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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.

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.”

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….

Does financial innovation always end in reduced risk premia?

Quarterly reports from Willis Re and Aon Benfield highlight the impact on US catastrophe pricing from the new capital flowing into the insurance sector through insurance linked securities (ILS) and collaterised covers. Aon Benfield stated that “clients renewing significant capacity in the ILS market saw their risk adjusted pricing decrease by 25 to 70 percent for peak U.S. hurricane and earthquake exposed transactions” and that “if the financial management of severe catastrophe outcomes can be attained at multiple year terms well inside the cost of equity capital, then at the extreme, primary property growth in active zones could resume for companies previously restricting supply”.

This represents a worrying shift in the sector. Previously, ILS capacity was provided at rates at least equal to and often higher than that offered by the traditional market. The rationale for a higher price made sense as the cover provided was fully collaterized and offered insurers large slices of non-concentrated capacity on higher layers in their reinsurance programmes. The source of the shift is significant new capacity being provided by yield seeking investors lured in by uncorrelated returns. The Economist’s Buttonwood had an article recently entitled “Desperately seeking yield” highlighting that spreads on US investment grade corporate bonds have halved in the past 5 years to about 300bps currently. Buttonwood’s article included Bill Gross’s comment that “corporate credit and high-yield bonds are somewhat exuberantly and irrationally priced”. As a result, money managers are searching for asset classes with higher yields and, by magic, ILS offers a non-correlating asset class with superior yield.  Returns as per those from Eurekahedge on the artemis.bm website in the exhibit below highlight the attraction.

ILS Returns EurekahedgeSuch returns have been achieved on a limited capacity base with rationale CAT risk pricing. The influx of new capital means a larger base, now estimated at $35 billion of capacity up from approximately $5 billion in 2005, which is contributing to the downward risk pricing pressures under way. The impact is particularly been felt in US CAT risks as these are the exposures offering the highest rate on lines (ROL) globally and essential risks for any new ILS fund to own if returns in excess of 500 bps are to be achieved. The short term beneficiaries of the new capacity are firms like Citizens and Allstate who are getting collaterised cover at a reduced risk premium.

The irony in this situation is that these same money managers have in recent years shunned traditional wholesale insurers, including professional CAT focussed firms such as Montpelier Re, which traded at or below tangible book value. The increase in ILS capacity and the resulting reduction of risk premia will have a destabilising impact upon the risk diversification and therefore the risk profile of traditional insurers. Money managers, particularly pension funds, may have to pay for this new higher yielding uncorrelated asset class by taking a hit on their insurance equities down the road!

Financial innovation, yet again, may not result in an increase in the size of the pie, as originally envisaged, but rather mean more people chasing a smaller “mispriced” pie. Sound familiar? When thinking of the vast under-pricing of risk that the theoretical maths driven securitisation innovations led to in the mortgage market, the wise words of the Buffet come to mind – “If you have bad mortgages….they do not become better by repackaging them”. Hopefully the insurance sector will avoid those mistakes!