Tag Archives: Risk premium

Multiple Temptation

I thought it was time for a quick catch up on all things reinsurance and specialty insurance since my last post a year ago. At that time, it looked like the underlying rating environment was gaining momentum and a hoped-for return to underwriting profitability looked on the cards. Of course, since then, the big game changer has been COVID-19.

A quick catch-up on the 2019 results, as below, from the Aon Reinsurance Aggregate (ARA) results of selected firms illustrates the position as we entered this year. It is interesting to note that reserve releases have virtually dried up and the 2019 accident year excluding cats is around 96%.

The Willis Re subset of aggregate results is broadly similar to the ARA (although it contains a few more of the lesser players and some life reinsurers and excludes firms like Beazley and Hiscox) and it shows that on an underling basis (i.e. accident year with normalised cat load), the trend is still upwards and more rate improvement is needed to improve attritional loss ratios.

The breakdown of the pre-tax results of the ARA portfolio, as below, shows that investment returns and gains saved the day in 2019.

The ROE’s of the Willis portfolio when these gains were stripped out illustrates again how underwriting performance needs to improve.

Of course, COVID-19 has impacted the sector both in terms of actual realised losses (e.g. event cancellations) and with the cloud of uncertainty over reserves for multiple exposures yet to be fully realised. There remains much uncertainty in the sector about the exact size of the potential losses with industry estimates ranging widely. Swiss Re recently put the figure at between $50-80 billion. To date, firms have established reserves of just over $20 billion. One of the key uncertainties is the potential outcome of litigation around business interruption cover. The case brought in the UK by the FCA on behalf of policyholders hopes to expedite lengthy legal cases over the main policy wordings with an outcome expected in mid-September. Lloyds industry insurance loss estimate is within the Swiss Re range and their latest June estimate is shown below against other historical events.

I think Alex Maloney of Lancashire summarised the situation well when he said that “COVID-19 is an ongoing event and a loss which will take years to mature”, adding that for “the wider industry the first-party claims picture will not be clear until 2021”. Evan Greenberg of Chubb described the pandemic as a slow rolling global catastrophe impacting virtually all countries, unlike other natural catastrophes it has no geographic or time limits and the event continues as we speak” and predicted that “together the health and consequent economic crisis will likely produce the largest loss in insurance history, particularly considering its worldwide scope and how both sides of the balance sheet are ultimately impacted”.

The immediate impact of COVID-19 has been on rates with a significant acceleration of rate hardening across most lines of business, with some specialty lines such as certain D&O covers have seen massive increases of 50%+. Many firms are reporting H1 aggregate rate increases of between 10% to 15% across their diversified portfolios. Insurance rate increases over the coming months and reinsurance rates at the January renewals, assuming no material natural cats in H2 2020, will be the key test as to whether a true hard market has arrived. Some insurers are already talking about increasing their risk retentions and their PMLs for next year in response to reinsurance rate hardening.

Valuations in the sector have taken a hit as the graph below from Aon on stock performance shows.

Leaving the uncertainty around COVID-19 to one side, tangible book multiples amongst several of my favourite firms since this March 2018 post, most of whom have recently raised additional capital in anticipation of a broad hard market in specialty insurance and reinsurance market, look tempting, as below.

The question is, can you leave aside the impact of COVID-19? That question is worthy of some further research, particularly on the day that Hiscox increased their COVID-19 reserves from $150 million to $230 million and indicated a range of a £10 million to £250 million hit if the UK business interruption case went against them (the top of the range estimate would reduce NTAs by 9%).

Food for thought.

Creepy Things

It has been a while since I looked at the state of the reinsurance and specialty insurance markets. Recent market commentary and insurers’ narratives at recent results have suggested market rates are finally firming up, amidst talk of reserve releases drying up and loss creep on recent events.

Just yesterday, Bronek Masojada the CEO of Hiscox commented that “the market is in a better position than it has been for some time”. The Lancashire CEO Alex Maloney said he was “encouraged by the emerging evidence that the (re)insurance market is now experiencing the long-anticipated improvements in discipline and pricing”. The Chubb CEO Evan Greenberg said that “pricing continued to tighten in the quarter while spreading to more classes and segments of business, particularly in the U.S. and London wholesale market”.

A look at the historical breakdown of combined ratios in the Aon Benfield Aggregate portfolio from April (here) and Lloyds results below illustrate the downward trend in reserve releases in the market to the end of 2018. The exhibits also indicate the expense disadvantage that Lloyds continues to operate under (and the reason behind the recently announced modernisation drive).

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In the Willis Re mid-year report called “A Discerning Market” their CEO James Kent said “there are signs that the longstanding concern over the level of reserve redundancy in past year reserves is coming to fruition” and that in “some classes, there is a clear trend of worsening loss ratios in recent underwriting years due to a prolonged soft market and an increase in loss severity.

 In their H1 presentation, Hiscox had an exhibit that quantified some of the loss creep from recent losses, as below.

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The US Florida hurricane losses have been impacted by factors such as assignment of benefits (AOB) in litigated water claims and subsequently inflating repair costs. Typhoon Jebi losses have been impacted by overlapping losses and demand surge from Typhoon Trami, the Osaka earthquake and demand from Olympics construction. Arch CEO Marc Grandisson believes that the market missed the business interruption and contingent BI exposures in Jebi estimates.

The fact that catastrophic losses are unpredictable, even after the event, is no surprise to students of insurance history (this post on the history of Lloyds is a testament to unpredictability). Technology and advances in modelling techniques have unquestionably improved risk management in insurance in recent years. Notwithstanding these advances, uncertainty and the unknown should always be considered when model outputs such as probability of loss and expected loss are taken as a given in determining risk premium.

To get more insight into reserve trends, it’s worth taking a closer look at two firms that have historically shown healthy reserve releases – Partner Re and Beazley. From 2011 to 2016, Partner Re’s non-life business had an average reserve release of $675 million per year which fell to $450 million in 2017, and to $250 million in 2018. For H1 2019, that figure was $15 million of reserve strengthening. The exhibit below shows the trend with 2019 results estimated based upon being able to achieve reserve releases of $100 million for the year and assuming no major catastrophic claims in 2019. Despite the reduction in reserve releases, the firm has grown its non-life business by double digits in H1 2019 and claims it is “well-positioned to benefit from this improved margin environment”.

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Beazley is one of the best insurers operating from London with a long history of mixing innovation with a balanced portfolio. It has doubled its net tangible assets (NTA) per share over the past 10 years and trades today at a 2.7 multiple to NTA. Beazley is also predicting double digit growth due to an improving rating environment whilst predicting “the scale of the losses that we, in common with the broader market, have incurred over the past two years means that below average reserve releases will continue this year”.

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And that’s the rub. Although reserves are dwindling, rate improvements should help specialty (re)insurers to rebuild reserves and improve profitability back above its cost of capital, assuming normal catastrophe loss levels. However, market valuations, as reflected by the Aon Benfield price to book exhibit below, look like they have all that baked in already.

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And that’s a creepy thing.

Happy Returns

A recently published paper, called “The Rate of Return on Everything, 1870–2015”, looks extremely interesting. The authors – Òscar Jordà, Katharina Knoll, Dmitry Kuvshinov, Moritz Schularick, and Alan M. Taylor – have collected a unique dataset of total returns for equity, housing, bonds, and treasury bills covering 16 advanced economies from 1870 to 2015.

The paper calculates real returns across asset classes on a global GDP weighted basis, as per this graph.

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The paper contains some fascinating conclusions, such as housing and equities having similar returns but with housing being considerably less volatile, as per this graph.

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Another fascinating graph is on the risk premium between risky and safe assets, as below.

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Given the time of year, I haven’t had an opportunity to consider the paper in detail but will hopefully get a chance over the Christmas break (and now back to wrapping presents!!).

A very happy Christmas to all who spend any time here. Have a great time and I hope Santa is kind!

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!