Tag Archives: ILS investor

The Big Wind

With four US hurricanes and one earthquake in current times, mother nature is reminding us homo-sapiens of her power and her unpredictability. As the massive Hurricane Irma is about to hit Florida, we all hope that the loss of life and damage to people’s lives will be minimal and that the coming days will prove humane. Forgive me if it comes across as insensitive to be posting now on the likely impact of such events on the insurance industry.

For the insurance sector, these events, and particularly Hurricane Irma which is now forecast to move up the west coast of Florida at strength (rather the more destruction path of up the middle of Florida given the maximum forces at the top right-hand side of a hurricane like this one), may be a test on the predictive powers of its models which are so critical to pricing, particularly in the insurance linked securities (ILS) market.

Many commentators, including me (here, here and here are recent examples), have expressed worries in recent years about current market conditions in the specialty insurance, reinsurance and ILS sectors. On Wednesday, Willis Re reported that they estimate their subset of firms analysed are only earning a 3.7% ROE if losses are normalised and reserve releases dried up. David Rule of the Prudential Regulatory Authority in the UK recently stated that London market insurers “appear to be incorporating a more benign view of future losses into their technical pricing”, terms and conditions continued to loosen, reliance on untested new coverages such as cyber insurance is increasing and that insurers “may be too sanguine about catastrophe risks, such as significant weather events”.

With the reinsurance and specialty insurance sectors struggling to meet their cost of capital and pricing terms and conditions being so weak for so long (see this post on the impact of soft pricing on risk profiles), if Hurricane Irma impacts Florida as predicted (i.e. on Saturday) it has the potential to be a capital event for the catastrophe insurance sector rather than just an earnings event. On Friday, Lex in the FT reported that the South-East US makes up 60% of the exposures of the catastrophe insurance market.

The models utilised in the sector are more variable in their output as events get bigger in their impact (e.g. the higher the return period). A 2013 post on the variation in loss estimates from a selected portfolio of standard insurance coverage by the Florida Commission on Hurricane Loss Projection Methodology (FCHLPM) illustrates the point and one of the graphs from that post is reproduced below.

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Based upon the most recent South-East US probable maximum losses (PML) and Atlantic hurricane scenarios from a group of 12 specialty insurers and reinsurers I selected, the graph below shows the net losses by return periods as a percentage of each firm’s net tangible assets. This graph does not consider the impact of hybrid or subordinate debt that may absorb losses before the firm’s capital. I have extrapolated many of these curves based upon industry data on US South-East exceedance curves and judgement on firm’s exposures (and for that reason I anonymised the firms).

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The results of my analysis confirm that specialty insurers and reinsurers, in aggregate, have reduced their South-East US exposures in recent years when I compare average figures to S&P 2014 data (by about 15% for the 1 in 100 return period). Expressed as a net loss ratio, the average for a 1 in 100  and a 1 in 250 return period respectively is 15% and 22%. These figures do look low for events with characteristics of these return periods (the average net loss ratio of the 12 firms from catastrophic events in 2005 and 2011 was 22% and 25% respectively) so it will be fascinating to see what the actual figures are, depending upon how Hurricane Irma pans out. Many firms are utilising their experience and risk management prowess to transfer risks through collaterised reinsurance and retrocession (i.e. reinsurance of reinsurers) to naïve capital market ILS investors.

If the models are correct and maximum losses are around the 1 in 100 return period estimates for Hurricane Irma, well capitalized and managed catastrophe exposed insurers should trade through recent and current events. We will see if the models pass this test. For example, demand surge (whereby labour and building costs increase following a catastrophic event due to overwhelming demand and fixed supply) is a common feature of widespread windstorm damage and is a feature in models (it is one of those inputs that underwriters can play with in soft markets!). Well here’s a thought – could Trump’s immigration policy be a factor in the level of demand surge in Florida and Texas?

The ILS sector is another matter however in my view due to the rapid growth of the private and unregulated collateralised reinsurance and retrocession markets to satisfy the demand for product supply from ILS funds and yield seeking investors. The prevalence of aggregate covers and increased expected loss attachments in the private ILS market resembles features of previous soft and overheated retrocession markets (generally before a crash) in bygone years. I have expressed my concerns on this market many times (more recently here). Hurricane Irma has the potential to really test underwriting standards across the ILS sector. The graph below from Lane Financial LLC on the historical pricing of US military insurer USAA’s senior catastrophe bonds again illustrates how the market has taken on more risk for less risk adjusted premium (exposures include retired military personnel living in Florida).

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The events in the coming days may tell us, to paraphrase Mr Buffet, who has been swimming naked or as Lex put it on Friday, “this weekend may be a moment when the search for uncorrelated returns bumps hard into acts of God”.

Hopefully, all parts of the catastrophe insurance sector will prove their worth by speedily indemnifying peoples’ material losses (nothing can indemnify the loss of life). After all, that’s its function and economic utility to society. Longer term, recent events may also lead to more debate and real action been taken to ensure that the insurance sector, in all its guises, can have an increased economic function and relevance in an increasingly uncertain world, in insuring perils such as floods for example (and avoiding the ridiculous political interference in risk transfer markets that has made the financial impact of flooding from Hurricane Harvey in Texas so severe).

Notwithstanding the insurance sector, our thoughts must be with the people who will suffer from nature’s recent wrath and our prayers are with all of those negatively affected now and in the future.

Uncorrelated CaT capital “is the cheapest”

One of the reasons given by market participants for competitive pricing in the ILS markets is the lower cost of capital required by such instruments due to the uncorrelated nature of the underlying exposure with other classes. I previously posted on the lower risk return for an ILS fully collaterised portfolio against a similar portfolio written by a mono-line property catastrophe reinsurer. The ILS investor may be prepared to accept a lower return due to the uncorrelated nature of the exposure. It is nonetheless resulting in lower prices for risk which has always ended badly in the past.

Twelve Capital are a well known ILS investment manager and recently published a white paper on the impact of ILS capital on the reinsurance industry. I liked the way they described the lower cost of capital issue, as below:

“Equity is the most expensive form of capital for the (re)insurance industry. Thanks to its diversification benefits, ILS is the cheapest. The most popular form of investment for those looking to enter the reinsurance market was, prior to the birth of ILS, equity offered by traditional reinsurers. However, returns on equity are eroded by company management costs and the tendency of reinsurers to diversify into less profitable lines of business. In addition, financial market investments on the asset side of the balance sheet expose reinsurance shareholders to additional financial market risks. A listed reinsurance stock thus has the disadvantage of being highly correlated to equity markets in general.

So, what ought to be a fundamentally uncorrelated investment gets transformed into a correlated investment, and the diversification benefit is lost. The investor is also exposed to the risk that the management of reinsurance companies might not always act in the best interests of shareholders.

As insurance investors focus on those lines of business that are favourably priced and soundly modelled, reinsurance companies might end up losing their most profitable lines to the ILS market. And it is this source of profit that reinsurers have traditionally relied upon to support and cross-subsidise substantial volumes of business that generally only break even. With profitable lines taken away by more efficient investors, reinsurance companies are left with business models that cannot sustain conventional cross-subsidisation.”

The comment on reinsurer’s management is a bit below the belt! The impact of the loss of the low frequency/high severity business to the traditional market is a valid one though. However, the long histories of the largest tier 1 reinsurers with large diverse portfolios and the ability to provide products and services across most business lines and jurisdictions indicate more robust business models than the commentary suggests in my opinion.

My previous post looked at the capital return of a fully collaterised provider such as an ILS fund against a mono-line catastrophe provider such as a property cat reinsurer. To see if the commentary above on a correlated investment is reflective of actual experience, the graph below shows the S&P500 against the share prices of the property catastrophe reinsurers Renaissance Re, Validus Re, Montpelier Re and Platinum Re since late 2002. Excluding Montpelier Re, which obviously had some company specific issues after the 2005 wind losses, the R2 for the other firms is remarkably similar around 65%. This suggests investing in the equity of these firms has indeed been a correlated investment in the past.

click to enlargePropCaT Reinsurers correlated to SP500

It emphasises that the traditional reinsurance market needs to focus on reducing such correlation, whether real or wrongly perceived, to compete better for this cheap capital.