Monthly Archives: May 2014

Is the Euro now safe?

Whilst reading commentary on the implications of the Euro elections and the procedural tensions over the selection of the next European Commission president between the EU parliament and Europe’s finance ministers, I came across a thought provoking article – “Whither the Euro”- from a March IMF publication by Oxford Professor Kevin O’Rourke.

O’Rourke points out that the preventative policies necessary to avoid another Euro crisis – first a banking union, then a single resolution framework, followed by a euro area fiscal backstop, and (maybe) a common deposit insurance framework – require a deepening of European integration or “more Europe”. Although progress has been made on banking union, the “show me the money” commitment required for the next steps of integration has not been forthcoming so far. Nichola Veron, in another IMF article entitled “Tectonic Shift”, describes banking union as “a regime change for European finance” and says that whilst “prospects for the first step (of banking union) are reasonably encouraging, it will be a long time before the implications for Europe’s financial stability and economic prospects can be comprehensively assessed”.

O’Rourke highlights the reality today and the choice facing Europe:

“Europe is now defined by the constraints it imposes on governments, not by the possibilities it affords them to improve the lives of their people. This is politically unsustainable. There are two solutions: jump forward to a federal political Europe, on whose stage left and right can compete on equal terms, or return to a European Union without a single currency and let individual countries decide for themselves.”

O’Rourke asks at what stage the European wide political resolve to jump forward will emerge, having failed to materially progress 5 years after the crisis. The election results which just emerged across Europe suggest that the electorate has little appetite for “more Europe” and that there is a real disconnect with policy makers.

I must admit that since the Draghi put dispersed the prospect of a Euro breakup, I haven’t given much thought to revisiting the messy consequences. The fantasy spreads of many European sovereign bonds, as highlighted in a previous post, do suggest that markets are currently being over-optimistic on the future monetary stability of the region. With the prospect of future uncertainty due from increasing electorate discontent across Europe and due to events such as the unresolved structural faults in many economies and the likely exit of the UK from the EU in a referendum due by the end of 2017, a logical prediction may be that we will revisit the whole subject of the Euro again in the years to come.

Computer says yes

Amlin reported their Q1 figures today and had some interesting comments on their reinsurance and retrocession spend that was down £50 million on the quarter (from 23% of gross premiums to 18%). Approx £20 million was due to a business line withdrawal with the remainder due to “lower rates and improved cover available on attractive terms”.

Amlin also stated “with the assistance of more sophisticated modelling, we have taken the decision to internalise a proportion of a number of programmes. Given the diversifying nature of many of our insurance classes, this has the effect of increasing mean expected profitability whilst only modestly increasing extreme tail risk.

The use by insurers of their economic capital models for reinsurance/retrocession purchases is a trend that is only going to increase as we enter into the risk based solvency world under Solvency II. Current market conditions have resulted in reinsurers being more open to offering multi-line aggregate coverage which protect against both frequency and severity with generous exposure inclusions.

It will only be a matter of time, in my opinion, before reinsurers underwrite coverage directly based upon a insurer’s own capital model, particularly when such a model has been approved by a firm’s regulator or been given the blessing of a rating agency.

Also in the future I expect that firms will more openly disclose their operating risk profiles. There was a trend a few years ago whereby firms such as Endurance (pre- Charman) and Aspen did include net risk profiles, such as those in the graphs below, in their investor presentations and supplements (despite the bad blood in the current Endurance-Aspen hostile take-over bid, at least it’s one thing they can say they have in common!).

click to enlargeOperating Risk Distributions

Unfortunately, it was a trend that did not catch on and was quickly discontinued by those firms. If insurers and reinsurers are increasingly using their internal capital models in key decision making, investors will need to insist on understanding them in more detail. A first step would be more public disclosure of the results, the assumptions, and their strengths and weaknesses.

IOSCO Report on Corporate Bonds

Staff from IOSCO issued a report in April on the global corporate bond market. Although there was nothing earth shattering in the report, there was some interesting insights. The report highlighted 4 themes as below:

  1. Corporate bond markets have become bigger, more important for the real economy, and increasingly global in nature.
  2. Corporate bond markets have begun to fill an emerging gap in bank lending and long-term financing and are showing potential for servicing SME financing needs.
  3. A search for yield is driving investment in corporate bond markets. A changing interest rate environment will create winners and losers.
  4. Secondary markets are also transforming to adapt to a new economic and regulatory environment. Understanding the nature and reasons for this transformation is key in identifying future potential systemic risk issues and opportunities for market development.

The report also highlights the uncertainty that remains on secondary markets in the event of a interest rate shock and the $11 trillion worth of corporate debt (out of $50 trillion) due to mature in the next seven years.

Some interesting graphs in the report include the one below on the different characteristics of issuances pre- and post- 2007.

click to enlargeIOSCO Pre2007 and Post2007 Corporate Bond Issuance April 2014

Other interesting graphs highlight how corporate bonds are taking up the stagnation in bank credit in the US and the EU, and also highlight the boom in bank credit in China, as below.

click to enlargeIOSCO Bank Credit and Corporate Bond Markets April 2014

And finally the graphs below show the increase in non-financial corporate bond issuance and the modest growth in high yield issuance.

click to enlargeIOSCO Corporate Bond Markets April 2014


Historical ROEs in reinsurance & specialty insurance

I was talking to an analyst last week about the returns on equity in the traditional reinsurer/specialty insurer market versus that in the ILS market. I have posted recently on the mid single digit returns currently on offer from (unlevered) ILS funds and also on the ROEs in the “traditional” market.

We couldn’t agree on what the historical ROE from the traditional market going back 20 years was so I decided to have a look at some figures. The graph below represents a simple average of a sample of firms going back to 1995. I selected a simple average rather than a weighted average as it should be a good representation of the varying business models and used operating ROEs where possible to reflect underwriting results. The number of firms in the 1990s in the sample is relatively small compared to the 2000s as many of the current firms were not around in their current form in the 1990s.

click to enlargeHistorical Reinsurer Specialty Insurer ROEs 1995 to 2013

The interesting outcome is that since 1995 the average (of the average annual operating) ROE is 10% with the 10 year average increasing from around 8%-9% to 11%-12% more recently. The volatility is obviously a function of the underlying risk (the standard deviation is 6%) although it is interesting that the recent high losses of 2005 and 2011 were not enough to push the average ROEs into negative territory. That illustrates the importance of differing business models in the sector.

Given the depressed level of risk premia across financial markets, it’s understandable that the capital markets have been attracted by a sector with an average ROE of 10%. Of course, the influx of new capital is making the average ever more unattainable. KBW are the latest market commentator who has called the relaxation of terms and conditions in reinsurance as a result of the softening market as “dangerous”. As the old underwriting adage goes – “don’t let the smell of the premium distract you from the stink of the risk”.

MGI Global Flows In A Digital Age Report

McKinsey Global Institute has an interesting report out entitled “Global flows in a digital age: How trade, finance, people, and data connect the world economy”. The report goes into different aspects of flows across the globe with a central assertion as follows:

Two major forces are now accelerating the growth and evolution of global flows. The first is increasing global prosperity. By 2025, 1.8 billion people around the world will enter the consuming class, nearly all from emerging markets, and emerging-market consumers will spend $30 trillion annually, up from $12 trillion today. This will create enormous new hubs for consumer demand and global production. The second major force is the growing pervasiveness of Internet connectivity and the spread of digital technologies. More than two-thirds of us have mobile phones. In 2012, there were 2.7 billion people connected to the Internet. A torrent of data now travels around the world. Cross-border Internet traffic grew 18-fold between 2005 and 2012.

One graph in the report that caught my attention was the one below of the growth in foreign revenues from top US firms across different sectors. This is interesting and feeds directly into some of the contentions asserted by Jeremy Siegel in justifying a high CAPE ratio (as discussed in this post).

click to enlargeMGI Revenue % of US firms from foreign markets

What is interesting about the graph above is the fall in the manufacturing firms since the financial crisis and the relatively slow growth of revenues outside of the US from the “established” technology and consumer firms in the US. Given the growth in global flows, it suggests they need to be more focused on the opportunities outside the US, particularly if the graph below on future consumption in 2025 turns out to accurate.

click to enlargeMGI emerging economies per capita GDP

I was particularly taken with the pieces of the report in relation to the impact of the internet and e-commerce. The following extract highlighted the impact:

“The power of digitization comes especially from its marginal cost economics that reduce costs associated with access, discovery, and distribution of goods and services to nearly zero. As a result, the cost of participating in flows is lowered for individuals, small firms, and entrepreneurs. This is already leading not only to innovations in business models but also to the emergence of micromultinationals, microwork, and microsupply chains that are able to tap into global opportunities. This significantly removes barriers to participating in global flows, broadening opportunities. It also will put pressure on all companies to innovate their business models to capture the opportunities and respond to new sources of competition, and to counter the pressure on their existing business models from digitization’s marginal-cost economics.”

The graph below shows the changes in data and communication flows over the past 5 years. The growth in traffic between the US and China and between the US and Latin America is noteworthy.

click to enlargeMGI data & communication change 2008 to 2013

The report does highlight that emerging economies lag significantly behind developed economies in cross-border internet traffic with impediments to growth such as high bandwidth prices and IP transit costs. The graph below highlights the dominance of the developed economies in areas such as content and online sales.

click to enlargeMGI emerging economies Internet & Data

It does however also show how things may grow as emerging economies take advantage of the power of the wired world. As the report states: “the pace of change is likely to accelerate even more dramatically as more of the world goes online”.

There is some other interesting stuff in the MGI report and its worth a quick read.