Monthly Archives: May 2013

ILS Pricing Party Heats Up

As we approach the July renewals, new capacity continues to pour into the insurance linked securities space pushing prices ever downward. Morgan Stanley estimate that so called alternative capital will make up 30% of the forthcoming July renewal. Market participants continue to cheer on the arrival of this capacity. To counter some of the concerns expressed about this market, some of which were outlined in my last post on this subject, I noticed an interesting article this week from Guy Carpenter’s website.

The article starts with an overview of the market stating “the impact has been dramatic; pricing has decreased more than 50 percent year over year, particularly for peak U.S. risks such as Florida”. And continues “the institutional money that is offering capacity to Florida wind at 40 percent less than last year’s pricing isn’t pricing Florida risk incorrectly, it just does not have the same capital costs and therefore can, on a sound basis, charge less for peak U.S. wind risk than the traditional reinsurance market on a sustained basis.

In other words, the return hurdles for institutional money is less! That doesn’t make sense if you consider the reduced diversification offered by investments in property catastrophe focused funds to institutional money compared to traditional reinsurers which have diversified portfolios spread over property, casualty, specialty and, in some cases, life business.

Guy Carpenter continue in their attempt to convince themselves that everything will be okay by stating that “increasing the breadth of an informed sophisticated investor base can only be a good thing for the markets’ long term prospects as it increases available capacity without leaving the market susceptible to reckless capital that will support transactions with ill-considered terms, which eventually cause problems themselves or set problematic precedents for others to follow.

I don’t really understand what they are saying here. Is it something as hollow as it’s okay to slash prices as they are “sophisticated investors”? I have even heard another broker try to justify the overall market benefit of the influx of capacity by concluding that excess capacity will result in more policyholders in the high risk zones being able to get property cover. I didn’t know that the institutional investors are getting into this asset class with the intent that the risk profiles expand! Where have we heard that before?

The article again states that “capacity is expanding because sophistication and attention to transaction mechanics is increasing, not decreasing.” Let’s look at a recent deal to see how that statement stacks up. One recent deal this month by Travelers, under the Long Point Re series, covering northeast US wind was priced as per the graphic below compared to last year.

Long Point Graph

Looking at a crude measure of risk and reward, as the coupon divided by expected loss, shows a ratio reduction from 741% to 345% for 2012 to 2013. Other recent deals also show reductions in the risk/reward dynamics such as the Turkish quake deal, under the Bosphorus Re banner, which got away for 250 basis points compared to an expected loss cost of 1% (that’s a 250% ratio). Industry veteran, Luca Albertini of ILS fund Leadenhall Capital Partners, remarked that the Turkish deal was significant as previously this market did not like to play in the sub-300 basis points deal area. Albertini put a positive spin on this development for his sector by saying that the new appetite for sub-300bps issuances means that a wider range of exposures and therefore deals can be marketed, thereby providing diversification. That sounds great but, to paraphrase a quote from Jim Leitner, is there any real benefit to diversification if such diversification comes from a portfolio of underpriced assets? Underpriced risk is, after all, mispriced risk.

I recently asked a banker, who has marketed this new asset class to clients, at what level of return would the institutional investors walk away. To my surprise he said none; based upon his previous experience of investors following sheep like into quant driven new “non-correlating” asset classes, only a loss would awaken investors to the risks. It’s depressing to think that institutional money still likes to partake in the practice of picking up pennies in front of a stream roller!

As readers will realise, I am becoming ever more cautious on the wholesale insurance & reinsurance sector. With overall demand decreasing and supply increasing, the sector looks like it’s reaching an inflection point. In the short term, returns will likely remain acceptable (high single/low double digit ROE) if claim inflation stays mute resulting in continuing underwriting profits/reserve releases and in the absence of large catastrophes. In the medium term, ILS pricing pressures and new capacity entering the traditional market (latest examples include new money from Qatar in the form of Q Re and the AON/Berkshire deal providing a 7.5% blind follow line across the Lloyds market) leads me to conclude that a more defensive investment strategy in this space is warranted.

Underwriting and Credit Cycle Circles

An article from Buttonwood in March reviewed a book by Thomas Aubrey – “Profiting from monetary policy – investing through the business cycle”. Aubrey argues that credit cycles are better predictors of equity and asset prices rather than economic growth. Differentials between the cost of capital and the return on capital drive capital supply.

In previous presentations on the insurance sector and the factors affecting underwriting cycles, I have used the credit cycle as an explanation for demand and supply imbalances. Given the current influx of yield seeking capital into the wholesale insurance market, by way of new risk transfer mechanisms in the ILS sector, and the irrational cost of capital driven by loose monetary policy around the world, Aubrey’s arguments make sense.

Using the calendar year combined ratios of the Lloyds of London insurance market as a proxy for the wholesale market, discounting such ratios at the risk free rate for each year with an assumed payout duration, and comparing these to an index of S&P defaults by origination year illustrates the relationship.

Underwriting & Credit CyclesThe more recent impact of natural catastrophes from 2005 and 2011 illustrates the higher concentration of shorter tail business lines in the past decade as interest rate reductions make longer tail lines less attractive.

Of course, no one factor drives the insurance cycle and there may be a degree of circularity in this picture. Many of the losses at Lloyds in the 1980s and 1990s came from asbestos and pollution claims, issues which drove many companies into insolvency. There is also a circularity between the insurance losses from the events of 9/11 and the economic impact following the bursting of the internet bubble. In addition, there are limitations in comparing calendar year ratios which includes reserve deterioration (particularly from asbestos years) against defaults by origination. Notwithstanding these items, it’s an interesting graph!

My Erratic Telecom Habit

One of the sectors that I have followed for nearly 15 years now is the emerging telecom sector, specifically the so called altnet or CLEC sector. My affiliation with this sector has been the cause of many highs and lows, some very painful lows, through the telecom/internet bubble & bust, the 2000’s and to this day. Initially the attraction was the boom in internet and data traffic and the leveraged nature of many of the firms. After spectacular gains in the go-go days of the bubble (I bought hook line and sinker into the “picks and shovel” rationale), the subsequent reality of the telecom bust and the “nuclear winter” left me with big losses. For those unfamiliar with the stories of the bubble era, Om Malik’s excellent book “Broadbandits: Inside the $750 bilion Telecom Heist” goes deep into the madness that prevailed.

Over the past 10 years odd, I have had a much more cautious and opportunistic approach on the sector and have had some success at dipping in and out of stocks/debt/options of restructured companies as they moved in and out of favour (particularly prior to the financial crisis). Successes in recent years include the post-bankruptcy Virgin Media and Global Crossing. One notable failure was a firm called XO Communications backed by the vulture investor Carl Icahn. A self publicised champion of the minor investor, when it suits him, investing alongside Icahn in XO proved to be a grave error. This article illustrates some of the drama. I Iearned much from the experience including the dangers of illiquid stocks, the nonsense of following a self hyped dominant “star” investor, and the obvious perils of over-leveraged stocks with poor balance sheets in commoditising businesses. Despite these up and downs, the core thesis of a rapidly increasing data consuming society with the potential for high return/high risk (and often leveraged) investments remains for those with an aggressive risk appetite, particularly now that most of the overcapacity from the telecom boom years is becoming less of a factor. For any investor in this space, Robert Powell’s website Telecom Ramblings is the go-to place to get sensible and experienced insights.

One commonly used valuation metric for telecoms is the EV/EBITDA multiple (although it needs to be supplemented with other metrics such as debt and cash-flow measures to get a holistic picture in the altnet space). The graph below shows the variation that has been prevalent in the sector (for selected firms that survived & there is many names that didn’t).

Historical EV/EBITDA Valuations (point selections as at Year End) click to enlarge

Historical EVtoEBITDA Multiples CLEC sector May 2013

As I was preparing to crystallise my thoughts & analysis on this sector (the discipline of having to write down my analysis for this blog is a big reason I am continuing with this blog experiment), the comments from Keith Meister of Corvex at the Ira Sohn conference this week on Level 3 and TW Telecom have been extremely timely. By the way, Meister is an old colleague of Carl Icahn and served as his envoy on the XO board. Given this pedigree, I would therefore totally discount anything he says as 100% self serving. This post will outline some of the historical experience and a follow-on post will outline my valuation analysis for the future of Level 3 and TW Telecom.

Anybody familiar with this space is well aware of the ups and downs of the soap opera that is Level 3. One of the key players in the telecom boom, it built a wholesale network with the help of vast amounts of equity and debt in the bubble years (raised $14 billion in 1998!) and through the 2000’s became a serial consolidator purchasing firms such as Genuity, Wiltel, Progress Telecom, ICG, Telcove, Looking Glass networks and Broadwing to rebalance its business away from the wholesale business into the enterprise space. It is quite incredible that this company avoided the Chapter 11 route that so many companies in this space had to go through to right-size their balance sheets in the face of the new reality of the sector in the 2000’s. With its merger with the restructured Global Crossing announced in 2011, Level 3 seems to have finally reached a level where its balance sheet fits its business. The company also now has diversity across products and regions which indicate that it may be the right time to focus on organic growth. The arrival of the new CEO, Jeff Storey who previously served as Level 3’s COO and previously was the CEO of Wiltel, and his comments on the latest conference call seem to have signalled that Level 3’s consolidation days are behind it and the focus will now be on driving the company forward given its extensive global assets and improved balance sheet. The company is also a potential attractive takeover target for larger established telecoms looking to expand or from regional telecoms or bandwidth hungry technology companies looking for diversification (the more fanciful speculation highlights Level 3’s chairman Walter Scott & his friendship with Warren Buffet and his place on Berkshire’s Board). Again, Robert Powell posts, such as the one this week on TW Telecom, are the place to go to get sensible and knowledgably views on items such as M&A speculation.

TW Telecom, on the other hand, is at the opposite end of the spectrum to Level 3. It always had a focus on the enterprise space and has such a determined management that its business execution normally results in an ability to predict its quarterly result to the nearest million. Its leverage has always being far more rational than that of Level 3 and it has grown into its balance sheet gracefully over the past years. TW telecom is the sensible stable child to Level 3’s wild rebel in this space. Indeed, TW Telecom’s lack of adventure has been recently cited as a reason why it may be ready for a takeover.

In order to get some context on these two US based firms and a view of what has happened to a European focussed altnet, I also include a historical review of a European company called COLT Telecom (recently cited by Telecom Ramblings as a potential acquisition target for Level 3).

Graph of Historical Share Price for LVLT, TWTC, COLT click to enlarge

Historical Share Prices LVLT TWTC COLT

The historical operating figures for these three companies are highlighted below.

Historical Level 3 Operating Metrics (US$s) click to enlarge

Historical Operating Metrics LVLT

Historical TW Telecom Operating Metrics (US$s) click to enlarge

Historical Operating Metrics TWTC

Historical COLT Group Operating Metrics (€s) click to enlarge

Historical Operating Metrics COLT

In the interests of open disclosure, I currently own stock & options in Level 3 and have owned some of the other companies named in this post in the past. I am currently re-examining my valuation methodologies for the sector, specifically for estimating Level 3’s future path using TW Telecom as an example of firm’s experience in a relatively steady state and COLT as an example of firm’s experience on a cross border basis. I have used traditional discounted cash-flow and EV/EBITDA multiple analysis in the past but have recently become more sceptical about the underlying theory for such methods. I am trying to adapt them to get a more realistic view of the sector based upon previous experiences. I will post a follow-up of my thoughts and conclusions.