Monthly Archives: March 2016

How low is CAT pricing?

So, the February dip in the equity market is but a memory with the S&P500 now in positive territory for the year. With the forward PE at 16.4 and the Shiller CAPE at 25.75, it looks like the lack of alternatives has, once again, brought investors back to the equity market. As Buttonwood puts it – “investors are reluctant bulls; there seems no alternative.”  A December report from Bank of England staffers Rachel and Smith (as per previous post) has an excellent analysis of the secular drivers on the downward path of real interest rates. I reproduced a sample of some of the interesting graphs from the report below.

click to enlargeReal interest & growth & ROC rates

In the course of a recent conversation with a friend on the lack of attractive investment opportunities the subject of insurance linked securities (ILS) arose. My friend was unfamiliar with the topic so I tried to give him the run down on the issues. I have posted my views on ILS many times previously (here, here and here are just a recent few). During our conversation, the question was asked how low is current pricing in the catastrophe market relative to the “technically correct” level.

So this post is my attempt at answering that question. On a back of the envelop basis (I am sure professionals in this sector will be appalled at my crude methodology!). Market commentary currently asserts that non-US risks are the more under-priced of the peak catastrophe risks. Guy Carpenter’s recent rate on line (ROL) regional index, which is a commonly used industry metric for premium as a percentage of limit, shows that US, Asian, European and UK risks are off 30%, 28%, 32% and 35% respectively off their 2012 levels.

Using the US as a proxy for the overall market, I superimposed the Guy Carpenter US ROL index over historical annual US insured losses (CPI inflation adjusted to 2015) as per Munich Re estimates in the graph below. The average insured loss and ROL index since 1990 is $25 billion and 168 respectively. On the graph below I show the 15 year average for both which is $32 billion and 178 respectively. The current ROL pricing level is 18% and 23% below the average ROL since 1990 and the 15 year average respectively.

click to enlargeUS CAT Losses & ROL Index

However, inflation adjusted insured losses are not exposure adjusted. Exposure adjusted losses are losses today which take into account today’s building stock and topology. To further illustrate the point, the graph in this 2014 post from Karen Clark shows exposure adjusted historical catastrophe losses above $10 billion. One of the vendor catastrophe modelling firms, AIR Worldwide, publishes its exposure adjusted annual average insured loss each year and its 2015 estimate for the US was $47 billion (using its medium timescale forecasts). That estimate is obviously some way off the 15 year average of $32 billion (which has been influenced by the recent run of low losses).

By way of answering the question posed, I have assumed (using nothing more than an educated guess) a base of an average annual insured loss level of $40 billion, being within an approximate inflation adjusted and exposure adjusted range of $35-45 billion, would imply a “technically correct” ROL level around 185. I guesstimated this level based upon the 10 year average settling at 195 for 4 years before the 2016 decline and applying a discount to 185 due to the lower cost of capital that ILS investors require. The former assumes that the market is an efficient means of price discovery for volatile risks and the latter is another way of saying that these ILS investors accept lower returns than professional insurers due to the magic which market wisdom bestows on the uncorrelated nature of catastrophic risk. 185 would put current US catastrophe premium at a 25% discount to the supposed “technical correct” level.

Some in the market say rates have bottomed out but, without any significant losses, rates will likely continue to drop. Kevin O’Donnell of RenRe recently said the following:

“We believe that a playbook relying on the old cycle is dead. The future will not see multi-region, multi-line hardening post-event. There’s too much capital interested in this risk and it can enter our business more quickly and with less friction. There will be cycles, but they will be more targeted and shorter and we have worked hard to make sure that we can attract the best capital, underwrite better, and deploy first when the market presents an opportunity.”

I cannot but help think that the capital markets are not fully appreciating the nuances of the underlying risks and simply treating catastrophe risks like other BB asset classes as the graph below illustrates.

click to enlargeBB Corporate vrs ILS Spreads

There is an alternate explanation. The factors impacting weather systems are incredibly complex. Sea surface temperatures (SSTs) and wind shear conditions are key variables in determining hurricane formation and characteristics. Elements which may come into play on these variables include the North Atlantic Oscillation (NAO) which is a fluctuation in pressure differences between the Icelandic and Azores regions, the Atlantic Multi-Decadal Oscillation (AMO) which measures the natural variability in sea surface temperature (and salinity) of the North Atlantic, and the El Niño Southern Oscillation (ENSO) which measures cyclical temperature anomalies in the Pacific Ocean off South America. Climate change is impacting each of these variables and it may be possible that US hurricanes will become less frequent (but likely more severe).

An article from late last year in the Nature Geoscience Journal from Klotzbach, Gray and Fogarty called “Active Atlantic hurricane era at its end?” suggests the active hurricane phase in the Atlantic could be entering a new quieter cycle of storm activity. The graph below is from their analysis.

click to enlargeAtlantic hurricane frequency

Could it be that the capital markets are so efficient that they have already factored in such theories with a 25% discount on risk premia? Yep, right.

Piddling Productivity

Walk around any office today and you will likely see staff on the internet or playing with their smartphones, the extent of which will depend upon the office etiquette. The rise of the networked society would intuitively imply increased productivity. Data analytics, the cloud, the ease with which items can be researched and purchased all imply a rise in efficiency and productivity. Or does it?

Productivity is about “working smarter” rather than “working harder” and it reflects our ability to produce more output by better combining inputs, owing to new ideas, technological innovations and business models. Productivity is critical to future growth. Has the rise of social media, knowing what your friends favourite type of guacamole is, made any difference to productivity? The statistics from recent years indicate the answer is no with the slowdown in productivity vexing economists with a multitude of recent opinion and papers on the topic. Stanley Fisher from the Fed stating in an interesting speech for earlier this month that “we simply do not know what will happen to productivity growth” and included the graph below in his presentation.

click to enlargeUS Average Productivity Growth 1952 to 2015

Martin Wolf in a piece in the FT on recent projections by the Office for Budget Responsibility (OBR) calls the prospects for productivity “the most important uncertainty affecting economic prospects of the British people”.

Some think the productivity statistics have misestimated growth and the impact of technology (e.g. the amount of free online services). A recent paper from earlier this month by Fed and IMF employees Byrne, Fernald and Reinsdorf concluded that “we find little evidence that the slowdown arises from growing mismeasurement of the gains from innovation in IT-related goods and services”.

The good news seems to be that productivity slumps are far from unprecedented according to a paper in September last year from Eichengreen, Park and Shin. The bad news is that the authors conclude the current slump is widespread and evident in advanced countries like the U.S. and UK as well as in emerging markets in Latin America, Southeast Europe and Central Asia including China.

A fascinating paper from December 2015 by staff at the Bank of England called “Secular drivers of the global real interest rate” covers a wide range of issues which are impacting growth, including productivity growth. I am still trying to digest much of the paper but it does highlight many of the economists’ arguments on productivity.

One of those is Robert Gordon, who has a new bestseller out called “The Rise and Fall of American Growth”. Gordon has long championed the view of a stagnation in technology advances due to structural headwinds such as an educational plateau, income inequality and public indebtedness.

click to enlargeAverage Annual Total Facor Productivity

Others argue that productivity comes in waves and new technology often takes time to be fully integrated into the production process (e.g. electricity took 20 years before the benefits showed in labour productivity).

Clearly this is an important issue and one which deserves the current level of debate. Time will tell whether we are in a slump and will remain there or whether we are at the dawn of a golden era of innovation led productivity growth…..

The bowels of the system and helicopters

The market volatility in 2016 did seem odd in certain respects. Valuations were too high and a correction was needed. No doubt. It’s more the way the selling seemed to be indiscriminate at certain points with oil and equity prices locked in step. Some argue that China selling reserves to support their currency or oil producing countries selling assets to make up for short falls in oil revenue may be behind some of the erratic behaviour. Buttonwood had an interesting piece over the past weeks on how consequences from new bank regulations are impacting market liquidity with unusual activity in derivative pricing such as negative swap rates and relative CDS rates.

Gilian Tett, in a FT article in January, pointed to the example of capital outflows from China. Whether repaying US debt (or as Tett succinctly calls it, a quasi carry trade in reverse) in face of likely further yuan weakness or withdrawals from overzealous M&A (about a quarter of China outbound deals are said to be in trouble) or other reasons behind the veil of the Chinese economy, the outflows are having impacts. Tett said:

“Capital flows, fuelled by politics and policy change, are where the important action is taking place. Deep in the bowels of the system all manner of financial flows are switching course, creating unexpected knock-on effects for many asset prices. Capital flight from China is one example. The energy sector is another.”

The strangle lockstep between oil and the S&P500 can be seen below.

click to enlargeoil and sp500

Energy has only a small impact on the S&P500 makeup, as can be seen below, and on the operating profit profile.

click to enlargeS&P Sector Weightings 1980 to 2015

The OECD interim economic outlook by Catherine Mann on 18th February recommended “maintaining accommodative monetary policy, supportive fiscal policies on investment led spending and more ambition on structural policies which raise global growth and reduce financial risks”. Ah, yes the old structural reform answer to all of our ills. The OECD gave some graphic reminders of where we are, as below.

click to enlargeUS & Euro Household & Nonfinancial Corporate Debt 2015

click to enlargeCentral Bank Balance Sheets 2015

Central Bank policies remain stuck to QE and increasingly exotic forms of monetary policy despite the obvious failure so far for QE to kick-start either inflation or growth. The latest experiment is on negative interest rate which has had funny impacts on banks and the lending rates they need to charge. Japan in particular has shown how their brand of negative rates was countered by a currency whiplash. Mark Carney, the Governor of the Bank of England, offered the view that “for monetary easing to work at a global level if cannot rely on simply moving scarce demand from one country to another.

A recent BIS article on negative interest rates in Switzerland, Europe and Japan stated that “there is great uncertainty about the behaviour of individuals and institutions if rates were to decline further into negative territory or remain negative for a prolonged period. It is unknown whether the transmission mechanisms will continue to operate as in the past and not be subject to tipping points“.

This week Mario Draghi came up with a new twist on negative interest rates, relying on targeted long-term refinancing operations (TLTROs) to give banks effectively free money. The currency impact will be interesting, particularly to see if the Japanese whiplash will repeat. One of the results of all this QE is that central banks are a much larger player in the system and have basically taken over the government bond markets in Europe, Japan, and America. The ECB even buys low-rated bonds, not just the AA and AAA positions taken by the Fed, and makes billions of euros in low-interest-rate loans to banks.

No less that Adair Turner, Martin Wolf and Ray Dalio have all made favourable comments about another evolution in QE, so called helicopter money (named after Milton Friedman).  Wolf argues that central banks should enter the arena of public investment in the face of inaction by fiscal authorities (by which I assume he means elected politicians). He passionately says “policymakers must prepare for a new “new normal” in which policy becomes more uncomfortable, more unconventional, or both.” Turner believes that targeted stimulus of nominal demand poses “less risk to future financial stability than the unconventional monetary policies currently being deployed“.

The recent anxiety by electorates across the developed world in expressing a desire for the certainty of the past, whether it be the popularity of Donald Trump, anti-immigrant rhetoric in Europe or the arguments in the UK to leave the EC, show that ordinary people are worried about the future and no end of short term monetary stimulus is likely to change that. Helicopter money sounds like a medicated solution to the symptoms of low growth rather than any real answer to the problem of slowing growth, Chinese and Japanese unsustainable debt loads and global productivity challenges due to aging populations.

Maybe it’s just me, and I do respect the views of Wolf, Turner and Dalio, but it looks to me a measure that is open to so much moral hazard as bordering on the surreal. It gives Central Banks more power in the markets and that could be dangerous without more thought on the unintended consequences. If we are moving piecemeal towards a Chicago Plan or some other alternate economic model, then somebody should get the public on board. I think they are desperately looking for new answers to the way we run our economies.