Tag Archives: London market insurers

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.

Lancashire finds the love

After going ex-dividend in November, investors went mega bearish on Lancashire (LRE.L) when it nearly dropped below the 500p level, as the graph below shows. A previous post highlighted the reasons behind the change in sentiment over the first half of 2014 on the once darling of the specialty insurance sector.

click to enlargeLancashire Insurance Group 2014 Share Price

The firm released its Q4 today and announced another special dividend of $0.50 on top of the regular $0.10 dividend. Driven by stable results, as per the graph below, and by the chatter that Lancashire could be an M&A target, the price today reflects a respectable 160% multiple to diluted tangible book. It was odd that although the firm’s executives joked about having prepared an answer to the M&A question, no analyst actually asked the question in the conference call today!

click to enlargeLancashire Historical Combined Loss 2008 to 2014

One of the big positives from the call today was the news that the firm has restructured their reinsurance programme that protects their book to give them more event coverage with reinstatements (away from previous aggregate cover). This provides more protection to Lancashire from multiple events. The PMLs as at January expressed as a percentage of the calendar year earned premiums (estimated figures for 2015) show the reduced net risk profile of this arbitrage strategy.

click to enlargeLancashire PMLs January 2015

It’s nice to see Lancashire recover some of its shine and it will be intriguing to see if it does become an M&A target in the coming months.

Lancashire is looking unloved

With exposure adjusted rates in the specialty insurance and reinsurance sector continually under pressure and founder/former CEO, Richard Brindle, making an unseemly quick exit with a generous pay-out, Lancashire’s stock has been decidedly unloved with the price trading well below the key £7 threshold highlighted in my last post on the subject in February. Although we remain in the middle of the US hurricane season (and indeed the Napa earthquake is a reminder that its always earthquake season), I thought it was a good time to have a quick look over Lancashire’s figures again, particularly as the share price broke below the £6 threshold earlier this month, a level not seen since early 2011. The stock has clearly now lost its premium valuation compared to others in the London market as the graph below shows.

click to enlargeLondon Market Specialty Insurers Tangible Book Value Multiples August 2014

Results for H1-2014, which include full numbers from the November 2013 acquisition of Cathedral, show a continuing trend on the impact of rate reductions on loss ratios, as per the graph below.

click to enlargeLancashire Historical Combined Loss 2006 to H12014

The impact of the Cathedral deal on reserve levels are highlighted below. The graph illustrates the consistent relative level of IBNR to case reserves compared to the recent past which suggests a limited potential for any cushion for loss ratios from prior year reserve releases.

click to enlargeLancashire Historical Net Loss Reserves

The management at Lancashire have clearly stated their strategy of maintaining their discipline whilst taking advantage of arbitrage opportunities “that allow us to maintain our core insurance and reinsurance portfolios, whilst significantly reducing net exposures and enhancing risk adjusted returns”. In my last post, I looked at post Cathedral gross and net PMLs as a percentage of earned premiums against historical PMLs. More applicable figures as per July for each year, against calendar year gross and net earned premiums (with an estimate for 2014), are presented below. They clearly show that the net exposures have reduced from the 2012 peak. It is important to note however that the Gulf of Mexico net 1 in 100 figures are high at 35%, particularly compared to many of its peers.

click to enlargeLancashire PMLs July 2010 to July 2014

There is of course always the allure of the special dividend. Lancashire has indicated that in the absence of attractive business opportunities they will look at returning most, if not all, of their 2014 earnings to shareholders. Assuming the remainder of 2014 is relatively catastrophe free; Lancashire is on track to make $1-$1.10 of EPS for the full year. If they do return, say, $1 to shareholders that represents a return of just below 10% on today’s share price of £6.18. Not bad in today’s environment! There may be a short term trade there in October after the hurricane season to take advantage of a share pick-up in advance of any special dividend.

Others in the sector are also holding out the prospect of special dividends to reward patient shareholders. The fact that other firms, some with more diverse businesses and less risky risk profiles, offer potential upside through special dividends may also explain why Lancashire has lost its premium tangible book multiple, as per the first graph in this post.

Notwithstanding that previously Lancashire was a favorite of mine due to its nimble and focused approach, I cannot get past the fact that the sector as a whole is mired in an inadequate risk adjusted premia environment (the impact of which I highlighted in a previous post). In the absence of any sector wide catalyst to change the current market dynamic, my opinion is that it is expedient to pass on Lancashire here, even at this multi-year low.

The game of chicken that is unfolding across this sector is best viewed from the side-lines in my view.