Tag Archives: Tokio Millennium Re

Low risk premia and leverage

The buzz from the annual insurance speed dating festival in Monte Carlo last week seems to have been subdued. Amid all the gossip about the M&A bubble, insurers and reinsurers tried to talk up a slowing of the rate of price decreases. Matt Weber of Swiss Re said “We’ve seen a slowing down of price decreases, although prices are not yet stable. We believe the trend will continue and we’ll see a stabilisation very soon”. However, analysts are not so sure. Moody’s stated that “despite strong signs that a more rational marketplace is emerging in terms of pricing, the expansion of alternative capital markets continues to threaten the traditional reinsurance business models”.  Fitch commented that “a number of fundamental factors that influence pricing remain negative” and that “some reinsurers view defending market share by writing business below the technical price floor as being an acceptable risk”. KBW comment that on-going pricing pressures will “eventually compressing underwriting margins below acceptable returns”.

It is no surprise then that much of the official comments from firms focused on new markets and innovation. Moody’s states that “innovation is a defence against ongoing disintermediation, which is likely to become more pronounced in areas in which reinsurers are not able to maintain proprietary expertise”. Munich Re cited developing new forms of reinsurance cover and partnering with hi-tech industries to create covers for emerging risks in high growth industries. Aon Benfield highlighted three areas of potential growth – products based upon advanced data and analytics (for example in wider indemnification for financial institutions or pharmaceuticals), emerging risks such as cyber, and covering risks currently covered by public pools (like flood or mortgage credit). Others think the whole business model will change fundamentally. Stephan Ruoff of Tokio Millennium Re said “the traditional insurance and reinsurance value chain is breaking up and transforming”. Robert DeRose of AM Best commented that reinsurers “will have a greater transformer capital markets operation”.

Back in April 2013, I posed the question of whether financial innovation always ends in reduced risk premia (here). The risk adjusted ROE today from a well spread portfolio of property catastrophe business is reportingly somewhere between 6% and 12% today (depending upon who you ask and on how they calculate risk adjusted capital). Although I’d be inclined to believe more in the lower range, the results are likely near or below the cost of capital for most reinsurers. That leads you to the magic of diversification and the over hyped “non-correlated” feature of certain insurance risks to other asset classes. There’s little point in reiterating my views on those arguments as per previous posts here, here and here.

In the last post cited above, I commented that “the use by insurers of their economic capital models for reinsurance/retrocession purchases is a trend that is only going to increase as we enter into the risk based solvency world under Solvency II”. Dennis Sugrue of S&P said “we take some comfort from the strength of European reinsurers’ capital modelling capabilities”, which can’t but enhance the reputation of regulatory approved models under Solvency II. Some ILS funds, such as Twelve Capital, have set up subordinated debt funds in anticipation of the demand for regulatory capital (and provide a good comparison of sub-debt and reinsurance here).

One interesting piece of news from Monte Carlo was the establishment of a fund by Guy Carpenter and a new firm founded by ex-PwC partners called Vario Partners. Vario states on their website they were “established to increase the options to insurers looking to optimise capital in a post-Solvency II environment” and are proposing private bonds with collateral structured as quota share type arrangements with loss trigger points at 1-in-100 or 1-in-200 probabilities. I am guessing that the objective of the capital relief focussed structures, which presumably will use Vario proprietary modelling capabilities, is to allow investors a return by offering insurers an ability to leverage capital. As their website saysthe highest RoE is one where the insurer’s shareholders’ equity is geared the most, and therefore [capital] at it’s thinnest”. The sponsors claim that the potential for these bonds could be six times that of the cat bond market. The prospects of allowing capital markets easy access to the large quota share market could add to the woes of the current reinsurance business model.

Low risk premia and leverage. Now that’s a good mix and, by all accounts, the future.

Follow-on (13th October 2015): Below are two graphs from the Q3 report from Lane Financial LLC which highlight the reduced risk premia prevalent in the ILS public cat bond market.

click to enlargeILS Pricing September 2015

click to enlargeILS Price Multiples September 2015

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.