runs a consultancy firm. In August 2012, her firm published a report on the exposure adjusted insured cost of historical storms that would cost $10 billion or more. The graph below reproduces the results of the report showing the cost per year for hurricanes greater than $10 billion up to 2011, with the 20 year average loss cost.

click to enlargeHistorical US Hurricanes greater than $10 billion Karen Clark

The graph below, also from the Karen Clark report, shows where the storms hit.

click to enlargeLandfall Points of Historical US Hurricanes Karen Clark

Roger Pielke continues to issue interesting insights on his blog and in a recent post he stated:

“We shouldn’t let the past 9 years of abnormally low hurricane activity lull us into a sense of complacency.  It is only a matter of time before the long streak with no US Cat 3+ and Florida hurricanes is broken.”

That is a message that the current reinsurance market is happily ignoring.

Arthur opens the US Hurricane Season

After Hurricane Arthur briefly made landfall in North Carolina on Thursday night, a weakened storm is now heading north. I thought this would be good time to have a look at the probable maximum losses (PMLs) published as at the Q1 2014 results by a sample of specialist (re)insurers, first presented in a post in June 2013. That post went into some detail on the uncertainties surrounding the published PMLs and should be read as relevant background to the figures presented here.

Despite predictions of an above average 2013 Atlantic hurricane season, the number of named hurricanes was the lowest since 1982. Predictions for the 2014 season are for a below average number of hurricanes primarily due to cooler sea temperatures in the Atlantic due to the transition to El Niño (although that is now thought to be slower than previously anticipated). The graph below includes the 2014 predictions.

click to enlargeHistorical Atlantic Storms & Hurricanes I like to look at PMLs as a percentage of net tangible assets (NTA) on a consistent basis across firms to assess exposures from a common equity viewpoint. Many firms include subordinated debt or other forms of hybrid debt in capital when showing their PMLS. For example, Lancashire has approximately $330 million of sub-debt which they include in their capital figures and I have show the difference with and without the sub-debt in the percentages for Lancashire in the graph below on US wind PMLs to illustrate the comparison.

Whether hybrid debt comes in before equity or alongside equity depends upon the exact terms and conditions. The detail of such instruments will determine whether such debt is classified as tier 1, 2 or 3 capital for regulatory purposes under Solvency II (although there are generous transitional timeframes of up to 10 years for existing instruments). The devil is often in the detail and that is another reason why I prefer to exclude them and use a consistent NTA basis.

As per the June 2013 post, firms often classify their US wind exposures by zone but I have taken the highest exposures for each (which may not necessarily be the same zone for each firm).

click to enlargeUS Wind PMLs Q1 2014 These exposures, although expressed as percentages of NTAs, should be considered net of potential profits made for 2014 to assess the real impact upon equity (provided, of course, that the expected profits don’t all come from property catastrophe lines!). If for example we assume a 10% return on NTA across each firm, then the figures above have to be adjusted.

Another issue, also discussed in the previous post, is the return period for similar events that each firms present. For example, the London market firms present Lloyds’ realistic disaster scenarios (RDS) as their PMLs. One such RDS is a repeat of the 1926 Miami hurricane which is predicted to cost $125 billion for the industry if it happened today. For the graph above, I have assumed a 1 in 200 return period for this scenario. The US & Bermudian firms do not present scenarios but points on their occurrence exceedance probability (OEP) curves.

As it is always earthquake season, I also include the PMLs for a California earthquake as per the graph below.

click to enlargeCalifornia EQ PMLs Q1 2014 In terms of current market conditions, the mid-year broker reports are boringly predictable. John Cavanagh, the CEO of Willis Re, commented in their report that “the tentacles of the softening market are spreading far and wide, with no immediate signs of relief. We’ve seen muted demand throughout 2014 and market dynamics are unlikely to change for some time to come. The current market position is increasingly challenging for reinsurers.” Aon Benfield, in their report, stated that “the lowest reinsurance risk margins in a generation stimulate new growth opportunities for insurers and may allow governments to reduce their participation in catastrophe exposed regions as insurance availability and affordability improves”. When people start talking about low pricing leading to new opportunities to take risk, I can but smile. That’s what they said during the last soft market, and the one before that!

Some commentators are making much of the recent withdrawal of the latest Munich Re bond on pricing concerns as an indicator that property catastrophe prices have reached a floor and that the market is reasserting discipline. That may be so but reaching a floor below the technical loss cost level sounds hollow to me when talking about underwriting discipline.

To finish, I have reproducing the graph on Flagstone Re from the June 2013 post as it speaks a thousand words about the dangers of relying too much on the published PMLs. Published PMLs are, after all, only indicators of losses from single events and, by their nature, reflect current (group) thinking from widely used risk management tools.

click to enlargeFlagstone CAT losses Follow-on: It occurred to me after posting that I could compare the PMLs for the selected firms as at Q1 2014 against those from Q1 2013 and the graph below shows the comparison. It does indicate that many firms have taken advantage of cheap reinsurance/retrocession and reduced their net profiles, as highlighted in this post on arbitrage opportunities. Some firms have gone through mergers or business model changes. Endurance, for example, has been changed radically by John Charman (as well as being an aggressive buyer of coverage). Lancashire is one of the only firms whose risk profile has increased using the NTA metric as a result of the Cathedral acquisition and the increase in goodwill.

click to enlargeUS Wind PMLs Q1 2013 vrs 2014

Reluctant Bulls

There was a nice piece from Buttonword in the Economist where he concluded that despite all the indicators of the equity market being overvalued that “investors are reluctant bulls; there seems no alternative”. This seems like a rationale explanation for the relatively irrational behaviour of current markets.

He highlighted indicators like the high CAPE, figures from the Bureau for Economic Analysis (BEA) on the profit dip in Q1, high share buybacks, figures from SocGen’s Andrew Lapthorne that the ratio of corporate debt to assets is close to its 2009 peak, and a BoA Merrill Lynch poll which shows that 48% of institutional investors are overweight equities whilst a net 15% believe they are overvalued.

Despite the bearish indicators everywhere, investors seem frozen by central bank indecision on whether economies still need help by remaining accommodative or that the recovery has taken hold and monetary policy needs to start to tighten.

Andrew Lapthorne released some analysis earlier this month highlighting that a significant amount of the previous year’s earnings growth was down to M&A from Verizon and AT&T and concluded that EPS growth by M&A and from share buybacks is a classic end of cycle indicator. Lapthorne produced the graph below of historical peaks and troughs in the S&P500 and noted that the average historical 1% down days is 27 per year since 1969 an the S&P500 has only had 16 in the past 12 months and that we have gone through the 4th longest period on record without a market correction of 10% or more.

click to enlarge
SocGen peak to through

Albert Edwards, also at SocGen, points to the difference in the BEA profit statistics and those reported being down to the expiration of tax provisions for accelerated depreciation and he concludes that “the bottom line is that the U.S. profits margin cycle has begun to turn down at long last“.

Even the perma-bull David Bianco of Deutsche Bank has cautioned against overvaluation calling the market complacent and moving into mania territory using their preferred measure of sentiment, namely the PE ratio divided by the VIX. The graph below from early June illustrates.

click to enlarge
DB Price Earnings VIX Ratio

From my point of view, I think the chart of the S&P500 for the past 10 years tells its own story about where we are. As Louis Rukeyser said “trees don’t grow to the sky“. Nor do equity markets.

click to enlarge

S&P500 Past 10 Years