Monthly Archives: April 2014

CaT pricing “heading for the basement”

Edward Noonan of Validus is always good copy and the Q1 conference call for Validus provided some insight into the market ahead of the important July 1 renewals. When asked by an analyst whether the catastrophe market was reaching a floor, Noonan answered that “I’m starting to think we might be heading for the basement”.

He also said “I think the truly disruptive factor in the market right now is ILS money. I made a comment that we’ve always viewed the ILS manager business behaving rationally. I can’t honestly say that (anymore with) what we’re seeing in Florida right now. I mean we have large ILS managers who are simply saying – whatever they quote we will put out a multi-hundred million dollar line at 10% less.

I have posted many times on the impact of new capital in the ILS market, more recently on the assertion that ILS funds havw a lower cost of capital. Noonan now questions whether investors in the ILS space really understand the expected loss cost as well as experienced traditional players. Getting a yield of 5% or lower now compared to 9% a few short years ago for BBB – risks is highlighted as an indication that investors lack a basic understanding of what they are buying. The growing trend of including terrorism risks in catastrophe programmes is also highlighted as a sign that the new market players are mispricing risk and lack basic understanding on issues such as a potential clash in loss definitions and wordings.

Validus highlight how they are disciplined in not renewing underpriced risk and arbitraging the market by purchasing large amounts of collaterised reinsurance and retrocession. They point to the reduction in their net risk profile by way of their declining PMLs, as the graph below of their net US wind PMLs as a percentage of net tangible assets illustrates.

This is positive provided the margins on their core portfolio don’t decrease faster than the arbitrage. For example, Validus made underwriting income in 2012 and 2013 of 6% and 17% of their respective year-end net tangible assets. The graph below also shows what the US Wind PML would be reduced by if an operating profit of 12% (my approximation of a significant loss free 2014 for Validus) could be used to offset the US Wind net losses. Continuing pricing reductions in the market could easily make a 12% operating profit look fanciful.

click to enlargeValidus Net US Wind PML as % of tangible net assets

I think that firms such as Validus are playing this market rationally and in the only way you can without withdrawing from core (albeit increasingly under-priced) markets. If risk is continually under-priced over the next 12 to 24 months, questions arise about the sustainability of many existing business models. You can outrun a train moving out of a station but eventually you run out of platform!

COLT calls time

COLT announced plans this week to cut €175 million of low margin voice wholesale business and take a €30 million restructuring charge in an attempt to address declining margins and halt operating cash burn, issues which I highlighted in a previous post. The stock took a hit and is down about 10% on the month. Press reports, like this FT article and this Guardian article, speculate that majority shareholder Fidelity is losing patience and the business is effectively for sale. Robert Powell at Telecom Ramblings is also speculating on potential buyers.

The graph below shows my rough estimates of the revenue and EBITDA margin (excluding restructuring charges) for 2014 and 2015 based upon COLT’s guidance (2015 is purely based upon my guestimates). The execution risk in the restructuring based upon the firm’s recent history doesn’t match up against any potential M&A upside in my opinion. This one is best to watch from the side-line. It should be interesting.

click to enlargeCOLT Telecom 2006 to 2013 Revenue & EBITDA Margin 2014 & 2015 forecast

IPCC Risk & Uncertainty

I haven’t had time to go into the latest WGIII IPCC report in detail (indeed I haven’t had much time recently to spend on blogging) but I had a quick browse through the report and there is an excellent chapter on “Integrated Risk and Uncertainty Assessment of Climate Change Response Policies” which goes through many of the key elements of current risk management theory and practise and how they can be applied to climate change.

A previous post highlighted the difficulties of making predictions given the uncertainties involved. The report highlights the “large number of uncertainties in scientific understanding of the physical sensitivity of the climate to the build‐up of GHGs” and acknowledges that these “physical uncertainties are multiplied by the many socioeconomic uncertainties that affect how societies would respond to emission control policies”. The report calls these socioeconomic uncertainties “profound” and lists examples as the development and deployment of technologies, prices for major primary energy sources, average rates of economic growth and the distribution of benefits and costs within societies, emission patterns, and a wide array of institutional factors such as whether and how countries cooperate effectively at the international level.

The IPCC gives a medium rating (50% probability) to the statement that the “current trajectory of global annual and cumulative emissions of GHGs is inconsistent with widely discussed goals of limiting global warming at 1.5 to 2 degrees Celsius above the preindustrial level”.

Included in Chapter 2 are the graphs below. According to the report “the representative concentration pathways (RCPs) are constructed by the IPCC on the bases of plausible storylines while insuring (1) they are based on a representative set of peer reviewed scientific publications by independent groups, (2) they provide climate and atmospheric models as inputs, (3) they are harmonized to agree on a common base year, and (4) they extend to the year 2100”. The 3 scenarios (A2, A1B and B1) are multi-model global averages of surface warming (relative to 1980–1999) shown as continuations of the 20th century simulations. Shading is the plus/minus one standard deviation range of individual model annual averages and the orange line is where concentrations were held constant at year 2000 values. Time permitting; it demonstrates that the conclusions and scenarios presented in the latest report are worth finding out more about.

click to enlargeIPCC global surface temperature scenarios from RCPs

Although each scenario is likely at the mercy of the uncertainties highlighted above, the open and thoughtful way the report is presented, including highlighting the underlying weaknesses, doesn’t mean that they (or the report) can be ignored. Indeed, the recent output from the IPCC will hopefully provide the basis for informed thinking on the subject in the coming years.

The report includes a reference to Kahneman-Tversky’s certainty effect where people overweight outcomes they consider certain, relative to outcomes that are merely probable. That implies that a 50% probability of the temperature blowing through 2 degrees celsius may not be enough to force real action. Unfortunately the underlying scientific and socioeconomic uncertainties inherent in making forecasts on temperature change over the next 30 to 50 years may mean that the required level of certainty cannot ever be achieved (until of course it’s too late).

Pricing Pressures & Risk Profiles

There have been some interesting developments in the insurance market this week. Today, it was announced that Richard Brindle would retire from Lancashire at the end of the month. The news is not altogether unexpected as Brindle was never a CEO with his ego caught up in the business. His take it or leave it approach to underwriting and disciplined capital management are engrained in Lancashire’s DNA and given the less important role of personalities in the market today, I don’t see the sell-off of 5% today as justified. LRE is now back at Q3 2011 levels and is 25% off its peak approximately a year ago. As per a previous post, the smaller players in the specialty business face considerable challenges in this market although LRE should be better placed than most. A recent report from Willis on the energy market illustrates how over-capacity is spreading across specialist lines. Some graphs from the report are reproduced below.

click to enlargeEnergy Insurance Market Willis 2013 Review

One market character who hasn’t previously had an ego check issue is John Charman and this week he revealed a hostile take-over of Aspen at a 116% of book value by his new firm Endurance Specialty. The bid was quickly rejected by Aspen with some disparaging comments about Endurance and Charman. Aspen’s management undoubtedly does not relish the prospect of having Charman as a boss. Consolidation is needed amongst the tier 2 (mainly Bermudian) players to counter over-capacity and compete in a market that is clustering around tier 1 global full service players. Although each of the tier 2 players has a different focus, there is considerable overlap in business lines like reinsurance so M&A will not be a case of one and one equalling two. To be fair to Charman the price looks reasonable at a 15% premium to Aspen’s high, particularly given the current market. It will be fascinating to see if any other bidders emerge.

After going ex-dividend, Swiss Re also took a dive of 9% this week and it too is at levels last seen a year ago. The dive was unusually deep due to the CHF7 dividend (CHF3.85 regular and CHF4.15 special). Swiss Re’s increasingly shareholder friendly policy makes it potentially attractive at its current 112% of book value. It is however not immune from the current market pricing pressures.

After doing some work recently on the impact of reducing premium rates, I built a very simple model of a portfolio of 10,000 homogeneous risks with a loss probability of 1%. Assuming perfect burning cost rating (i.e. base rate set at actual portfolio mean), the model varied the risk margin charged. I ran the portfolio through 10,000 simulations to get the resulting distributions. As the graph below shows, a decreasing risk margin not only shifts the distribution but also changes the shape of the distribution.

click to enlargeRisk Premium Reductions & Insurance Portfolio Risk Profile

This illustrates that as premium rates decline the volatility of the portfolio also increases as there is less of a buffer to counter variability. In essence, as the market continues to soften, even with no change in loss profile, the overall portfolio risk increases. And that is why I remain cautious on buying back into the sector even with the reduced valuations of firms like Lancashire and Swiss Re.

Deflating Bubbles

The market is currently full of overdue anguish, with the air coming out of some of the frothier areas of the market notably in the biotech and internet sectors. To get an idea of the movements, I had a quick look at the S&P500 against a number of other indices such as the Powershares S&P high beta, S&P low volatility, & Nasdaq Internet ETFs plus the Nasdaq Biotech Index (SPHB, SPLV, PNQI & NBI respectively) as per the graph below.

click to enlargeS&P500 vrs SPHB SPLV NBI PNQI

One of the more amusing bubbles in the recent run-up has been that surrounding the creeping legalization of cannabis in the US. Penny stocks in the sector, as if straight out of “The Wolf of Wall Street”, have been rocketing. Some of the more dubious firms have jumped on the bandwagon by coming up with fanciful plans on exploiting cannabis markets after having tried their luck as software, oil exploration or even tanning companies! Firms such as CannaVest (CANV) and Vape Holdings (VAPE) have shown classic pump & dump penny stock rises and falls in recent months.

One stock that has rode both the biotech and the cannabis buddle is a UK firm called GW Pharmaceuticals (GWP.L) founded in 1998 to develop cannabinoid prescription medicines to meet patient needs under medical supervision. Their main product, Sativex, a treatment for moderate to severe spasticity is approved or near approval in a number of countries such as Norway, Israel, and Austria. Bulls point to approval in the US of Sativex and the potential for other cannabinoid products in areas such as cancer and diabetes to justify the current valuation of multiples of revenue for this loss making firm. GWP has risen from 50p last year to a high (forgive the pun!) of 400p in March with a fall back to 250p recently. Cannabis stocks offer the ultimate high for aging stoners, add in some biotech hype for GWP and the sky is the limit to a happy ever after fantasy……….will people ever learn!

To me, the deflating of sector bubbles is a very healthy sign of a rational market.  Whether an outbreak of rationality will last is another matter.