Tag Archives: Hedge Fund Reinsurer

Thoughts on ILS Pricing

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“.

When does one plus one equal more than two?

S&P released a thoughtful piece on Monday called “Hedge Fund Reinsurers: Are The Potential Rewards Worth The Added Risk?” I couldn’t find a direct link to the article but Artemis has a good summary here. They start by asking whether combining a reinsurer strategy with a hedge fund strategy can create higher risk adjusted returns than the two approaches could achieve separately. They conclude with the following:

“The potential crossover between hedge funds and reinsurers offers compelling possibilities. However, a commensurate focus on additional risks would have to supplement the singular focus on higher investment returns. Considering both is necessary in determining whether one plus one is truly greater than two. This depends on whether combining hedge funds and reinsurers can create additional diversification benefits that don’t occur in these two types of organisations independently, thus creating a more capital efficient vehicle. We believe it’s possible. However, in our view, closing the gap between reinsurer and hedge fund risk cultures and implementing prudent risk controls is necessary to realize these benefits.”

I have posted on this topic before. One of the hedge fund reinsurer strategies is to combine low volatility P&C business (primarily as a source of cheap “float”)with the alpha seeking asset business. My problem with this strategy is that every reinsurer is looking out for low volatility/stable return (re)insurance business (its the holy grail after all!), even more so in today’s highly efficient and competitive market. So what can clever chino wearing quants living on a tropical island offer that every other established reinsurer can’t? I suspect that the answer is to price the business with a higher discount rate based upon their higher expected return. S&P point out that this may create increased risks elsewhere such as liquidity risk in stress scenarios. Another strategy is to combine volatile property catastrophe risk with higher asset risk, essentially combining two tail risk strategies. This pushes the business model more towards the highly leveraged model as per that used by the monoline insurer, the ultimate “picking up pennies in front of a stream-roller” play.

To get an idea of the theory behind the various strategies, the graph below illustrates the diversification of each using the calculation in the Solvency II standard formula, with different concentrations for market, counterparty, life, health and non-life risks (selected for illustration purposes only).

click to enlargeHedge Fund Reinsurer Diversification

The graph shows that a hedge fund reinsurer with a low volatility liability strategy shows the least amount of diversification compared to a composite, non-life or a property cat reinsurer due to the dominance of market risk. Interesting, the high risk strategy of combining a hedge fund strategy on assets with property cat on the liability side shows diversification at a similar level (i.e. 78%) to that of a non-life reinsurer where non-life risk dominates.

Hedge fund reinsurers would no doubt argue that, through their alpha creating ability, the 25% correlation between market and non-life risk is too high for them. Reducing that correlation to 0% for the hedge fund reinsurers gives the diversification above, as per “Diversification 1” above. Some may even argue that the 25% correlation in the standard formula is too low for traditional players, as this post on Munich Re’s results excluding catastrophic losses illustrates, so I have shown the diversification for an illustrative composite, non-life or a property cat reinsurer with a 75% correlation between market and non-life risks, as per “Diversification 2” above.

In my opinion, one plus one is always two and under-priced risk cannot be justified by combining risk strategies. Risk is risk and combining two risks doesn’t change the fundamentals of each. One strategy that hasn’t re-emerged as yet is what I call the hedging reinsurer whereby liabilities are specifically hedged by asset strategies. Initially, the property cat reinsurers tried to use weather derivatives to hedge their risk but an illiquid market for weather derivatives and the considerable amount of basis risk resulted in difficulties with the strategy. The strategy is commonly used on the life side of the business with investment type business, particularly business with guarantees and options. Also the appetite for longevity risk by those reinsurers with significant mortality exposure that can significantly hedge the longevity risk is a major developing market trend. I do not see why the strategy could not be used more on the non-life side for economic related exposures such as mortgage indemnity or other credit type exposures.

In the immediate term, the best strategy that I see is the arbitrage one that those who have survived a few underwriting cycles are following, as per this post. On that point, I noticed that BRIT, in their results today, stated they have “taken advantage of current market conditions in reinsurance to significantly strengthen group wide catastrophe cover. These additional protections include a property aggregate catastrophe cover and some additional variable quota share protection”. When risk is cheap, arbitrating it makes the most sense to me as a strategy, not doubling up on risks.