Tag Archives: new ILS capacity

Insurance & capital market convergence hype is getting boring

As the horde of middle aged (still mainly male) executives pack up their chinos and casual shirts, the overriding theme coming from this year’s Monte Carlo Renez-Vous seems to be impact of the new ILS capacity or “convergence capital” on the reinsurance and specialty insurance sector. The event, described in a Financial Times article as “the kind of public display of wealth most bankers try to eschew”, is where executives start the January 1 renewal discussions with clients in quick meetings crammed together in the luxury location.

The relentless chatter about the new capital will likely leave many bored senseless of the subject. Many may now hope that, just like previous hot discussion topics that were worn out (Solvency II anybody?), the topic fades into the background as the reality of the office huts them next week.

The more traditional industry hands warned of the perils of the new capacity on underwriting discipline. John Nelson of Lloyds highlighted that “some of the structures being used could undermine some of the qualities of the insurance model”. Tad Montross of GenRe cautioned that “bankers looking to replace lost fee income” are pushing ILS as the latest asset class but that the hype will die down when “the inability to model extreme weather events accurately is better understood”. Amer Ahmed of Allianz Re predicted the influx “bears the danger that certain risks get covered at inadequate rates”. Torsten Jeworrek of Munich Re said that “our research shows that ILS use the cheapest model in the market” (assumingly in a side swipe at AIR).

Other traditional reinsurers with an existing foothold in the ILS camp were more circumspect. Michel Lies of Swiss Re commented that “we take the inflow of alternative capital seriously but we are not alarmed by it”.

Brokers and other interested service providers were the loudest cheerleaders. Increasing the size of the pie for everybody, igniting coverage innovative in the traditional sector, and cheap retrocession capacity were some of the advantages cited. My favourite piece of new risk management speak came from Aon Benfield’s Bryon Ehrhart in the statement “reinsurers will innovate their capital structures to turn headwinds from alternative capital sources into tailwinds”. In other words, as Tokio Millennium Re’s CEO Tatsuhiko Hoshina said, the new capital offers an opportunity to leverage increasingly diverse sources of retrocessional capacity. An arbitrage market (as a previous post concluded)?

All of this talk reminds me of the last time that “convergence” was a buzz word in the sector in the 1990s. For my sins, I was an active participant in the market then. Would the paragraph below from an article on insurance and capital market convergence by Graciela Chichilnisky of Columbia University in June 1996 sound out of place today?

“The future of the industry lies with those firms which implement such innovation. The companies that adapt successfully will be the ones that survive. In 10 years, these organizations will draw the map of a completely restructured reinsurance industry”

The current market dynamics are driven by low risk premia in capital markets bringing investors into competition with the insurance sector through ILS and collaterised structures. In the 1990s, capital inflows after Hurricane Andrew into reinsurers, such as the “class of 1992”, led to overcapacity in the market which resulted in a brutal and undisciplined soft market in the late 1990s.

Some (re)insurers sought to diversify their business base by embracing innovation in transaction structures and/or by looking at expanding the risks they covered beyond traditional P&C exposures. Some entered head first into “finite” type multi-line multi-year programmes that assumed structuring could protect against poor underwriting. An over-reliance on the developing insurance models used to price such transactions, particularly in relation to assumed correlations between exposures, left some blind to basic underwriting disciplines (Sound familiar, CDOs?). Others tested (unsuccessfully) the limits of risk transfer and legality by providing limited or no risk coverage to distressed insurers (e.g. FAI & HIH in Australia) or by providing reserve protection that distorted regulatory requirements (e.g. AIG & Cologne Re) by way of back to back contracts and murky disclosures.

Others, such as the company I worked for, looked to cover financial risks on the basis that mixing insurance and financial risks would allow regulatory capital arbitrage benefits through increased diversification (and may even offer an inflation & asset price hedge). Some well known examples* of the financial risks assumed by different (re)insurers at that time include the Hollywood Funding pool guarantee, the BAe aircraft leasing income coverage, Rolls Royce residual asset guarantees, dual trigger contingent equity puts, Toyota motor residual value protection, and mezzanine corporate debt credit enhancement  coverage.

Many of these “innovations” ended badly for the industry. Innovation in itself should never be dismissed as it is a feature of the world we live in. In this sector however, innovation at the expense of good underwriting is a nasty combination that the experience in the 1990s must surely teach us.

Bringing this back to today, I recently discussed the ILS market with a well informed and active market participant. He confirmed that some of the ILS funds have experienced reinsurance professionals with the skills to question the information in the broker pack and who do their own modelling and underwriting of the underlying risks. He also confirmed however that there is many funds (some with well known sponsors and hungry mandates) that, in the words of Kevin O’Donnell of RenRe, rely “on a single point” from a single model provided by to them by an “expert” 3rd party.

This conversation got me to thinking again about the comment from Edward Noonan of Validus that “the ILS guys aren’t undisciplined; it’s just that they’ve got a lower cost of capital.” Why should an ILS fund have a lower cost of capital to a pure property catastrophe reinsurer? There is the operational risk of a reinsurer to consider. However there is also operational risk involved with an ILS fund given items such as multiple collateral arrangements and other contracted 3rd party service provided functions to consider. Expenses shouldn’t be a major differing factor between the two models. The only item that may justify a difference is liquidity, particularly as capital market investors are so focussed on a fast exit. However, should this be material given the exit option of simply selling the equity in many of the quoted property catastrophe reinsurers?

I am not convinced that the ILS funds should have a material cost of capital advantage. Maybe the quoted reinsurers should simply revise their shareholder return strategies to be more competitive with the yields offered by the ILS funds. Indeed, traditional reinsurers in this space may argue that they are able to offer more attractive yields to a fully collaterised provider, all other things being equal, given their more leveraged business model.

*As a complete aside, an article this week in the Financial Times on the anniversary of the Lehman Brothers collapse and the financial crisis highlighted the role of poor lending practices as a primary cause of significant number of the bank failures. This article reminded me of a “convergence” product I helped design back in the late 1990s. Following changes in accounting rules, many banks were not allowed to continue to hold general loan loss provisions against their portfolio. These provisions (akin to an IBNR type bulk reserve) had been held in addition to specific loan provision (akin to case reserves). I designed an insurance structure for banks to pay premiums previously set aside as general provisions for coverage on massive deterioration in their loan provisions. After an initial risk period in which the insurer could lose money (which was required to demonstrate an effective risk transfer), the policy would act as a fully funded coverage similar to a collaterised reinsurance. In effect the banks could pay some of the profits in good years (assuming the initial risk period was set over the good years!) for protection in the bad years. The attachment of the coverage was designed in a way similar to the old continuous ratcheting retention reinsurance aggregate coverage popular at the time amongst some German reinsurers. After numerous discussions, no banks were interested in a cover that offered them an opportunity to use profits in the good times to buy protection for a rainy day. They didn’t think they needed it. Funny that.

Shifting risk profiles in an arbitrage reinsurance market

There was some interesting commentary from senior executives in the reinsurance and specialty insurance sector during the Q2 conference calls.

Evan Greenberg of ACE gave the media a nice sound-bite when he characterised the oversupply in the property catastrophe sector as “that pond with more drinking out of it”. He also highlighted, that following a number of good years, traditional reinsurers “are hungry” and that primary insurers are demanding better deals as their balance sheets have gotten stronger and more able to retain risk. Greenberg warns that, despite claims of discipline by many market participants, for some reinsurers “it’s all they do for a living and so they feel compelled” to compete against the new capacity.

Kevin O’Donnell of Renaissance Re put some interesting perspective on the new ILS capacity by highlighting that in the early days of the property catastrophe focused reinsurer business model, they “thought about taking risk on a single model”. These reinsurers developed into multi-model and some into proprietary model users. O’Donnell highlighted that the new capacity from capital markets “is somewhat similar to” earlier property catastrophe reinsurance business models and “that, but beyond relying in some instances, on just a single model, they are relying on a single point.” O’Donnell stressed that “it’s very important to understand the shape of the distribution, not just the mean.” Edward Noonan of Validus commented that “the ILS guys aren’t undisciplined; it’s just that they’ve got a lower cost of capital.

Historically lax pricing in reinsurance has quickly trickled down into softer conditions in primary insurance markets. In the US, although commercial insurance rates have moderated from an average increase of 5% to 4% in recent months, the overall trend remains upwards and above loss trend. Greenberg believes that the reason why it could be different this time is “the size of balance sheet on the primary side on the large players” and that more intelligent data analytics means that primary insurers are “making different kinds of decisions about how to hold retentions” and “how to think about exposure”. Although Greenberg makes valid points, in my opinion if pricing pressures continue in the reinsurance sector, the knock-on impacts onto the primary sector will eventually start to emerge.

As always, the market in property catastrophe is dependent upon events, particularly from the current windstorm season. Noonan of Validus commented that the market can’t “sustain a couple more years of 15% off”, referring to the recent Florida rate reductions. Diversified reinsurers point to their ability to rebalance their portfolios in response to the current market. However the resulting impact on risk adjusted returns will be an issue the industry needs to address. The always insightful and ever direct John Charman, now at the helm of Endurance Specialty, highlights the need to contain expenses in the industry. Charman commented “when I look at the industry, it’s very mature.” He characterised some carriers as being “very cumbersome” and “over-expensed”.

For the property catastrophe reinsurers, the shorter term impact on their business models will likely be that they will have to follow a capital management and shareholder strategy more compatible with the return profile of the ILS funds. In terms of valuations, the market is currently making little distinction between diversified reinsurers and catastrophe focussed reinsurers as the graph below of price to tangible book for pure reinsurers and catastrophe reinsurers show. Absent catastrophe events, that lack of distinction by the market could change in the near term.

click to enlargeReinsurers price to tangible book multiples August 2013

In the shorter term, the more seasoned and experienced players know how to react to an influx of new capacity. The conferences calls demonstrate those taking advantage of the arbitrage opportunities. Benchimol of AXIS commented that “we have actually started to hedge our reinsurance portfolio using ILWs and other transactions of that type.” O’Donnell commented that “we continue to look for attractive ways of ceding reinsurance risk as a means to optimizing our reinsurance portfolio.” Charman commented that “we also took advantage of the abundant capital by purchasing Florida retro protection”. Noonan commented that “we also found good value in the retrocession market and took the opportunity to purchase a significant amount of protection for our portfolio during the quarter.” Iordanou of Arch commented that “we did buy more this quarter” and that “we felt we were getting good deals.

Right now, we are clearly in an arbitrage market and the reinsurers that will thrive in this market are those who are clever enough to use the current market dislocation to their advantage.