Tag Archives: insurance linked securities

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.”

Pimping the Peers (Part 2)

In the last post on this topic, I highlighted how new technologies, broadly under the fintech tag, had the potential to disrupt the banking sector, primarily by means of automating processes rather than any major reinventing of business models (although I did end that post with a bit of a rant about innovation and human behaviour). Blockchain is the hot topic that seems to be cropping up everywhere (I’ll leave that for another time). This post is about insurance and new technology, or in the jargon, insurtech.

The traditional business model in the insurance industry is not reacting well to a world of low or negative interest rates. For the life insurance sector, the duration mismatch between their liabilities and their assets is having a perverse impact as interest rates have fallen. Savings returns for aging populations have been sacrificed in Central Bank’s attempt to stimulate economic growth.

In addition, the traditional distribution channel for selling life insurer’s products, and the old adage is that these products are sold rather than bought, has relied too heavily on aging tied agents whose focus is on the wealthy client that can generate more fees than the middle class. The industry is generally at a loss on how to sell products in a low interest world to the mass market and to the new tech savvy generation. As a result, the industry and others are throwing money at a rash of new start-ups in insurance, as the exhibit on some of the current hyped firms focusing on life insurance below illustrates.

click to enlargelife-insurance-big-data

As the exhibit illustrates, the focus of these new start-ups is weighted towards technologies around product development, distribution, and underwriting. Some will likely succeed in trying to differentiate further the existing clientele of life insurers (e.g. real time health data). Many will be gobbled up or disappear. Differing attitudes between those aged under 34 and the older generation towards online distribution channels can be clearly seen in the survey results in the exhibit below.

click to enlargeattitudes-to-life-insurance-distribution-channels

With longevity and low interest rates the dominant challenges for life insurers today, automation of processes will assist in cutting expenses in the provision of products (mainly to the existing customer base) but will not likely meaningfully address the twin elephants in the room.  Citigroup reckons that in 20 of the largest OECD countries the unfunded government liability for pensions is around $78 trillion which compares to approximately $50 trillion in GDP for all OECD countries in 2015. I look forward to conversing with a robo-advisor in the near future on what products it recommends for that problem!

Insurance itself is hundreds of years old and although the wonderfully namely bottomry (the earliest form of marine hull insurance) or ancient burial societies are early examples, non-life insurance really took off with mass markets after the great fire of London in 1666.

The most hyped example of insurtech in the non-life sector is the impact of technologies on the motor business like drive-less cars and car telematics. This paper from Swiss Re shows that the impact over the next 20 years of such advances on motor premia could be dramatic.

Much of the focus from insurtech innovation is on reducing expenses, an item that the industry is not light on. The graph below shows examples of the level of acquisition and overhead expenses in the non-life sector across different jurisdictions.

click to enlargenonlife-expense-ratios

A recent report from Aon Benfield went further and looked at expenses across the value chain in the US P&C insurance sector, as below. Aon Benfield estimated overall expenses make up approximately half of gross risk premium, much of which represents juicy disruption targets for new technology in the insurtech world.

click to enlargeexpenses-across-the-value-chain

Insurance itself is based upon the law of large numbers and serves a socially useful function in reducing economic volatility by transferring risks from businesses and consumers. In 1906, Alfred Manes defined insurance as “an economic institution resting on the principle of mutuality, established for the purpose of supplying a fund, the need for which arises from a chance occurrence whose probability can be estimated”.

One of the issues identified with the current non-life insurance sector is the so-called protection gap. This is in effect where insurers’ risk management practises have got incredibly adapt at identifying and excluding those risks most likely to result in a claim. Although good for profits, it does bring the social usefulness of the transference of only the pristine risks into question (for everybody else). The graph below from Swiss Re illustrates the point by showing economic and insured losses from natural catastrophe events as a % of GDP.

click to enlargeinsurance-protection-gap-uninsured-vrs-insured-losses

It’s in the context of low investment returns and competitive underwriting markets (in themselves being driven by low risk premia across asset classes) that a new technology driven approach to the mutual insurance model is being used to attack expense and protection gap issues.

Mutuals represent the original business model for many insurers (back to burial schemes and the great fire of 1666) and still represent approximately a third of the sector in the US and Europe today. Peer to peer insurers are what some are calling the new technology driven mutuals. In fact, most of the successful P2P models to date, firms like Guevara, Friendsurance, and Inspeer are really intermediaries who pool consumers together for group discounts or self-financing of high deductibles.

Lemonade, which launched in New York this week, is a peer to peer platform which issues its own insurance policies and seeks to address the protection gap issue by offering broader coverage. The firm has been heavily reinsured by some big names in insurance like Berkshire Hathaway and Lloyd’s. It offers a fee based model, whereby the policyholders pay claims through mutualisation (assumingly by pools determined by pre-defined criteria). Daniel Schreiber, CEO and co-founder of Lemonade says that the firm will be ”the only insurer that doesn’t make money by denying claims”. Dan Ariely, a big deal in the world of Behavioral Economics, has been named as Chief Behavioral Officer, presumably in an effort to assist in constructing pools of well behaved policyholders.

The graphic below tries to illustrate how the business model is evolving (or should that be repeating?). Technology offers policyholders the opportunity to join with others to pool risk, hitherto a process that was confined to associations amongst professional groups or groups bound by location. Whether technology offers the same opportunity to underwrite risks profitably (or at least not at a loss) but with a larger reach remains to be seen.

click to enlargeinsurance-business-models

It does occur to me that it may be successful in addressing areas of dislocation in the industry, such as shortfalls in coverage for flood insurance, where a common risk and mitigant can be identified and addressed in the terms of the respective pool taking the risks on.

For specialty re/insurers, we have already seen a bifurcation between the capital providers/risk takers and the risk portfolio managers in the ILS arena. Newer technology driven mutual based insurers also offer the industry a separation of the management of risk pools and the risk capital provided to underwrite them. I wish them well in their attempts at updating this most ancient of businesses and I repeat what I said in part 1 of this post – don’t let the sweet scent of shiny new technology distract you from the smell of the risk…..

Naive Newcomers

The insurance sector has been hit by the Brexit fallout on worries about macro-economic impacts; albeit not to the same extend as the banks. Swiss Re has their latest Sigma world insurance report out. The impact of investment returns on the life insurance sector is obvious but it is interesting to see the contribution from investment income on the profitability of the aggregate of the eight largest markets in the non-life insurance sector, as per the graph from the report below.

click to enlargeNonLife Insurance Sector Profit Breakdown

The insurance sector faces a number of challenges as a recent FT article pointed out. The reinsurance sector also faces challenges, not least of which is a competitive pricing environment and the destabilising influx of new yield seeking capital through new innovations in the insurance linked securities (ILS) market. I have posted my views on the ILS sector many times (more recently here) and in this post I offer more similar thoughts. It is interesting to compare the ROEs in the Sigma report from the non-life insurance sector against those from the reinsurance sector (with the ROEs since 2005 coming from the Guy Carpenter composite index), as per the graph below.

click to enlargeGlobal Insurance & Reinsurance ROEs 1999 to 2016e

The graph is not exactly comparing like with like (e.g. non-life insurance versus composite reinsurance) but it gives the general idea of higher but more volatile ROEs in the reinsurance side compared to more stable but lower ROEs on the direct insurance side. The average since 1999 for insurance is 7% and 9% for reinsurance, with standard deviations of 3.6% and 4.6% respectively. It also confirms that ROEs are under pressure for both sectors and as capital markets continue to siphon off volatile excess catastrophe exposed business, the ROEs of the more proportional traditional reinsurance sector are converging on those of their direct brethren, although a differential will always exist given the differing business models.

It is important to note that these ROEs are returns on equity held by traditional insurers and reinsurers, the majority of which are highly rated by external agencies, who hold a small fraction of their total exposure (if measured as the sum of the policy limits issued) as capital. For example, the new European solvency framework, Solvency II, requires capital at a 1 in 200 level and it is generally assumed to be akin to a financial strength rating of BB or BBB, depending upon a firm’s risk profile.

As I argued previously (more recently in this post), these (re)insurers are akin to fractional reserve banks and I still struggle to understand how ILS structures, which are 100% collaterised, can offer their investors such an attractive return given their fully funded “capital” level in the ROE calculation. The industry argument is that investors have a lower cost of capital due to the uncorrelated nature of the pure insurance risk present in ILS.

My suspicion is that the lower cost of capital assigned by investors is reflective of a lack of understanding of the uncertainties surrounding the risks they are taking on and an over-reliance on modelling which does not fully consider the uncertainties. My fear is that capital is been leveraged or risks are been arbitraged through over-generous retrocession deals passing on under-priced risk to naive capital newcomers.

The accelerating growth in the so-called alternative capital in insurance is shown in the graph below from Aon Benfield, with growth in the private collaterised reinsurance being particularly strong in the last four years (now overshadowing the public CAT bond market). ILS funds, managed by professional asset manager specialists, are largely behind the growth in private collaterised deals with assets under management growing from $20 billion in 2012 to over $50 billion today. Private collaterised deals are usually lower down the reinsurance tower (e.g. attach at lower loss levels) and as such offer higher premiums (as a percentage of limits, aka rate on line or ROL) for the increased exposure to loss. On a risk adjusted basis, these don’t necessarily offer higher ROEs than higher attaching/lower risk CAT bonds.

click to enlargeAlternative Insurance ILS Capital Growth

Property catastrophe pricing has been under particular pressure in the past few years due to the lack of significant insured catastrophe losses. In a previous post, I crudely estimate CAT pricing to be 25% below its technical rate. Willis Re is the first of the brokers to have its mid-year renewal report out. In it, Willis said that ILS funds “were more aggressive on pricing during the second quarter as spreads declined for liquid reinsurance investments”. I also find it interesting that the collaterised ILW volumes have ticked up recently. Pricing and lax terms and conditions in the retrocession sector are historically a sign that discipline is breaking down. Asset managers in the ILS space must be under pressure in maintaining their high fees in a reduced CAT risk premia environment and this pressure is likely to be contributing to the potential for market indiscipline.

I therefore find the graph below very telling. I used the figures from Lane Financial (see here) for the annual total return figures from CAT bonds, which closely match those of the Swiss Re Total Return Index. For the ILS fund returns I used the figures from the Eurekahedge ILS Advisors Index which I adjusted to take out the not unconsiderable typical ILS fund management fees. The 2016 figures are annualized based upon published year to date figures (and obviously assume no major losses).

click to enlargeCAT Bond vrs ILS Fund Returns

The graph shows that ILS fund returns have broken with historical patterns and diverged away from those of CAT bonds as the prevalence in private collaterised deals has grown in recent years. In other words, ILS funds have moved to higher rate on line business, which is by definition higher risk, as they push to service the larger level of assets under management. The question is therefore do the investors really understand the significance of this change? Have they adjusted their cost of capital to reflect the increased risk? Or are some ILS funds representing the higher returns as their ability to get higher returns at the same risk level (against the trend of everybody else in the industry in a softening market)?

Innovation is to be encouraged and a necessary part of progress. Innovation dependent on the naivety of new investors however does not end well.

I can’t but help think of Michael Wade’s comment in 2009 about the commonality between the financial crisis and problems at Lloyds of London (see this post on lessons from Lloyds) when he said that “the consequence with the excess capital was that underlying risks could be underpriced as they were being passed on”. My advice to ILS investors is the next time they are getting a sales pitch with promises of returns that sound too good, look around the room, and ask yourself who is the greater fool here….

Pimping the Peers (Part 1)

Fintech is a much hyped term currently that covers an array of new financial technologies. It includes technology providers of financial services, new payment technologies, mobile money and currencies like bitcoin, robo-advisers, crowd funding and peer to peer (P2P) lending. Blockchain is another technology that is being hyped with multiple potential uses. I posted briefly on the growth in P2P lending and crowd-funding before (here and here) and it’s the former that is primarily the focus of this post.

Citigroup recently released an interesting report on the digital disruption impact of fintech on banking which covers many of the topics above. The report claims that $19 billion has been invested in fintech firms in 2015, with the majority focussed in the payments area. In terms of the new entrants into the provision of credit space, the report highlights that over 70% of fintech investments to date have being in the personal and SME business segments.

In the US, Lending Club and Prosper are two of the oldest and more established firms in the marketplace lending sector with a focus on consumer lending. Although each are growing rapidly and have originated loans in the multiple of billions in 2015, the firms have been having a rough time of late with rates being increased to counter poor credit trends. Public firms have suffered from the overall negative sentiment on banks in this low/negative interest rate environment. Lending Club, which went public in late 2014, is down about 70% since then whilst Prosper went for institutional investment instead of an IPO last year. In fact, the P2P element of the model has been usurped as most of the investors are now institutional yield seekers such as hedge funds, insurers and increasingly traditional banks. JP Morgan invested heavily in another US firm called OnDeck, an online lending platform for small businesses, late in 2015. As a result, marketplace lending is now the preferred term for the P2P lenders as the “peer” element has faded.

Just like other disruptive models in the technology age, eBay and Airbnb are examples, initially these models promised a future different from the past, the so called democratization of technology impact, but have now started to resemble new technology enabled distribution platforms with capital provided by already established players in their sectors. Time and time again, digital disruption has eroded distribution costs across many industries. The graphic from the Citi report below on digital disruption impact of different industries is interesting.

click to enlargeDigital Disruption

Marketplace lending is still small relative to traditional banking and only accounts for less than 1% of loans outstanding in the UK and the US (and even in China where its growth has been the most impressive at approx 3% of retail loans). Despite its tiny size, as with any new financial innovation, concerns are ever-present about the consequences of change for traditional markets.

Prosper had to radically change its underwriting process after a shaky start. One of their executives is recently quoted as saying that they “will soon be on our sixth risk model”. Marrying new technology with quality credit underwriting expertise (ignoring the differing cultures of each discipline) is a key challenge for these fledging upstarts. An executive in Kreditech, a German start-up, claimed that they are “a tech company who happens to be doing lending”. Critics point to the development of the sector in a benign default environment with low interest rates where borrowers can easily refinance and the churning of loans is prevalent. Adair Turner, the ex FSA regulator, recently stirred up the new industry with the widely reported comment that “the losses which will emerge from peer-to-peer lending over the next five to 10 years will make the bankers look like lending geniuses”. A split of the 2014 loan portfolio of Lending Club in the Citi report as below illustrates the concern.

click to enlargeLending Club Loan By Type

Another executive from the US firm SoFi, focused on student loans, claims that the industry is well aware of the limitations that credit underwriting solely driven by technology imbues with the comment that “my daughter could come up with an underwriting model based upon which band you like and it would work fine right now”.  Some of the newer technology firms make grand claims involving superior analytics which, combined with technologies like behavioural economics and machine learning, they contend will be able to sniff out superior credit risks.

The real disruptive impact that may occur is that these newer technology driven firms will, as Antony Jenkins the former CEO of Barclays commented, “compel banks to significantly automate their business”. The Citigroup report has interesting statistics on the traditional banking model, as per the graphs below. 60% to 70% of employees in retail banking, the largest profit segment for European and US banks, are supposedly doing manual processing which can be replaced by automation.

click to enlargeBanking Sector Forecasts Citi GPS

Another factor driving the need to automate the banks is the cyber security weaknesses in patching multiple legacy systems together. According to the Citigroup report, “the US banks on average appear to be about 5 years behind Europe who are in turn about a decade behind Nordic banks”. Within Europe, it is interesting to look at the trends in bank employee figures in the largest markets, as per the graph below. France in particular looks to be out of step with other countries.

click to enlargeEuropean Bank Employees

Regulators are also starting to pay attention. Just this week, after a number of scams involving online lenders, the Chinese central bank has instigated a crack down and constituted a multi-agency task force. In the US, there could be a case heard by the Supreme Court which may create significant issues for many online lenders. The Office of the Comptroller of the Currency recently issued a white paper to solicit industry views on how such new business models should be regulated. John Williams of the San Francisco Federal Reserve recently gave a speech at a recent marketplace lending conference which included the lucid point that “as a matter of principle, if it walks like a duck and quacks like a duck, it should be regulated like a duck”.

In the UK, regulators have taken a gentler approach whereby the new lending business models apply for Financial Conduct Authority authorisation under the 36H regulations, which are less stringent than the regimes which apply to more established activities, such as collective investment schemes. The FCA also launched “Project Innovate” last year where new businesses work together with the FCA on their products in a sandbox environment.

Back in 2013, I asked the question whether financial innovation always ended in lower risk premia in this post. In the reinsurance sector, the answer to that question is yes in relation to insurance linked securities (ILS) as this recent post on current pricing shows. It has occurred to me that the new collateralised ILS structures are not dissimilar in methodology to the 100% reserve banks, under the so-called Chicago plan, which economists such as Irving Fisher, Henry Simons and Milton Friedman proposed in the 1930s and 1940s. I have previously posted on my difficulty in understanding how the fully collaterised insurance model can possibly accept lower risk premia than the traditional “fractional” business models of traditional insurers (as per this post). The reduced costs of the ILS model or the uncorrelated diversification for investors cannot fully compensate for the higher capital required, in my view. I suspect that the reason is hiding behind a dilution of underwriting standards and/or leverage being used by investors to juice their returns. ILS capital is now estimated to make up 12% of overall reinsurance capital and its influence on pricing across the sector has been considerable. In Part 2 of this post, I will look into some of the newer marketplace insurance models being developed (it also needs a slick acronym – InsurTech).

Marketplace lending is based upon the same fully capitalized idea as ILS and 100% reserve banks. As can be seen by the Citigroup exhibits, there is plenty of room to compete with the existing banks on costs although nobody, not yet anyway, is claiming that such models have a lower cost of capital than the fractional reserve banks. It is important not to over exaggerate the impact of new models like marketplace lending on the banking sector given its current immaterial size. The impact of technology on distribution channels and on credit underwriting is likely to be of greater significance.

The indirect impact of financial innovation on underwriting standards prior to the crisis is a lesson that we must learn. To paraphrase an old underwriting adage, we should not let the sweet smell of shiny new technology distract us from the stink of risk, particularly where such risk involves irrational human behaviour. The now infamous IMF report in 2006 which stated that financial innovation had “increased the resilience of the financial system” cannot be forgotten.

I am currently reading a book called “Between Debt and the Devil” by the aforementioned Adair Turner where he argues that private credit creation, if left solely to the free market under our existing frameworks, will overfund secured lending on existing real estate (which my its nature is finite), creating unproductive volatility and financial instability as oversupply meets physical constraints. Turner’s book covers many of the same topics and themes as Martin Wolf’s book (see this post). Turner concludes that we need to embrace policies which actively encourage a less credit intensive economy.

It is interesting to see that the contribution of the financial sector has not reduced significantly since the crisis, as the graph on US GDP mix below illustrates. The financialization of modern society does not seem to have abated much since the crisis. Indeed, the contribution to the value of the S&P500 from the financials has not decreased materially since the crisis either (as can be seen in the graph in this post).

click to enlargeUS GDP Breakdown 1947 to 2014

Innovation which makes business more efficient is a feature of the creative destruction capitalist system which has increased productivity and wealth across generations. However, financial innovation which results in changes to the structure of markets, particularly concerning banking and credit creation, has to be carefully considered and monitored. John Kay in a recent FT piece articulated the dangers of our interconnected financial world elegantly, as follow:

Vertical chains of intermediation, which channel funds directly from savers to the uses of capital, can break without inflicting much collateral damage. When intermediation is predominantly horizontal, with intermediaries mostly trading with each other, any failure cascades through the system.

When trying to understand the potential impacts of innovations like new technology driven underwriting, I like to go back to an exhibit I created a few years ago trying to illustrate how  financial systems have been impacted at times of supposed innovation in the past.

click to enlargeQuote Money Train

Change is inevitable and advances in technology cannot, nor should they, be restrained. Human behaviour, unfortunately, doesn’t change all that much and therefore how technological advances in the financial sector could impact stability needs to be ever present in our thoughts. That is particularly important today where global economies face such transformational questions over the future of the credit creation and money.

How low is CAT pricing?

So, the February dip in the equity market is but a memory with the S&P500 now in positive territory for the year. With the forward PE at 16.4 and the Shiller CAPE at 25.75, it looks like the lack of alternatives has, once again, brought investors back to the equity market. As Buttonwood puts it – “investors are reluctant bulls; there seems no alternative.”  A December report from Bank of England staffers Rachel and Smith (as per previous post) has an excellent analysis of the secular drivers on the downward path of real interest rates. I reproduced a sample of some of the interesting graphs from the report below.

click to enlargeReal interest & growth & ROC rates

In the course of a recent conversation with a friend on the lack of attractive investment opportunities the subject of insurance linked securities (ILS) arose. My friend was unfamiliar with the topic so I tried to give him the run down on the issues. I have posted my views on ILS many times previously (here, here and here are just a recent few). During our conversation, the question was asked how low is current pricing in the catastrophe market relative to the “technically correct” level.

So this post is my attempt at answering that question. On a back of the envelop basis (I am sure professionals in this sector will be appalled at my crude methodology!). Market commentary currently asserts that non-US risks are the more under-priced of the peak catastrophe risks. Guy Carpenter’s recent rate on line (ROL) regional index, which is a commonly used industry metric for premium as a percentage of limit, shows that US, Asian, European and UK risks are off 30%, 28%, 32% and 35% respectively off their 2012 levels.

Using the US as a proxy for the overall market, I superimposed the Guy Carpenter US ROL index over historical annual US insured losses (CPI inflation adjusted to 2015) as per Munich Re estimates in the graph below. The average insured loss and ROL index since 1990 is $25 billion and 168 respectively. On the graph below I show the 15 year average for both which is $32 billion and 178 respectively. The current ROL pricing level is 18% and 23% below the average ROL since 1990 and the 15 year average respectively.

click to enlargeUS CAT Losses & ROL Index

However, inflation adjusted insured losses are not exposure adjusted. Exposure adjusted losses are losses today which take into account today’s building stock and topology. To further illustrate the point, the graph in this 2014 post from Karen Clark shows exposure adjusted historical catastrophe losses above $10 billion. One of the vendor catastrophe modelling firms, AIR Worldwide, publishes its exposure adjusted annual average insured loss each year and its 2015 estimate for the US was $47 billion (using its medium timescale forecasts). That estimate is obviously some way off the 15 year average of $32 billion (which has been influenced by the recent run of low losses).

By way of answering the question posed, I have assumed (using nothing more than an educated guess) a base of an average annual insured loss level of $40 billion, being within an approximate inflation adjusted and exposure adjusted range of $35-45 billion, would imply a “technically correct” ROL level around 185. I guesstimated this level based upon the 10 year average settling at 195 for 4 years before the 2016 decline and applying a discount to 185 due to the lower cost of capital that ILS investors require. The former assumes that the market is an efficient means of price discovery for volatile risks and the latter is another way of saying that these ILS investors accept lower returns than professional insurers due to the magic which market wisdom bestows on the uncorrelated nature of catastrophic risk. 185 would put current US catastrophe premium at a 25% discount to the supposed “technical correct” level.

Some in the market say rates have bottomed out but, without any significant losses, rates will likely continue to drop. Kevin O’Donnell of RenRe recently said the following:

“We believe that a playbook relying on the old cycle is dead. The future will not see multi-region, multi-line hardening post-event. There’s too much capital interested in this risk and it can enter our business more quickly and with less friction. There will be cycles, but they will be more targeted and shorter and we have worked hard to make sure that we can attract the best capital, underwrite better, and deploy first when the market presents an opportunity.”

I cannot but help think that the capital markets are not fully appreciating the nuances of the underlying risks and simply treating catastrophe risks like other BB asset classes as the graph below illustrates.

click to enlargeBB Corporate vrs ILS Spreads

There is an alternate explanation. The factors impacting weather systems are incredibly complex. Sea surface temperatures (SSTs) and wind shear conditions are key variables in determining hurricane formation and characteristics. Elements which may come into play on these variables include the North Atlantic Oscillation (NAO) which is a fluctuation in pressure differences between the Icelandic and Azores regions, the Atlantic Multi-Decadal Oscillation (AMO) which measures the natural variability in sea surface temperature (and salinity) of the North Atlantic, and the El Niño Southern Oscillation (ENSO) which measures cyclical temperature anomalies in the Pacific Ocean off South America. Climate change is impacting each of these variables and it may be possible that US hurricanes will become less frequent (but likely more severe).

An article from late last year in the Nature Geoscience Journal from Klotzbach, Gray and Fogarty called “Active Atlantic hurricane era at its end?” suggests the active hurricane phase in the Atlantic could be entering a new quieter cycle of storm activity. The graph below is from their analysis.

click to enlargeAtlantic hurricane frequency

Could it be that the capital markets are so efficient that they have already factored in such theories with a 25% discount on risk premia? Yep, right.