Category Archives: Insurance Firms

ILS illuminations

Insurance linked securities (ILS) are now well established in the insurance industry. ILS as an asset class offer, according to its many fans, the benefits of diversification and low correlation to other asset classes whilst offering a stable and attractive risk/reward return. The impact of the new capital on the traditional market has been profound and wide ranging (and a much posted upon topic in this blog – here, here & here for example).

ILS fund managers maintained an “aggressive posture” on price at the recent April renewals according to Willis Re as ILS capacity continues to demonstrate its cost of capital advantage. ILS fund managers are also looking to diversify, moving beyond pure short tail risks and looking at new previously uninsured or underinsured exposures, as well as looking to move their capital along the value-chain by sourcing primary risk more directly and in bulk.

An industry stalwart, John Kavanagh of Willis Re, commented that “with results on many diversifying non-catastrophe classes now marginal, there is greater pressure on reinsurers to address the pricing in these classes” and that “many reinsurers remain prepared to let their top line revenue growth stall and are opting to return excess capital to their shareholders”. The softening reinsurance market cycle is now in its fifth year and S&P estimates that “even assuming continued favourable prior-year reserve releases and benign natural catastrophe losses, we anticipate that reinsurers will barely cover their cost of capital over the next two years”.

Rather than fight the new capital on price, some traditional (re)insurers are, according to Brandan Holmes of Moody’s, “deploying third-party capital in their own capital structures in an effort to lower their blended cost of capital” and are deriving, according to Aon Benfield, “significant benefits from their ability to leverage alternative capital”. One can only fight cheap capital for so long, at some stage you just arbitrage against it (sound familiar!).

A.M. Best recently stated that “more collateralised reinsurance programs covering nonpeak exposures are ceded to the capital markets”. The precipitous growth in the private transacted collateralised reinsurance subsector can be seen in the graph from Aon below.

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Nick Frankland of Guy Carpenter commented that “the capital landscape is ever-changing” and that “such capital diversity also elevates the position of the broker”. Some argue that the all-powerful role of the dominant brokers is exacerbating market softness. These brokers would counterargue that they are simply fulfilling their role in an efficient market, matching buyers and sellers. As Frankland puts it, brokers are “in the strongest position to provide access to all forms of capital and so secure the more beneficial rates and terms and conditions”. Dominic Christian of Aon Benfield commented last year that “to some extent alternative sources of capital are already, and have already uberized insurance and reinsurance, by bringing increased sources of supply”.

Perhaps alone amongst industry participants, Weston Hicks of Alleghany, has questioned the golden goose of cheap ILS capital stating that “some new business models that separate the underwriting decision from the capital provider/risk bearer are, in our view, problematic because of a misalignment of incentives”. Such concerns are batted aside as old fashioned in this new world of endless possibilities. Frighteningly, John Seo of ILS fund manager Fermat Capital, suggests that “for every dollar of money that you see in the market right now, I think there is roughly 10 dollars on the sidelines waiting to come in if the market hardens”.

As an indicator of current ILS pricing, the historical market spread over expected losses in the public CAT bond market can be seen in the exhibit below with data sourced from Lane Financial. It is interesting to note that the average expected loss is increasing indicating CAT bonds are moving down the risk towers towards more working layer coverages.

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In a previous post, I argued that returns from an ILS fund index, with the net returns judgementally adjusted to get to comparable figures gross of management fees, were diverging against those from a pure CAT bond index. I argued that this divergence may illustrate that the ILS funds with exposure to the private collateralised reinsurance sector may be taking on higher risk exposures to pump returns (or may be passing risks amongst themselves in an embryonic spiral) and that ILS investors should be careful they understand the detail behind the risk profiles of the ILS funds they invest in.

Well, the final 2016 figures, as per the graph below, show that the returns in my analysis have in fact converged rather than diverged. On the face of it, this rubbishes my argument and I have to take that criticism on. Stubbornly, I could counter-argue that the ILS data used in the comparison may not reflect the returns of ILS funds with large exposure to collateralised reinsurance deals. Absent actual catastrophic events testing the range of current fund models, better data sources are needed to argue the point further.

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In their annual review of 2016, Lane Financial have an interesting piece on reducing transparency across both the public and private ILS sector. They characterise the private collateralised reinsurance sector as akin to a dark pool compared to the public CAT bond market which they likened to a lit exchange. Decreased transparency across the ILS sector “should send up warning flags” for all market participants as it makes calculating Net Asset Valuations (NAV) with monthly or quarterly frequency more difficult. They argue that the increased use of a relatively smaller public CAT bond market for pricing points across the ILS sector, the less credible is the overall valuation. This is another way of expressing my concern that the collateralised reinsurance market could be destabilising as it is hidden (and unregulated).

In the past, as per this post, I have questioned how the fully funded ILS market can claim to have a lower cost of capital against rated reinsurers who only have to hold capital against a percentage of their exposed limit, akin to fractional banking (see this post for more on that topic). The response is always down to the uncorrelated nature of ILS to other asset classes and therefore its attraction to investors such as pension funds who can apply a low cost of capital to the investment due to its uncorrelated and diversifying portfolio benefits. Market sponsors of ILS often use graphs such as the one below from the latest Swiss Re report to extoll the benefits of the asset class.

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A similar exhibit, this time from a Lombard Odier brochure, from 2016 shows ILS in an even more favourable light!

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As anybody who has looked through any fund marketing metrics knows, performance comparisons with other investment strategies are fraught with bias and generally postdictive. The period over which the comparison is made and the exact indices chosen (look at the differing equity indices used in the comparisons above) can make material differences. Also, the size and liquidity of a market is important, a point which may negate any reliance on ILS returns prior to 2007 for example.

I thought an interesting exercise would be to compare actual historical ILS returns, as represented by the Swiss Re Global Cat Bond Total Return Index, against total returns (i.e. share price annual change plus dividends paid in year) from equity investment in reinsurers across different time periods. The most applicable business model for comparison would be pure property catastrophe reinsurers but unfortunately there are not many of them left.

I have chosen RenRe (RNR) and Validus (VR), from 2007, as representatives of the pure property cat business model, although both have diversified their portfolios away from pure short tail business in recent years. I also selected three of the biggest European reinsurers – Munch Re, Swiss Re and Hannover Re – all of which are large diverse composite reinsurers. Finally, I constructed a US$ portfolio using equal shares of each of the five firms mentioned above (RenRe represents 40% of the portfolio until 2007 when Validus went public) with the € and CHF shares converted at each year end into dollars.

The construction of any such portfolio is postdictive and likely suffers from multiple biases. Selecting successful firms like RenRe and Validus could validly be criticised under survival bias. To counter such criticism, I would point out that the inclusion of the European reinsurers is a considerable historic drag on returns given their diverse composite footprint (and associated correlation to the market) and the exclusion of any specialist CAT firm that has been bought out in recent years, generally at a good premium, also drags down returns.

The comparison over the past 15 years, see graph below, shows that Munich and Swiss struggle to get over their losses from 2002 and 2003 and during the financial crisis. Hannover is the clear winner amongst the Europeans. The strong performance of Hannover, RenRe and Validus mean that the US$ portfolio matches the CAT bond performance after the first 10 years, albeit on a more volatile basis, before moving ahead on a cumulative basis in the last 5 years. The 15-year cumulative return is 217% for the CAT bond index and 377% return for the US$ equity portfolio.

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The comparison over the past 10 years, see graph below, is intriguing. Except for Validus, the CAT bond index beats all other firms and the US$ portfolio for non-volatile returns hands down in the first 5 years. Hannover, Validus and the portfolio each make a strong comeback in the most recent 5 years. The 10-year cumulative return is 125% for the CAT bond index and 189% return for the US$ equity portfolio.

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The comparison over the past 5 years, see graph below, shows that all firms and the portfolio handily beats the CAT bond index. Due to an absence in large loss activity over the recent past and much more shareholder friendly actions by all reinsurers, the equity returns have been steady and non-volatile. The 5-year cumulative return is 46% for the CAT bond index and 122% return for the US$ equity portfolio.

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Overall then, ILS may offer less volatile and uncorrelated returns but I would personally prefer the, often lumpier, historical equity returns from a selected portfolio of top reinsurers in my pension pot (we all could have both in our pension funds!). Then again, the influx of new capital into ILS has put the future viability of the traditional reinsurance business models into question so future equity returns from the sector may not be too rosy.

At the end of the day, the bottom line is whether current market risk premia is adequate, irrespective of being supplied by ILS fund managers or traditional reinsurers. Based upon what I see, I have grave misgivings about current market pricing and therefore have no financial exposure, ILS or equity or otherwise, to the market at present.

Additional Comment, 29th April 2017: The ILS website Artemis.bm had an interesting piece on comments from Torsten Jeworrek of Munich Re during their March conference call. The applicable comment is as follows:

“And now I give you another example, which is not innovation per se or not digitalization, but you know that more and more alternative capital came into the insurance industry over the last years; hedge funds, pension refunds, participating particularly in the cat business and as a trend that not all of the limits they provide, cat limits are fully collateralized anymore. That means there are 10 scenarios; hurricane, earthquake, [indiscernible], and so on; which are put together, but not 10 times the limit is collateralized, let’s say only 4 times, 5 times.

That means these hedge funds and pension funds so to speak in the future if they don’t have to provide full 100% collateralized for all the limits they provide, they need a certain credit risk for the buyer. The more they entertain, the more there’s a likelihood that this reinsurance can also fail. The question is how far will that go and this kind of not fully collateralized reinsurance, will that be then accepted as a reinsurance by the regulator or will that be penalized at a certain time otherwise we don’t have level playing field anymore, which means the traditional reinsurer who was strongly monitored and regulated and also reported as really expensive and a burden for our industry and for us and on the other hand, you have very lean pension and hedge funds who even don’t have to provide the same amount of capital for the same risk.”

Oh AIG, where art thou?

In my last post on AIG, I expressed my doubts about the P&C targets outlined in their plan. After first announcing a $20 billion retroactive reinsurance deal with Berkshire covering long tail commercial P&C reserves for accident years prior to 2015 in January, AIG just announced another large commercial lines reserve charge of $5.6 billion principally from their US business. The graph below shows the impact upon their 2016 pre-tax operating income.

click to enlargeaig-pretax-operating-income-2012-to-2016

The latest reserve hit amounts to 12% of net commercial reserves at end Q3 2016 and compares to 7%, 8% and 6% for previous 2015, 2010, and 2009 commercial reserve charges. Whereas previously reserve strengthening related primarily to excess casualty and workers compensation (WC) business (plus an asbestos charge in 2010), this charge also covers primary casualty and WC business. The accident year vintage of the releases is also worryingly immature, as the graph below shows. After the 2016 charge, AIG have approx $7 billion of cover left on the Berkshire coverage.

click to enlargeaig-reserve-strengthening-accident-year-distribution

Although AIG have yet again made adjustments to business classifications, the graph below shows near enough the development of the accident year loss ratios on the commercial book over recent times.

click to enlargeaig-commercial-pc-accident-year-loss-ratios-2011-to-2016

It is understandable that AIG missed their aggressive target against the pricing background of the past few years as illustrated by the latest Marsh report, as the exhibits below on global commercial rates and the US and European subsets show.

click to enlargeglobal-insurance-market-index

click to enlargeus-europe-insurance-market-index

All of these factors would make me very skeptical on the targeted 62% exit run rate for the 2017 accident year loss ratio on the commercial book. And no big reinsurance deal with Berkshire (or with Swiss Re for that matter) or $5 billion of share buybacks (AIG shares outstanding is down nearly a third since the beginning of 2014 due to buybacks whilst the share price is up roughly 25% over that period), can impact the reality which AIG has now to achieve. No small ask.

Some may argue that AIG have kitchen-sinked the reserves to make the target of accident year loss ratios in the low 60’s more achievable. I hope for the firm’s sake that turns out to be true (against the odds). The alternative may be more disposals of profitable (life) businesses, possibly eventually leading to a sale of the rump and maybe the disappearance of AIG altogether.

A Tale of Two Insurers

My negativity on the operating prospects for the reinsurance and specialty insurance sector has been articulated many times previously in this blog. Many of the same factors are impacting the broader commercial insurance market. Pricing conditions in the US and globally can be seen in the graph below.

click to enlargeUS and Global Commercial Insurance Pricing

Two insurers, at different ends of the size scale, which I have previously posted on, are AIG (more recently here and here) and Lancashire (more recently here and here). Given that a lot has happened to each since I last posted on them, I thought a quick update on both would give an interesting insight into the current market.

First up is AIG who have been under a lot of pressure from shareholders to unlock value, including a break-up plan for the insurance giant from the opportunistic rascal Carl Icahn. The graph below shows a breakdown of recent operating results (as ever with AIG longer term comparisons are hampered by their ever changing reporting segments). The improvement in the UGC mortgage insurance business has been dwarfed by the poor non-life results which were impacted by a significant reserve strengthening charge.

click to enlargeAIG PreTax Operating Income 2012 to 2015

In January, Peter Hancock (the 5th CEO since Hank Greenberg left in 2005) announced a new strategic plan to the end of 2017, the main points of which are

  • Return at least $25 billion of capital to shareholders through dividends and share buy-backs from operating profits, divestitures and other actions such as monetizing future life profits by $4-5 billion through reinsurance purchases.
  • Enhance transparency by separating into an operating portfolio with a goal of over 10% return on equity and a legacy portfolio that will focus on return of capital. Reorganize into at least nine modular, more self-contained business units to enhance accountability, transparency, and strategic flexibility.
  • Reduce general operating expenses by $1.6 billion, 14 percent of the 2015 expenses.
  • Improve the commercial P&C accident year loss ratio by six points.
  • Pursue an active divestiture program, including initially the 20% IPO of UGC.

The non-life reserve charge in 2015 amounted to $3.6 billion. 60% of the charge came from the (mainly US) casualty business, 16% from financial lines (again mainly in the US) and 15% from the run-off business. After the last material reserve strengthening in 2010, the worrying aspect of the 2015 charge is that approximately two thirds comes from accident years not yet 10 years old (which is relatively immature for long tail casualty business particularly when 42% of the charge is on excess casualty business). The impact of the reserve hikes on the commercial P&C segment can be clearly seen in the graph below.

click to enlargeAIG Commercial P&C Combined Ratio Breakdown 2008 to 2015

Perhaps the most aggressive target, given current market conditions, in the strategic plan is the 6% improvement in the commercial P&C accident year loss ratio by the end of 2017. The plan includes exiting approximately $1 billion of US casualty business, including poorly performing excess casualty business, primary and excess auto liability, health-care and financial lines business. Growth of $0.5 billion is been targeted in multi-national, financial lines, property upper middle market and major accounts which involve specialist engineering capabilities, international casualty and emerging risks such as cyber and M&A insurance. AIG also recently announced a two year reinsurance deal with Swiss Re on their US casualty book (it looks like a 25% quota share). The scale of the task for AIG in meeting this target can be seen in the exhibit below which takes a number of slides from the strategy presentation.

click to enlargeAIG Commercial P&C Metrics

I was struck by a quote from the firm on their turnaround plan – “We will use the data and analytical tools we have invested in to significantly differentiate and determine where we should focus our resources.” I suspect that every significant insurer would claim to have, or at least aspire to have, similar analytical capabilities. Big data and analytical driven underwriting is undoubtedly the future for large insurers with access to large amounts of quality data. Fortune had an interesting recent article on the analytical firm Palantir who are working with some insurers on sharpening their underwriting criteria for the social media age. An analyst in Citi even suggested that Goggle should look at buying AIG as a fintech play. The entry of the big internet firms into the insurance sector seems inevitable in some form or other, although I doubt AIG will be part of any such strategy.

As to the benefits of staying a large composite insurer, AIG cited an analysis commissioned by consultants Oliver Wyman supporting the benefits of diversification between the life and non-life business of AIG. Using the S&P consolidated model as a proxy, Oliver Wyman estimate a $7.5 billion capital benefit to AIG compared to separate life and non-life businesses, as envisaged in Icahn’s plan.

So, can AIG achieve the aggressive operational targets they have set themselves for the P&C business? Current market conditions present a considerable challenge. Combined with their recent results, an end of 2017 target for a 6% improvement is extremely aggressive. Too aggressive for my liking. However, the P&C results should improve somewhat over the short term (particularly if there is no more big reserve charges) and actions such as expense reductions, monetizing future life profits and divestitures will give AIG the fire power to hand out sweeties to shareholders. For those willing to take the punt, the return of a chunk of the $25 billion target in dividends and share buy-backs over the next 2 years for a firm with a current market value of $61 billion, trading at a 0.72 multiple to book value (trading around 0.92 of book less AOCI and DTA), may be too tempting to resist. It does have a certain allure…..

Lancashire, a London market specialty insurer and reinsurer with a mantra of disciplined underwriting, is at the opposite end of the scale spectrum with a niche focus. Long cherished by investors for its shareholder friendly dividend policies, Lancashire has been under pressure of late due to the heavy competition in its niche markets. The energy insurance sector, for example, has been described by the broker Willis as dismal with capacity chasing a smaller premium pool due to the turmoil in the oil market. A number of recent articles (such as here and here) highlight the dangers. Alex Maloney, the firm’s CEO, described the current market as “one of the most difficult trading environments during the last twenty years”. In addition, Lancashire lost its founder, Richard Brindle, in 2014 plus the CEO, the CFO and some senior underwriters of its Lloyds’ Cathedral unit in 2015.

The graph below shows the breakdown of reported historical calendar year combined ratios plus the latest accident year net loss ratio and paid ratio.

click to enlargeLancashire Ratio Breakdown 2008 to 2015

The underwriting discipline that Lancashire professes can be seen in the recent accident year loss ratios and in the 30% drop in gross written premiums (GWP), as per the graph below. The drop is more marked in net written premiums at 35% due to the increase in reinsurance spend to 25% of GWP (from approx 10% in its early years).

click to enlargeLancashire GWP Breakdown 2008 to 2015

The timely and astute increase in reinsurance protection spend can be seen in the decrease in their peak US aggregate exposures. The latest probable maximum loss (PML) estimates for their US peak exposures are approximately $200 million compared to historical levels of $300-350 million. Given the lower net premium base, the PML figures in loss ratio terms have only dropped to 40% from 50-60% historically. Lancashire summed up their reinsurance purchasing strategy as follows:

“Our outwards reinsurance programme provides a breadth and depth of cover which has helped us to strengthen our position and manage volatility. This helps us to continue to underwrite our core portfolio through the challenges posed by the cycle.”

As with AIG, the temptation for shareholders is that Lancashire will continue with their generous dividends, as the exhibit below from their Q4 2015 presentation shows.

click to enlargeLancashire Dividend History 2015

The other attraction of Lancashire is that it may become a take-over target. It currently trades at 1.4 times tangible book level which is rich compared to its US and Bermudian competitors but low compared to its peers in Lloyds’ which trade between 1.58 and 2.0 times tangible book. Lancashire itself included the exhibit below on tangible book values in its Q4 2015 presentation.

click to enlargeInsurance Tangible Book Value Multiple 2012 to 2015

It is noteworthy that there has been little activity on the insurance M&A front since the eye boggling multiples achieved by Amlin and HCC from their diversification hungry Japanese purchasers. Many in the market thought the valuations signaled the top of the M&A frenzy.

Relatively, AIG looks more attractive than Lancashire in terms of the potential for shareholder returns. However, fundamentally I cannot get away from current market conditions. Risk premia is just too low in this sector and no amount of tempting upside through dividends, buy-backs or M&A multiples can get me comfortable with the downside potential that comes with this market. As per the sentiment expressed in previous posts, I am happy with zero investment exposure to the insurance sector right now. I will watch this one play out from the sidelines.

Hot Take-outs

In many episodes of fervent investment activity within a particular hot spot, like the current insurance M&A party, there is a point where you think “really?”. The deal by Mitsui Sumitomo to take over Amlin at 2.4 times tangible book is one such moment. A takeover of Amlin was predicted by analysts, as per this post, so that’s no surprise but the price is.

With the usual caveat on the need to be careful when comparing multiples for US, Bermuda, London and European insurers given the different accounting standards, the graph below from a December post, shows the historical tangible book value levels and the improving multiples being applied by the market to London firms such as Amlin.

click to enlargeHistorical Tangible Book Multiples for Reinsurers & Specialty Insurers

Comparable multiples from recent deals, as per the graph below, show the high multiple of the Mitsui/Amlin deal. Amlin has a 10 year average ROE around 20% but a more realistic measure is the recent 5 year average of 11%. In today’s market, the short to medium term ROE expectation is likely to be in the high single digits. Even at 10%, the 2.4 multiple looks aggressive.

click to enlargeM&A Tangible Book Multiples September 2015

There is little doubt that the insurance M&A party will continue and that the multiples may be racy. In the London market, the remaining independent players are getting valued as such, as per the graph below tracking valuations at points in time.

click to enlargeLondon Specialty Insurers Tangible Book Values

When the hangover comes, a 2.4 multiple will look even sillier than its does now at this point in the pricing cycle. In the meantime, its party like 1999 time!

Lancashire finds the love

After going ex-dividend in November, investors went mega bearish on Lancashire (LRE.L) when it nearly dropped below the 500p level, as the graph below shows. A previous post highlighted the reasons behind the change in sentiment over the first half of 2014 on the once darling of the specialty insurance sector.

click to enlargeLancashire Insurance Group 2014 Share Price

The firm released its Q4 today and announced another special dividend of $0.50 on top of the regular $0.10 dividend. Driven by stable results, as per the graph below, and by the chatter that Lancashire could be an M&A target, the price today reflects a respectable 160% multiple to diluted tangible book. It was odd that although the firm’s executives joked about having prepared an answer to the M&A question, no analyst actually asked the question in the conference call today!

click to enlargeLancashire Historical Combined Loss 2008 to 2014

One of the big positives from the call today was the news that the firm has restructured their reinsurance programme that protects their book to give them more event coverage with reinstatements (away from previous aggregate cover). This provides more protection to Lancashire from multiple events. The PMLs as at January expressed as a percentage of the calendar year earned premiums (estimated figures for 2015) show the reduced net risk profile of this arbitrage strategy.

click to enlargeLancashire PMLs January 2015

It’s nice to see Lancashire recover some of its shine and it will be intriguing to see if it does become an M&A target in the coming months.