Following on from a recent post on windstorms in the US, I have taken several loss preliminary estimates recently published by firms (and these are very early estimates and therefore subject to change) and overlaid them against the South-East US probable maximum loss (PML) curves and Atlantic hurricane scenarios previously presented, as below. The range of insured losses for Harvey, Irma and Maria (now referred to as HIM) are from $70 billion to $115 billion, averaging around $90 billion.
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The loss estimates by firm depend heavily upon the risk profile of each. As a generalisation, it could be said that the aggregate US wind losses are averaging around the 1 in 100 loss level.
Given there was over $20 billion of insured losses from H1 and factoring in developing losses such as the Mexico earthquake, the California wildfires and the current windstorm Ophelia hitting Ireland, annual insured losses for 2017 could easily reach $120 billion. The graph below shows the 2016 estimates from Swiss Re and my $120 billion 2017 guesstimate (it goes without saying that much could still happen for the remainder of the year).
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At a $120 billion level of insured loss for 2017, the 10 year average increase from around $55 billion to $65 billion. In a post in early 2016, I estimated that catastrophe pricing was about 25% too low based upon annual average losses of $40 billion per year. We will see whether the 2017 losses are enough to deplete the overcapitalisation in the market and return pricing towards their technical rate. I wouldn’t hold my breath on that as although there may be material aggregate losses in the private collateralised market and other pockets of the retrocession market, the appetite of yield seeking investors will likely remain unabated in the current interest rate environment.
Although the comparison between calendar year ratios and credit defaults is fraught with credibility issues (developed accident year ratios to developed default rates are arguably more comparable), I updated my previous underwriting cycle analysis (here in 2014 and here in 2013). Taking the calendar year net loss ratios of Munich Re and Lloyds of London excluding catastrophe and large losses (H1 results for 2017), I then applied a crude discount measure using historical risk-free rates plus 100 basis points to reflect the time value of money, and called the resulting metric the adjusted loss ratio (adjusted LR). I compared these adjusted LRs for Munich and Lloyds to S&P global bond credit default rates (by year of origin), as per the graph below.
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This shows that the years of relatively benign attritional claims together with the compounding impact of soft pricing over the past years may finally be coming to an end. Time will tell. All in all, it makes for a very interesting period for the market over the next 6 to 12 months.
In the interim, let’s hope for minimal human damage from the current California wildfires and windstorm Ophelia.
Posted in General
Tagged 1 in 100 event, 1 in 200 capital, 1 in 250 event, 99.5% VaR, adjusted premium, AIR, Atlantic hurricane, California wildfires, catastrophe insurance sector, catastrophe risks, collateralised reinsurance, cost of capital, credit cycles, Eqecat, exceedance curves, fat tail, Florida windstorm, Hurricane Harvey, Hurricane Irma, Hurricane Jose, hybrid capital, ILS, ILS fund, ILS funds, ILS investor, ILS market, ILS multiples, ILS pricing, insurance linked securities, insurance sector, LMX spiral, London market insurers, loss exceedance estimates, Mexico earthquake, model uncertainty, natural catastrophes, nature unpredictability, net tangible assets, PML, probable maximum losses, property catastrophe pricing, rate on line, reinsurance pricing, reinsurance rates, reserve releases, return periods, RMS, ROE normalised, ROL, sources of uncertainty, South-East US catastrophe exposure, specialty insurance, subordinate debt, tail risk, tail VaR, TVaR, underwriting cycles, US hurricanes, US wind perils, vendor models, west coast Florida, Willis Re, windstorm Ophelia, yield seeking investors
Hedge funds are becoming ever more active in the reinsurance space. Initially, the main draw was the ILS space as a source of high yields from an uncorrelated asset class. As the historical returns show (see previous post), this has been a successful strategy over the past 5 to 8 years.
However, as yield seeking investors, particularly from increased pension investment in specialist ILS funds, have flooded the market with supply over the past 12 months with the resulting downward pressure on rates (latest Willis Re report has some Florida rates down 25%), attention may switch towards strategies of getting directly involved in providing capital to the sector. Existing hedge fund backed reinsurers such as Greenlight Re, Third Point, SAC Re and PAC Re have attracted attention, most recently for their tax advantages as per this Bloomberg article in February.
Despite the obvious tax attraction of some hedge fund backed reinsurer strategies (particularly for those focussed on easy to enter commodity markets like property catastrophe), the more solid firms are driven by the leverage that medium to long term insurance float can bring to enhance their investment returns. The daddy of this strategy is of course Warren Buffet. A report entitled “Buffet’s Alpha” from 2012 co-authored by professionals in AQR Capital Management summarises the strategy. The report concludes that “the secret to Buffett’s success is his preference for cheap, safe, high-quality stocks combined with his consistent use of leverage to magnify returns while surviving the inevitable large absolute and relative drawdowns this entails” and “that Buffett applies about 1.6-to-1 leverage financed partly using insurance float with a low financing rate, and that leveraging safe stocks can largely explain Buffett’s performance.”
With current accident year underwriting margins thin and reinsurance pricing increasingly driven by black box quant underwriting, it seems inevitable that naïve newcomers will try to repeat Buffet’s formula for success by aggressively chasing insurance float for leverage. Such new capacity, if substantial, will test the sector’s relatively newfound (and hard fought) reputation for underwriting discipline at a time of building headwinds for the sector.
Posted in Insurance Market
Tagged accident year underwriting, AQR Buffets Alpha, hedge funds reinsurance, insurance float leverage, PAC Re, property catastrophe pricing, reinsurance leverage, SAC Re, specialist ILS fund, Third Point Re, underwriting discipline, Warren Buffet float