Category Archives: Insurance Market

The Float Game Goes Into Overdrive

Posted on 15/04/2015 | 1 comment

The IMF today warned about rising global financial stability risks. Amongst the risks, the IMF highlighted the “continued financial risk taking and search for yield keep stretching some asset valuations” and that “the low interest rate environment also poses challenges for long term investors, particularly for weaker life insurance companies in Europe”. The report states that “the roles and adequacy of existing risk-management tools should be re-examined to take into account the asset management industry’s role in systemic risk and the diversity of its products”.

In late March, Swiss Re issued a report which screamed that the “current high levels of financial repression create significant costs and lower long-term investors’ ability to channel funds into the real economy”. The financial repression, as Swiss Re calls it, has resulted in an estimated loss of $470 billion of interest income to US savers since the financial crisis which impacts both households and long-term investors such as insurance companies and pension funds.

Many market pundits, Stanley Druckenmiller for example, have warned of the destabilizing impacts of long term low interest rates. I have posted before on the trend of hedge funds using specialist insurance portfolios as a means to take on more risk on the asset side of the balance sheet in an attempt to copy the Warren Buffet insurance “float” investment model. My previous post highlighted Richard Brindle’s entry into this business model with a claim that they can dynamically adjust risk from one side of the balance sheet to the other. Besides the influx of hedge fund reinsurers, there are the established models of Fairfax and Markel who have successfully followed the “Buffet alpha” model in the past. A newer entry into this fold is the Chinese firm Fosun with their “insurance + investment twin-driver core strategy”.

The surprise entry by the Agnelli family’s investment firm EXOR into the Partner/AXIS marriage yesterday may be driven by a desire to use the reinsurer as a source of float for its investments according to this Artemis article on the analyst KBW’s reaction to the new offer. In the presentation on the offer from EXOR’s website, the firm cites as a rationale for a deal the “opportunity to exploit know-how synergies between EXOR investment activities” and the reinsurer’s investment portfolio.

Perhaps one of the most interesting articles on the current market in recent weeks is this one from the New York Times. The article cites the case of how the private equity firm Apollo Global Management purchased Aviva’s US life insurance portfolio, ran it through some legit regulatory and tax arbitrage structures with Goldman Sachs help, and ended up using some of the assets behind the insurance liabilities to prop up the struggling casino company behind Caesars and Harrah’s casinos. Now that’s a story that speaks volumes to me about where we are in the risk appetite spectrum today.

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Thoughts on ILS Pricing

Posted on 29/03/2015 | 3 comments

Valuations in the specialty insurance and reinsurance sector have been given a bump up with all of the M&A activity and the on-going speculation about who will be next. The Artemis website reported this week that Deutsche Bank believe the market is not differentiating enough between firms and that even with a lower cost of capital some are over-valued, particularly when lower market prices and the relaxation in terms and conditions are taken into account. Although subject to hyperbole, industry veteran John Charman now running Endurance, stated in a recent interview that market conditions in reinsurance are the most “brutal” he has seen in his 44 year career.

One interesting development is the re-emergence of Richard Brindle with a new hybrid hedge fund type $2 billion firm, as per this Bloomberg article. Given the money Brindle made out of Lancashire, I am surprised that he is coming back with a business plan that looks more like a jump onto the convergence hedge fund reinsurer band wagon than anything more substantive given current market conditions. Maybe he has nothing to lose and is bored! It will be interesting to see how that one develops.

There have been noises coming out of the market that insurance linked securities (ILS) pricing has reached a floor. Given that the Florida wind exposure is ground zero for the ILS market, I had a look through some of the deals on the Artemis website, to see what pricing was like. The graph below does only have a small number of data points covering different deal structures so any conclusions have to be tempered. Nonetheless, it does suggest that rate reductions are at least slowing in 2015.

click to enlargeFlorida ILS Pricing

Any review of ILS pricing, particularly for US wind perils, should be seen in the context of a run of low storm recent activity in the US for category 3 or above. In their Q3-2014 call, Renaissance Re commented (as Eddie pointed out in the comments to this post) that the probability of a category 3 or above not making landfall in the past 9 years is statistically at a level below 1%. The graph below shows some wind and earthquake pricing by vintage (the quake deals tend to be the lower priced ones).

click to enlargeWind & Quake ILS Pricing by year

This graph does suggest that a floor has been reached but doesn’t exactly inspire any massive confidence that pricing in recent deals is any more adequate than that achieved in 2014.

From looking through the statistics on the Artemis website, I thought that a comparison to corporate bond spreads would be interesting. In general (and again generalities temper the validity of conclusions), ILS public catastrophe bonds are rated around BB so I compared the historical spreads of BB corporate against the average ILS spreads, as per the graph below.

click to enlargeILS Spreads vrs BB Corporate Spread

The graph shows that the spreads are moving in the same direction in the current environment. Of course, it’s important to remember that the price of risk is cheap across many asset classes as a direct result of the current monetary policy across the developed world of stimulating economic activity through encouraging risk taking.

Comparing spreads in themselves has its limitation as the underlying exposure in the deals is also changing. Artemis uses a metric for ILS that divides the spread by the expected loss, referred to herein as the ILS multiple. The expected loss in ILS deals is based upon the catastrophe modeller’s catalogue of hurricane and earthquake events which are closely aligned to the historical data of known events. To get a similar statistic to the ILS multiple for corporate bonds, I divided the BB spreads by the 20 year average of historical default rates from 1995 to 2014 for BB corporate risks. The historical multiples are in the graph below.

click to enlargeILS vrs BB Corporate Multiples

Accepting that any conclusions from the graph above needs to consider the assumptions made and their limitations, the trends in multiples suggests that investors risk appetite in the ILS space is now more aggressive than that in the corporate bond space. Now that’s a frightening thought.

Cheap risk premia never ends well and no fancy new hybrid business model can get around that reality.

Follow-up: Lane Financial LLC has a sector report out with some interesting statistics. One comment that catch my eye is that they estimate a well spread portfolio by a property catastrophic reinsurer who holds capital at a 1-in-100 and a 1-in-250 level would only achieve a ROE of 8% and 6.8% respectively at todays ILS prices compared to a ROE of 18% and 13.3% in 2012. They question “the sustainability of the independent catastrophe reinsurer” in this pricing environment and offer it as an explanation “why we have begun to see mergers and acquisitions, not between two pure catastrophe reinsurers but with cat writers partnering with multi-lines writers“.

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Cyber Insurance Catastrophe Scenario

Posted on 23/03/2015 | 2 comments

The UK government and Marsh released an interesting report today on cyber risk and insurance. Most cyber insurance is written on a standalone basis or as an add-on to professional indemnity, D&O, general liability or business interruption and property covers. Policy wording and terms and conditions vary widely. One of the current uncertainties is what will happen when a major attack, or more likely a frequency of industry wide cyber attacks, occurs and how traditional insurance exclusions will hold up in the case of legal challenge. The recent 2014 ruling on the Sony Playstation’s 2011 data breach provided the insurance industry comfort that they will stand up but nothing is certain when new types of losses unforeseen by existing policy wordings meet the US legal system.

The report relieves some interesting facts on the market such as the quantum and variability of current pricing for cyber insurance, as the paragraph and graphic below show.

“There are several factors that influence the price of different insurance products. In the case of cyber insurance, the price may also be driven by uncertainty over the risk compared to more traditional covers. This seems to be the case, with much flatter pricing for cyber across firms than for other lines of insurance; the difference between third and first quartile pricing is 1.7x for cyber, 9.1x for general liability, and 2.6x for property. The combination of a higher absolute price and lower price differentiation suggests that cyber is early in its development and that underwriters are more conservative about the risk, creating a challenge to a core role of insurance – namely, that high pricing discourages take up, and flat pricing provides no incentive for firms to reduce their cyber risk and save on premiums.”

click to enlarge2014 Cyber Insurance Market Pricing

On the topic of a probable maximum loss (PML) for the insurance sector, the report uses a fairly unscientific 20% of the estimated 2014 aggregate limit of £100 billion, based upon industry expert judgment, as a guesstimate.

click to enlargeCyber Catastrophe Scenario

Given the need for insurers to diversify their product offerings in this soft specialty insurance market, future demand for cyber insurance products (the report says the cyber insurance market will grow threefold over the next 3 to 5 years) will mean that more accurate estimates for risk accumulations need to be developed.

At this stage in the product cycle for cyber insurance, most insurers can likely rely on their friendly and premium hungry reinsurer to take the aggregation risk from their cyber exposures (estimated by the report to be £20 billion). Given the capital markets risk appetite for low yields and insurance risks, it would not surprise me if some investment bank is currently busily working away on the first cyber bond!

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Tails of VaR

Posted on 01/02/2015 | 3 comments

In an opinion piece in the FT in 2008, Alan Greenspan stated that any risk model is “an abstraction from the full detail of the real world”. He talked about never being able to anticipate discontinuities in financial markets, unknown unknowns if you like. It is therefore depressing to see articles talk about the “VaR shock” that resulted in the Swissie from the decision of the Swiss National Bank (SNB) to lift the cap on its FX rate on the 15th of January (examples here from the Economist and here in the FTAlphaVille). If traders and banks are parameterising their models from periods of unrepresentative low volatility or from periods when artificial central bank caps are in place, then I worry that they are not even adequately considering known unknowns, let alone unknown unknowns. Have we learned nothing?

Of course, anybody with a brain knows (that excludes traders and bankers then!) of the weaknesses in the value-at-risk measure so beloved in modern risk management (see Nassim Taleb and Barry Schachter quotes from the mid 1990s on Quotes page). I tend to agree with David Einhorn when, in 2008, he compared the metric as being like “an airbag that works all the time, except when you have a car accident“.  A piece in the New York Times by Joe Nocera from 2009 is worth a read to remind oneself of the sad topic.

This brings me to the insurance sector. European insurance regulation is moving rapidly towards risk based capital with VaR and T-VaR at its heart. Solvency II calibrates capital at 99.5% VaR whilst the Swiss Solvency Test is at 99% T-VaR (which is approximately equal to 99.5%VaR). The specialty insurance and reinsurance sector is currently going through a frenzy of deals due to pricing and over-capitalisation pressures. The recently announced Partner/AXIS deal follows hot on the heels of XL/Catlin and RenRe/Platinum merger announcements. Indeed, it’s beginning to look like the closing hours of a swinger’s party with a grab for the bowl of keys! Despite the trend being unattractive to investors, it highlights the need to take out capacity and overhead expenses for the sector.

I have posted previously on the impact of reduced pricing on risk profiles, shifting and fattening distributions. The graphic below is the result of an exercise in trying to reflect where I think the market is going for some businesses in the market today. Taking previously published distributions (as per this post), I estimated a “base” profile (I prefer them with profits and losses left to right) of a phantom specialty re/insurer. To illustrate the impact of the current market conditions, I then fattened the tail to account for the dilution of terms and conditions (effectively reducing risk adjusted premia further without having a visible impact on profits in a low loss environment). I also added risks outside of the 99.5%VaR/99%T-VaR regulatory levels whilst increasing the profit profile to reflect an increase in risk appetite to reflect pressures to maintain target profits. This resulted in a decrease in expected profit of approx. 20% and an increase in the 99.5%VaR and 99.5%T-VaR of 45% and 50% respectively. The impact on ROEs (being expected profit divided by capital at 99.5%VaR or T-VaR) shows that a headline 15% can quickly deteriorate to a 7-8% due to loosening of T&Cs and the addition of some tail risk.

click to enlargeTails of VaR

For what it is worth, T-VaR (despite its shortfalls) is my preferred metric over VaR given its relative superior measurement of tail risk and the 99.5%T-VaR is where I would prefer to analyse firms to take account of accumulating downside risks.

The above exercise reflects where I suspect the market is headed through 2015 and into 2016 (more risky profiles, lower operating ROEs). As Solvency II will come in from 2016, introducing the deeply flawed VaR metric at this stage in the market may prove to be inappropriate timing, especially if too much reliance is placed upon VaR models by investors and regulators. The “full detail of the real world” today and in the future is where the focus of such stakeholders should be, with much less emphasis on what the models, calibrated on what came before, say.

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Updated Insurance Multiples

Posted on 05/12/2014 | Leave a comment

It has been a while since I looked at net tangible asset multiples for reinsurers and selected specialty insurers (the last such post is here). Motivated by the collapse in Lancashire’s multiple (briefly mentioned in a previous post) since they went ex-dividend, I redid the tangible book multiple figures. Previously I have used average operating ROEs as the x-axis but this time I have used annualized total returns since year-end 2010 (to capture the 2011 catastrophe year with the recent results of the past 3 years). Annualized total returns are made up of tangible book growth and dividends paid in 2011 to today. The split between tangible book growth and dividends, on an annualized basis across the past 4 years, for each firm as per the graph below (when calculating tangible book values, as is my usual practise disclosed previously, I excluded all goodwill and intangibles, except for the present value of future profits (PVFP) for life reinsurance business for European reinsurers).

click to enlargeReinsurers & Specialty Insurer Total Return December 2014

The graph of tangible book multiples to annualized returns is below. [Note – although insurance accounting has converged somewhat in recent years, caution still needs to be taken when comparing UK, European, and Bermudian/US firms due to the differing accounting regimes under which results are reported].

click to enlargeReinsurers & Specialty Insurers NTA Multiples December 2014

I split the firms into different colours – green is for the Bermudian & US firms, red is for London market firms, and blue is for the European composite reinsurers. In terms of who else may get involved in M&A following the Renaissance/Platinum deal, its interesting to see most of the Bermudians bunched up so close to each other in valuation and return profiles. The higher valued and larger firms may be the instigators in taking over smaller competitors but it looks more likely that medium sized firms need to get with today’s realities and seek tie-ups together. Who will wait it out in the hope of some market changing event or who will get it together in 2015 will be fascinating to watch!!

Follow-on: To get an idea of historical changes in the tangible book multiples in the three groupings above, the graph below shows the trends. The multiples in each year are simple averages across the firms (and not all are at the same point in the year) but the graph nonetheless gives an idea of changing market sentiment. Although the London and European firms are a smaller sample than the Bermudian/US firms, the graph indicates that the market is confident that the underwriting indiscipline of years past have been overcome in the London market, thus justifying a premium multiple. Time will tell on that score…..

click to enlargeHistorical Tangible Book Multiples for Reinsurers & Specialty Insurers

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