Tag Archives: credit cycle

Bumpy Road

After referring to last year’s report in the previous post, the latest IMF Global Financial Stability Report called “A Bumpy Road Ahead” was released yesterday. Nothing earth-shattering from the report when compared to previous and current commentary. The following statements are typical:

“Many markets still have stretched valuations and may experience bouts of volatility in the period ahead, in the context of continued monetary policy normalization in some advanced countries. Investors and policymakers should be cognizant of the risks associated with rising interest rates after years of very easy financial conditions and take active steps to reduce these risks.”


“Valuations of risky assets are still stretched, with some late-stage credit cycle dynamics emerging, reminiscent of the pre-crisis period. This makes markets exposed to a sharp tightening in financial conditions, which could lead to a sudden unwinding of risk premiums and a repricing of risky assets. Moreover, liquidity mismatches and the use of financial leverage to boost returns could amplify the impact of asset price moves on the financial system.”

With the US 10 year breaking 2.9% today and concerns about a flattening yield curve, the IMF puts global debt at $164 trillion or 225% of GDP (obviously a different basis from the IIF’s estimate of global debt at $237 trillion or 318% of GDP) and warns about the US projected debt increase due to its “pro-cyclical policy actions”.

In a chapter the IMF calls “The Riskiness of Credit Allocations” it presents an interesting graph, as below, using its financial conditions index which uses multiple inputs constructed using a methodology that’s wonderfully econometrically complex, as is the IMF way.

click to enlarge

The IMF warn that “a variety of indicators point to vulnerabilities from financial leverage, a deterioration in underwriting standards, and ever more pronounced reaching for yield behaviour by investors in corporate and sovereign debt markets around the world”.

Munich’s Underwriting Cycle

Munich Re had a good set of results last week with a 12.5% return on equity on a profit of €3.3 billion (with the reinsurance business contributing €2.8 billion of the profit). A €1 billion share buyback was also announced contributing to the ongoing shareholder friendly actions by industry players. Munich is targeting €3 billion for 2014 but warned of challenges ahead including “the lingering low-interest-rate environment, increasing competition in reinsurance, and changes in demand from clients in primary insurance”.

Torsten Jeworrek, Munich Re’s Reinsurance CEO, cited tailor-made solutions as a strength for Munich highlighting “multi-year treaties (occasionally incorporating cross-line and cross-regional covers), retroactive reinsurance solutions, transactions for capital relief, comprehensive consultation on capital management, and the insurance of complex liability, credit and large industrial risks”.

Whilst looking through the 2013 report, I noticed historical calendar year combined ratios (COR) for the P&C business (reinsurance & primary) including and excluding catastrophes. I dug up these figures going back to 1991 as per the graph below. A small amount of adjustment was needed, particularly in relation to the 24.3% and 17.1% of deterioration for 2001 and 2002 relating to 9/11 losses (which I included as catastrophes in the CaT ratio for those years). As with a previous post on underwriting cycles, I then “normalised” the COR excluding catastrophes for the changes in interest rates using a crude discount measure based upon the US risk free rate for each calendar year plus 150 bps over 2.5 years. That may be conservative, particularly for the 1990s where equities were a bigger part of European’s asset portfolio. I then added the (undiscounted) CaT ratio to the discounted figures to give an idea of the historical underwriting cycle.

click to enlargeMunich Underwriting Cycle

The “normalised” average discounted COR (excluding CaT) since 1991 is 87% and the average over the past 10 years is 83%. The standard deviation for the series since 1991 is 6% and for the last 10 years 4% indicating a less volatile period in recent years in core ratios excluding catastrophes.

The average CaT ratio since 1991 is 7% versus 9% over the past 10 years. The standard deviation for the CaT ratio since 1991 is 8% and for the last 10 years 9% indicating a more volatile period in recent years in CaT ratios.

Adding the discounted CORs and the (undiscounted) CaT ratios, the average since 1991 and over the past 10 years is 95% and 92% respectively (with standard deviation of 11% and 9% respectively).

As Munich is the largest global reinsurer, the ratios (reinsurance & primary split approx 80%:20%) above represent a reasonable cross section of industry and give an average operating return of 5% to 8% depending upon the time period selected. Assuming a 0.5% risk free return today, that translates into a rough risk adjusted return as per the Sharpe ratio of 0.44 and 0.80 for the period to 1991 and over the past 10 years respectively. Although the analysis is crude and only considers operating results, these figures are not exactly earth-shattering (even if you think the future will be more like the last 10 years rather than the longer term averages!).

Such results perhaps explain the growing trend of hedge funds using reinsurance vehicles as “float” generators. If the return on assets over risk free is increased from the 150 bps assumed to 300 bps in the analysis above, the Sharpe ratios increase to more acceptable 0.73 and 1.13 respectively. And that ignores the tax benefits amongst other items!

As an aside, I again (as per this post) compared the underlying discounted COR (excluding catastrophes) from Munich against a credit index of global corporate defaults (by originating year as a percentage of the 1991 to 2013 average) in the graph below. As a proxy for the economic & business cycles, it illustrates an obvious connection.

click to enlargeMunich Underwriting & Credit Cycle

Underwriting and Credit Cycle Circles

An article from Buttonwood in March reviewed a book by Thomas Aubrey – “Profiting from monetary policy – investing through the business cycle”. Aubrey argues that credit cycles are better predictors of equity and asset prices rather than economic growth. Differentials between the cost of capital and the return on capital drive capital supply.

In previous presentations on the insurance sector and the factors affecting underwriting cycles, I have used the credit cycle as an explanation for demand and supply imbalances. Given the current influx of yield seeking capital into the wholesale insurance market, by way of new risk transfer mechanisms in the ILS sector, and the irrational cost of capital driven by loose monetary policy around the world, Aubrey’s arguments make sense.

Using the calendar year combined ratios of the Lloyds of London insurance market as a proxy for the wholesale market, discounting such ratios at the risk free rate for each year with an assumed payout duration, and comparing these to an index of S&P defaults by origination year illustrates the relationship.

Underwriting & Credit CyclesThe more recent impact of natural catastrophes from 2005 and 2011 illustrates the higher concentration of shorter tail business lines in the past decade as interest rate reductions make longer tail lines less attractive.

Of course, no one factor drives the insurance cycle and there may be a degree of circularity in this picture. Many of the losses at Lloyds in the 1980s and 1990s came from asbestos and pollution claims, issues which drove many companies into insolvency. There is also a circularity between the insurance losses from the events of 9/11 and the economic impact following the bursting of the internet bubble. In addition, there are limitations in comparing calendar year ratios which includes reserve deterioration (particularly from asbestos years) against defaults by origination. Notwithstanding these items, it’s an interesting graph!