Tag Archives: reinsurance

The New Normal (Again)

I expect that next week’s reinsurance jamboree in Monte Carlo will be full of talk of innovative and technology streaming-lining business models (as per this post on AI and insurance). This recent article from the FT is just one example of claims that technology like blockchain can reduce costs by 30%. The article highlights questions about whether insurers are prepared to give up ownership of data, arguably their competitive advantage, if the technology is really to be scaled up in the sector.

As a reminder of the reinsurance sector’s cost issues, as per this post on Lloyds’, the graph below illustrates the trend across Lloyds’, the Aon Benfield Aggregate portfolio, and Munich’s P&C reinsurance business.

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Until the sector gets serious about cutting costs, such as overpaid executives on luxury islands or expensive cities and antiquated business practises such as holding get togethers in places like Monte Carlo, I suspect expenses will remain an issue. In their July review, Willis stated that a “number of traditional carriers are well advanced in their plans to reduce their costs, including difficult decisions around headcount” and that “in addition to cost savings, the more proactively managed carriers are applying far greater rigor in examining the profitability of every line of business they are accepting”. Willis highlighted the potential difficulties for the vastly inefficient MGA business that many have been so actively pursuing. As an example of the type of guff executives will trot out next week, Swiss Re CEO, Christian Mumenthaler, said “we remain convinced that technology will fundamentally change the re/insurance value chain”, likely speaking from some flash office block in one of the most expensive cities in the world!

On market conditions, there was positive developments on reinsurance pricing at the January renewals after the 2017 losses with underlying insurance rates improving, as illustrated by the Marsh composite commercial rate index (example from US below).

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However, commentators have been getting ever more pessimistic as the year progresses, particularly after the mid-year renewals. Deutsche Bank recently called the reinsurance pricing outlook “very bleak”. A.M. Best stated that “the new normal for reinsurers appears to be one with returns that are less impressive and underwriting and fee income becoming a larger contributor to profits” and predicts, assuming a normal large loss level, an 8% ROE for 2018 for the sector. Willis, in their H1 report, puts the sectors ROE at 7.7% for H1 2018. S&P, in the latest report that is part of their Global Highlights series, also expects a ROE return for 2018 around 6% to 8% and estimates that “reinsurers are likely to barely cover their cost of capital in 2018 and 2019”.

S&P does question why “the market values the industry at a premium to book value today (on average at 1.24x at year-end 2017), and at near historical highs, given the challenges” and believes that potential capital returns, M&A and interest rate rises are all behind elevated valuations.  The recent Apollo PE deal for Aspen at 1.12 times book seems a large way off other recent multiples, as per this post, but Aspen has had performance issues. Still its interesting that no other insurer was tempted to have a go at Aspen with the obvious synergies that such a deal could have achieved. There is only a relatively small number of high quality players left for the M&A game and they will not be cheap!

As you are likely aware, I have been vocal on the impact the ILS sector has had in recent years (most recently here and here). With so-called alternative capital (at what size does it stop being alternative!) now at the $95 billion-mark according to Aon, A.M. Best makes the obvious point that “any hope for near-term improvement in the market is directly correlated to the current level of excess capacity in the overall market today, which is being compounded by the continued inflow of alternative capacity”. Insurers and reinsurers are not only increasing their usage of ILS in portfolio optimisation but are also heavily participating in the sector. The recent purchase by Markel of the industry leading and oldest ILS fund Nephila is an interesting development as Markel already had an ILS platform and is generally not prone to overpaying.

I did find this comment from Bob Swarup of Camdor in a recent Clear Path report on ILS particularly telling – “As an asset class matures it inevitably creates its own cycle and beta. At this point you expect fees to decline both as a function of the benefits of scale but also as it becomes more understood, less of it becomes alpha and more of it becomes beta” and “I do feel that the fees are most definitely too high right now and to a large extent this is because people are trying to treat this as an alternative asset class whereas it is large enough now to be part of the general mix”. Given the still relatively small size of the ILS sector, it’s difficult for ILS managers to demonstrate true alpha at scale (unless they are taking crazy leveraged bets!) and therefore pressure on current fees will become a feature.

A.M. Best articulated my views on ILS succinctly as follows: “The uncorrelated nature of the industry to traditional investments does appear to have value—so long as the overall risk-adjusted return remains appropriate”. The graph below from artemis.bm shows the latest differential between returns and expected cost across the portfolio they monitor.

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In terms of the returns from ILS funds, the graph below shows the underlying trend (with 2018 results assuming no abnormal catastrophic activity) of insurance only returns from indices calculated by Lane Financial (here) and Eurekahedge (here). Are recent 5 year average returns of between 500 and 250 basis points excess risk free enough to compensation for the risk of a relatively concentrated portfolio? Some think so. I don’t.

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Whether reinsurers and specialty insurers will be able to maintain superior (albeit just above CoC) recent returns over ILS, as illustrated in this post, through arbitrating lower return ILS capital or whether their bloated costs structures will catch them out will be a fascinating game to watch over the coming years. I found a section of a recent S&P report, part of their Global Highlights series, on cat exposures in the sector, amusing. It stated that in 2017 “the reinsurance industry recorded an aggregate loss that was assessed as likely to be incurred less than once in 20 years” whilst “this was the third time this had happened in less than 20 years“.

So, all in all, the story is depressingly familiar for the sector. The new normal, as so many commentators have recently called it, amounts to overcapacity, weak pricing power, bloated cost structures, and optimistic valuations. Let’s see if anybody has anything new or interesting to say in Monte Carlo next week.

As always, let’s hope there is minimal human damage from any hurricanes such as the developing Hurricane Florence or other catastrophic events in 2018.

Another look across insurance cycles

Following on from a previous post on insurance cycles and other recent posts, I have been looking over the inter-relationship between insurance cycles in the US P&C market, the Lloyds of London market and the reinsurance market. Ideally, the comparisons should be done on an accident year basis (calendar year less prior year reserve movements) with catastrophic/large losses for 2001/2005/2011 excluded but I don’t (yet) have sufficient historical data to make such meaningful comparisons.

The first graph shows calendar year combined ratios in each of the three markets. The US P&C figures contain both consumer and commercial business and as a result are less volatile with the other markets. For example, Lloyds results are from specialty business classes like energy, marine, credit & surety, A&H, specialty casualty, excess and surplus (E&S) lines and reinsurance. The reinsurance ratios are those for most reinsurers as per S&P in their annual global reports. For good measure, I have also included the US real interest rates to show the impact that reduced investment income is having on the trend in combined ratios across all markets. Overall, ratios have been on a downward trend since the early 1990s. However, if catastrophic losses and reserve releases are excluded ratios have been on an upward trend since 2006 across Lloyds and the reinsurance markets. Recent rate increases in the US such as the high single digit rate increases in commercial property & workers comp (see Aon Benfield January report for details on US primary rate trends) may mean that the US P&C market comes in with a combined ratio below 100% for the full 2013 year (from 102% and 106% in 2012 and 2011 respectively).

click to enlargeInsurance Cycle Combined RatiosAs commented on above, the US P&C ratios cover consumer and commercial exposures and don’t fully show the inter-relationship between the different business classes across that market. The graph below shows the calendar year ratios in the US across the main business classes and paint a more volatile picture than the red line above.

click to enlargeUS Commercial Business Classes Combined Ratios

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.

Relative valuations of selected reinsurers and wholesale insurers

It’s been a great 12 months for wholesale insurers with most seeing their share price rise by 20%+, some over 40%. As would be expected, there has been some correlation between the rise in book values and the share price increase although market sentiment to the sector and the overall market rally have undoubtedly also played their parts. The graph below shows the movements over the past 12 months (click to enlarge).

12 month share price change selected reinsurers March 2013The price to tangible book is one of my preferred indicators of value although it has limitations when comparing companies reporting under differing accounting standards & currencies and trading in different exchanges. The P/TBV valuations as at last weekend are depicted in the graph below. The comments in this post are purely made on the basis of the P/TBV metric calculated from published data and readers are encouraged to dig deeper.

I tend to look at the companies relative to each other in 4 broad buckets – the London market firms, the continental European composite reinsurers, the US/Bermuda firms, and the alternative asset or “wannabe buffet” firms.  Comparisons across buckets can be made but adjustments need to be made for factors such as those outlined in the previous paragraph. Some firms such as Lancashire actually report in US$ as that is where the majority of their business is but trade in London with sterling shares. I also like to look at the relative historical movements over time & the other graph below from March 2011 helps in that regard.

Valuations as at March 2013 (click to enlarge):

Price to net tangible book & 5 year average ROE reinsurers March 2013

Valuations as at March 2011 (click to enlarge):

Price to net tangible book & 5 year average ROE reinsurers March 2011 The London market historically trades at the highest multiples – Hiscox, Amlin, & Lancashire are amongst the leaders, with Catlin been the poor cousin. Catlin’s 2012 operating results were not as strong as the others but the discount it currently trades at may be a tad unfair. In the interest of open disclosure, I must admit to having a soft spot for Lancashire. Their consistent shareholder friendly actions result in the high historical valuation. These actions and a clear communication of their straight forward business strategy shouldn’t distract investors from their high risk profile. The cheeky way they present their occurrence PMLs in public disclosures cannot hide their high CAT exposures when the occurrence PMLs are compared to their peers on a % of tangible asset basis. Their current position relative to Hiscox and Amlin may be reflective of this (although they tend to go down when ex dividend, usually a special dividend!).

Within the continental European composite reinsurer bucket, the Munich and Swiss, amongst others, classify chunky amounts of present value of future profits from their life business as an intangible. As this item will be treated as capital under Solvency II, further metrics need to be considered when looking at these composite reinsurers. The love of the continental Europeans of hybrid capital and the ability to compare the characteristics of the varying instruments is another factor that will become clearer in a Solvency II world. Compared to 2011 valuations Swiss Re has been a clear winner. It is arguable that the Munich deserves a premium given it’s position in the sector.

The striking thing about the current valuations of the US/Bermudian bucket is how concentrated they are, particularly when compared to 2011. The market seems to be making little distinction between the large reinsurers like Everest and the likes of Platinum & Montpelier. That is surely a failure of these companies to distinguish themselves and effectively communicate their differing business models & risk profiles.

The last bucket is the most eccentric. I would class firms such as Fairfax  in this bucket. Although each firm has its own twist, generally these companies are interested in the insurance business as the provider of cheap “float”, a la Mr Buffet, with the focus going into the asset side. Generally, their operating results are poorer than their peers and they have a liking for the longer tail business if the smell of the float is attractive enough (which is difficult with today’s interest rate). This bucket really needs to be viewed through different metrics which we’ll leave for another day.

Overall then, the current valuations reflect an improved sentiment on the sector. Notwithstanding the musings above, nothing earth shattering stands out based solely on a P/TBV analysis.  The ridiculously low valuations of the past 36 months aren’t there anymore. My enthusiasm for the sector is tempered by the macro-economic headwinds, the overall run-up in the market (a pull-back smells inevitable), and the unknown impact upon the sector of the current supply distortions from yield seeking capital market players entering the market.