Tag Archives: leverage

Crises Chronicles

Ray Dalio is on a mission to share insights gained over 40 years at the helm of the vastly successful Brightwater Associates. After the financial crisis, Dalio published an excellent article on the workings of the economy. In 2017, he expanded on his previously published philosophy in a book called Principles (as per this summary). More recently he published a free downloadable book called A Template for Understanding Big Debt Crises, available here.

I have a copy of Principles but I must admit I have yet to finish reading it (on my to do list!). I have read the first section of the latest Big Debt Crises book and would highly recommend it. The second section of the book has detailed case studies (the US 2007-11, the US 1928-37, and Germany 1918-24) and the third section is a compendium of 48 other case studies.

Two graphs below from the Big Debt Crises book are worth reproducing, reflecting key factors behind our economy today.

click to enlarge

click to enlarge

Dalio is an astute student of history. He recently commented that “the biggest mistake that most people make is to judge what will be good by what has been good lately”.

Amen to that.

Broken Record II

As the S&P500 hit an intraday all-time high yesterday, it’s been nearly 9 months since I posted on the valuation of the S&P500 (here). Since then, I have touched on factors like the reversal of global QE flows by Central Banks (here) and the lax credit terms that may be exposed by tightening monetary conditions (here). Although the traditional pull back after labor day in the US hasn’t been a big feature in recent years, the market feels frothy and a pullback seems plausible. The TINA (There Is No Alternative) trade is looking distinctly tired as the bull market approaches the 3,500-day mark. So now is an opportune time to review some of the arguments on valuations.

Fortune magazine recently had an interesting summary piece on the mounting headwinds in the US which indicate that “the current economic expansion is much nearer its end than its beginning”. Higher interest rates and the uncertainty from the ongoing Trump trade squabble are obvious headwinds that have caused nervous investors to moderate slightly valuation multiples from late last year. The Fortune article points to factors like low unemployment rates and restrictions on immigration pushing up wage costs, rising oil prices, the fleeting nature of Trump’s tax cuts against the long-term impact on federal debt, high corporate debt levels (with debt to EBITDA levels at 15 years high) and the over-optimistic earnings growth estimated by analysts.

That last point may seem harsh given the 24% and 10% growth in reported quarterly EPS and revenue respectively in Q2 2018 over Q2 2017, according to Factset as at 10/08/2018. The graph below shows the quarterly reported growth projections by analysts, as per S&P Dow Jones Indices, with a fall off in quarterly growth in 2019 from the mid-20’s down to a 10-15% range, as items like the tax cuts wash out. Clearly 10-15% earnings growth in 2019 is still assuming strong earnings and has some commentators questioning whether analysts are being too optimistic given the potential headwinds outlined above.

click to enlarge

According to Factset as at 10/08/2018, the 12-month forward PE of 16.6 is around the 5-year average level and 15% above the 10-year average, as below. As at the S&P500 high on 21/08/2018, the 12-month forward PE is 16.8.

click to enlarge

In terms of the Shiller PE or the cyclically adjusted PE (PE10), the graph below shows that the current PE10 ratio of 32.65 as at the S&P500 high on 21/08/2018, which is 63% higher than 50-year average of 20. For the purists, the current PE10 is 89% above the 100-year average.

click to enlargeCAPE Shiller PE PE10 as at 21082018 S&P500 high

According to this very interesting research paper called King of the Mountain, the PE10 metric varies across different macro-economic conditions, specifically the level of real interest rates and inflation. The authors further claim that PE10 becomes a statistically significant and economically meaningful predictor of shorter-term returns under the assumption that PE10 levels mean-revert toward the levels suggested by prevailing macroeconomic conditions rather than toward long-term averages. The graph below shows the results from the research for different real yield and inflation levels, the so-called valuation mountain.

click to enlarge

At a real yield around 1% and inflation around 2%, the research suggests a median PE around 20 is reasonable. Although I know that median is not the same as mean, the 20 figure is consistent with the 50-year PE10 average. The debates on CAPE/PE10 as a valuation metric have been extensively aired in this blog (here and here are examples) and range around the use of historically applicable earnings data, adjustments around changes in accounting methodology (such as FAS 142/144 on intangible write downs), relevant time periods to reflect structural changes in the economy, changes in dividend pay-out ratios, the increased contribution of foreign earnings in US firms, and the reduced contribution of labour costs (due to low real wage inflation).

One hotly debated issue around CAPE/PE10 is the impact of the changing profit margin levels. One conservative adjustment to PE10 for changes in profit margins is the John Hussman adjusted CAPE/PE10, as below, which attempts to normalise profit margins in the metric. This metric indicates that the current market is at an all time high, above the 1920s and internet bubbles (it sure doesn’t feel like that!!). In Hussman’s most recent market commentary, he states that “we project market losses over the completion of this cycle on the order of -64% for the S&P 500 Index”.

click to enlarge

Given the technological changes in business models and structures across economic systems, I believe that assuming current profit margins “normalise” to the average is too conservative, particularly given the potential for AI and digital transformation to cut costs across a range of business models over the medium term. Based upon my crude adjustment to the PE10 for 2010 and prior, as outlined in the previous Broken Record post (i.e. adjusted to 8.5%), using US corporate profits as a % of US GDP as a proxy for profit margins, the current PE10 of 32.65 is 21% above my profit margin adjusted 50-year average of 27, as shown below.

click to enlargeCAPE Shiller PE PE10 adjusted as at 21082018 S&P500 high

So, in summary, the different ranges of overvaluation for the S&P500 at its current high are from 15% to 60%. If the 2019 estimates of 10-15% quarterly EPS growth start to look optimistic, whether through deepening trade tensions or tighter monetary policy, I could see a 10% to 15% pullback. If economic headwinds, as above, start to get serious and the prospect of a recession gets real (although these things normally come quickly as a surprise), then something more serious could be possible.

On the flipside, I struggle to see where significant upside can come from in terms of getting earnings growth in 2019 past the 10-15% range. A breakthrough in trade tensions may be possible although unlikely before the mid-term elections. All in all, the best it looks like to me in the short term is the S&P500 going sideways from here, absent a post-labor day spurt of profit taking.

But hey, my record on calling the end to this bull market has been consistently broken….

Low risk premia and leverage

The buzz from the annual insurance speed dating festival in Monte Carlo last week seems to have been subdued. Amid all the gossip about the M&A bubble, insurers and reinsurers tried to talk up a slowing of the rate of price decreases. Matt Weber of Swiss Re said “We’ve seen a slowing down of price decreases, although prices are not yet stable. We believe the trend will continue and we’ll see a stabilisation very soon”. However, analysts are not so sure. Moody’s stated that “despite strong signs that a more rational marketplace is emerging in terms of pricing, the expansion of alternative capital markets continues to threaten the traditional reinsurance business models”.  Fitch commented that “a number of fundamental factors that influence pricing remain negative” and that “some reinsurers view defending market share by writing business below the technical price floor as being an acceptable risk”. KBW comment that on-going pricing pressures will “eventually compressing underwriting margins below acceptable returns”.

It is no surprise then that much of the official comments from firms focused on new markets and innovation. Moody’s states that “innovation is a defence against ongoing disintermediation, which is likely to become more pronounced in areas in which reinsurers are not able to maintain proprietary expertise”. Munich Re cited developing new forms of reinsurance cover and partnering with hi-tech industries to create covers for emerging risks in high growth industries. Aon Benfield highlighted three areas of potential growth – products based upon advanced data and analytics (for example in wider indemnification for financial institutions or pharmaceuticals), emerging risks such as cyber, and covering risks currently covered by public pools (like flood or mortgage credit). Others think the whole business model will change fundamentally. Stephan Ruoff of Tokio Millennium Re said “the traditional insurance and reinsurance value chain is breaking up and transforming”. Robert DeRose of AM Best commented that reinsurers “will have a greater transformer capital markets operation”.

Back in April 2013, I posed the question of whether financial innovation always ends in reduced risk premia (here). The risk adjusted ROE today from a well spread portfolio of property catastrophe business is reportingly somewhere between 6% and 12% today (depending upon who you ask and on how they calculate risk adjusted capital). Although I’d be inclined to believe more in the lower range, the results are likely near or below the cost of capital for most reinsurers. That leads you to the magic of diversification and the over hyped “non-correlated” feature of certain insurance risks to other asset classes. There’s little point in reiterating my views on those arguments as per previous posts here, here and here.

In the last post cited above, I commented that “the use by insurers of their economic capital models for reinsurance/retrocession purchases is a trend that is only going to increase as we enter into the risk based solvency world under Solvency II”. Dennis Sugrue of S&P said “we take some comfort from the strength of European reinsurers’ capital modelling capabilities”, which can’t but enhance the reputation of regulatory approved models under Solvency II. Some ILS funds, such as Twelve Capital, have set up subordinated debt funds in anticipation of the demand for regulatory capital (and provide a good comparison of sub-debt and reinsurance here).

One interesting piece of news from Monte Carlo was the establishment of a fund by Guy Carpenter and a new firm founded by ex-PwC partners called Vario Partners. Vario states on their website they were “established to increase the options to insurers looking to optimise capital in a post-Solvency II environment” and are proposing private bonds with collateral structured as quota share type arrangements with loss trigger points at 1-in-100 or 1-in-200 probabilities. I am guessing that the objective of the capital relief focussed structures, which presumably will use Vario proprietary modelling capabilities, is to allow investors a return by offering insurers an ability to leverage capital. As their website saysthe highest RoE is one where the insurer’s shareholders’ equity is geared the most, and therefore [capital] at it’s thinnest”. The sponsors claim that the potential for these bonds could be six times that of the cat bond market. The prospects of allowing capital markets easy access to the large quota share market could add to the woes of the current reinsurance business model.

Low risk premia and leverage. Now that’s a good mix and, by all accounts, the future.

Follow-on (13th October 2015): Below are two graphs from the Q3 report from Lane Financial LLC which highlight the reduced risk premia prevalent in the ILS public cat bond market.

click to enlargeILS Pricing September 2015

click to enlargeILS Price Multiples September 2015

Delirious Deleveraging

Michael Lewis, in his 2011 book “Boomerang” on the consequences of the financial crisis, said that “leverage buys you a glimpse of a prosperity you haven’t earned”. Well, if that is true, we are all in trouble based upon the findings from the fascinating Geneva report “Deleveraging? What Deleveraging?” from Luigi Buttiglione, Philip Lane, Lucrezia Reichlin and Vincent Reinhart, published yesterday.

The report paints a stark picture, as the following statements illustrate:

“Contrary to widely held beliefs, the world has not yet begun to delever and the global debt-to-GDP is still growing, breaking new highs. At the same time, in a poisonous combination, world growth and inflation are also lower than previously expected, also – though not only – as a legacy of the past crisis. Deleveraging and slower nominal growth are in many cases interacting in a vicious loop, with the latter making the deleveraging process harder and the former exacerbating the economic slowdown. Moreover, the global capacity to take on debt has been reduced through the combination of slower expansion in real output and lower inflation.”

The report has a number of attention grabbing graphs on debt levels as a % of GDP like the one below on the US and others on Europe, China and global debt levels, as below.

click to enlargeUS Debt as % of GDP

click to enlargeDebt as % of GDP

The report is particularly pessimistic about China’s medium term prospects after its rapid 72% rise in debt levels since the crisis. On the US and the UK, for the countries who “managed the trade-off between deleveraging policies and output costs better so far, by avoiding a credit crunch while achieving a meaningful reduction of debt exposure of the private sector and the financial system” the legacy of “a substantial re-leveraging of the public sector, including the central banks” leaves a considerable challenge for the future.

ILS Fund versus PropertyCat Reinsurer ROEs

Regular readers will know that I have queried how insurance-linked securities (ILS) funds, currently so popular with pensions funds, can produce a return on equity that is superior to that of a diversified property catastrophe reinsurer given that the reinsurer only has to hold a faction of its aggregate limit issued as risk based capital whereas all of the limits in ILS are collaterised. The recent FT article which contained some interesting commentary from John Seo of Fermat Capital Management got me thinking about this subject again. John Seo referred to the cost advantage of ILS funds and asserted that reinsurers staffed with overpaid executives “can grow again, but only after you lay off two out of three people”. He damned the traditional sector with “these guys have been so uncreative, they have been living off earthquake and hurricane risks that are not that hard to underwrite.

Now, far be it from me to defend the offshore chino loving reinsurance executives with a propensity for large salaries and low taxation. However, I still can’t see that the “excessive” overheads John Seo refers to could offset the capital advantage that a traditional property catastrophe reinsurer would have over ILS collateral requirements.

I understood the concept of ILS structures that provided blocks of capacity at higher layers, backed by high quality assets, which could (and did until recently) command a higher price than the traditional market. Purchasers of collaterised coverage could justify paying a premium over traditional coverage by way of large limits on offer and a lower counterparty credit risk (whilst lowering concentration risk to the market leading reinsurers). This made perfect sense to me and provided a complementary, yet different, product to that offered by traditional reinsurers. However, we are now in a situation whereby such collaterised reinsurance providers may be moving to compete directly with traditional coverage on price and attachment.

To satisfy my unease around the inconsistency in equity returns, I decided to do some simple testing. I set up a model of a reasonably diversified portfolio of 8 peak catastrophic risks (4 US and 4 international wind and quake peak perils). The portfolio broadly reflects the market and is split 60:40 US:International by exposure and 70:30 by premium. Using aggregate exceedance probability (EP) curves for each of the main 8 perils based off extrapolated industry losses as a percentage of limits offered across standard return periods, the model is set up to test differing risk premiums (i.e. ROL) for each of the 8 perils in the portfolio and their returns.  For the sake of simplicity, zero correlations were assumed between the 8 perils.

The first main assumption in the model is the level of risk based capital needed by the property catastrophe reinsurer to compete against the ILS fund. Reviewing some of the Bermudian property catastrophe players, equity (common & preferred) varies between 280% and 340% of risk premiums (net of retrocessions). Where debt is also included, ratios of up to 400% of net written premiums can be seen. However, the objective is to test different premium levels and therefore setting capital levels as a function of premiums distorts the results. As reinsurer’s capital levels are now commonly assessed on the basis of stressed economic scenarios (e.g. PMLs as % of capital), I did some modelling and concluded that a reasonable capital assumption for the reinsurer to be accepted is the level required at a 99.99th percentile or a 1 in 10,000 return period (the graph below shows the distribution assumed). As the graph below illustrates, this equates to a net combined ratio (net includes all expenses) of the reinsurer of approximately 450% for the average risk premium assumed in the base scenario (the combined ratio at the 99.99th level will change as the average portfolio risk premium changes).

click to enlargePropCAT Reinsurer Combined Ratio Distribution

So with the limit profile of the portfolio is set to broadly match the market, risk premiums per peril were also set according to market rates such that the average risk premium from the portfolio was 700 bps in a base scenario (again broadly where I understand the property catastrophe market is currently at).

Reviewing some of the actual figures from property catastrophe reinsurer’s published accounts, the next important assumption is that the reinsurer’s costs are made up of 10% acquisition costs and 20% overhead (the overhead assumption is a bit above the actual rates seen by I am going high to reinforce Mr Seo’s point about greedy reinsurance executives!) thereby reducing risk premiums by 30%. For the ILS fund, the model assumes a combined acquisition and overhead cost of just 10% (this may also be too light as many ILS funds are now sourcing some of their business through brokers and many reinsurance fund managers share the greedy habits of the traditional market!).

The results below show the average simulated returns for a reinsurer and an ILS fund writing the same portfolio with the expense levels as detailed above (i.e 30% versus 10%), and with different capital levels (reinsurer at 99.99th percentile and the ILS fund with capital equal to the limits issued). It’s important to stress that the figures below do not included investment income so historical operating ROEs from property catastrophe reinsurers are not directly comparable.

click to enlargePropCAT Reinsurer & ILS Fund ROE Comparison

So, the conclusion of the analysis re-enforces my initial argument that the costs savings cannot compensate for the leveraged nature of a reinsurer’s business model compared to the ILS fully funded model. However, this is a simplistic comparison. Why would a purchaser not go with a fully funded ILS provider if the product on offer was exactly the same as that of a reinsurer? As outlined above, both risk providers serve different needs and, as yet, are not full on competitors (although this may be the direction of the changes underway in the market currently).

Also, many ILS funds likely do use some form of leverage in their business model whether by way of debt or retrocession facilities. And competition from the ILS market is making the traditional market look at its overhead and how it can become more cost efficient. So it is likely that both business models will adapt and converge (indeed, many reinsurers are now also ILS managers).

Notwithstanding these issues, I can’t help conclude that (for some reason) our pension funds are the losers here by preferring the lower returns of an ILS fund sold to them by investment bankers than the higher returns on offer from simply owning the equity of a reinsurer (admittedly without the same operational risk profile). Innovative or just cheap risk premia? Go figure.