Change is a fact of life and this is no different in the world of (re) insurance which, although seeing new opportunities, is also being presented with fresh challenges. Managing the underwriting cycle, with its oscillations in pricing driven by the ebb and flow of capital, is a prerequisite skill for seasoned practitioners. Responsibility for the latest change in pricing, as evidenced by the downward shift in the June 1 renewals, has been laid firmly at the door of the convergence market which has brought a rising tide of new capital flooding into the reinsurance space.
As the industry adjusts, questions have been raised as to whether the cycle has entered a new phase or whether it signifies a more fundamental, longer-term development. Could this new capital structure represent a paradigm shift in the property catastrophe market where “the pump don’t work ‘cause the vandals took the handles”, as Bob Dylan presciently observed in 1965?1
Typically, the property catastrophe reinsurance industry has “pumped” out average returns in the region of 15% over the last decade and significantly more in the period post Hurricane Andrew (1992). There has been considerable volatility in returns over the years but investors have been willing to accept the risk/reward trade-off with low cat years such as 2006, 2007 and 2009 offsetting high cat losses that were a feature in 2005, 2008 and 2011. It is this property catastrophe “pump” that is now the subject of much debate.
Losses in 2011 were remarkable for their geographic spread, incidence of peril and size, with insured losses totalling a staggering US$108bn – a number second only to the US$123bn record set in 2005. As the industry was able to absorb these losses relatively easily, these events were described in terms of income rather than balance sheet impact and, large though the sums were, these were not enough to alter pricing significantly other than on loss affected accounts. The traditional pricing levers of shock losses and the long-expected significant reserve deficits have failed to materialise. Instead industry commentators and participants have focused on the prolonged period of low investment returns to exert pressure on pricing rather than the more typical headline grabbing catalysts. Yet despite calls to move up a gear, there had been little meaningful response to date.
Paradoxically, it is the same low investment return environment that has also attracted the new capital to the industry. With interest rates still near historic lows, the search for attractive asset classes has broadened and gained in intensity. Alternative capital in the form of indexed linked securities (ILS) is not a new phenomenon. Since the pioneering days in the mid-1990s, post Hurricane Andrew and the Northridge earthquake, the market grew steadily and reached high peaks (2007 catastrophe bond new issues US$7.0bn) post the record 2005 loss year with Hurricanes Katrina, Rita and Wilma.2
The liquidity crisis of 2008 dampened activity as issuance fell by over 60% from the 2007 peak.3 The credit crisis, however served to underline the attractiveness of uncorrelated risk and issuance in 2012 increased by almost fourfold since this low. The first wave of alternative capital providers were characterised as an elite type of investor – super-sophisticated, fleet of foot and opportunistic – looking to benefit from the supernormal returns that the industry could intermittently offer.
The latest wave perhaps serves to underline the maturity of the market, in that reinsurance risks have generally become more intelligible and convertible into capital markets instruments. The new wave of alternative capital is characterised by a different type of investor – namely the pension funds, life insurance and mutual funds looking to invest in catastrophe risk. But could these well-informed, sophisticated long-term investors also be regarded as vandals?
In my view, the market is the most disciplined it has ever been – possibly a counter intuitive statement given the headlines reporting a 10%-20% fall in US peak zone rates. But I think this discipline reflects not only better risk management and more sophisticated widespread use of models but also the different heritage of the capital now backing the market. Cat bond market expectations are delineated by (lower) bond market returns. Investors are not only willing to extend the breadth of assets in their portfolios but, in this more uncertain world, willing to pay a price for uncorrelated risk. In contrast, the traditional market is driven by the need to deliver returns to the equity investor and is in the business of managing aggregation of risk. The crux lies in concentration of risk. Florida (and indeed the US) is a peak zone in the context of the traditional reinsurance market but it is not in the context of the broader investment market – the total global cat risk market is estimated to equate, in terms of size, to approximately 1% of global pension fund assets. In addition, uncorrelated returns drive improved portfolio risk adjusted returns. The recent Florida renewals suggest that this difference has been recognised and the traditional market was willing to let go of business that did not meet its return criteria.
So far, so good. But while the traditional market has held the line and been prepared to concede some territory in the upper layers, will this situation continue? Where do the pain thresholds lie? The reality is that investors in ILS may lose their entire investment and this may prove tough to bear; it is not in the normal experience of the investor. Dividend or yield may be suspended temporarily and while asset prices can fall, they rarely reach zero. Florida has been loss free for seven years but the (recent) past, as we all know, is no guide to the future. Yet a consensus view seems to be emerging that this new capital is here for the long-term and is not simply an opportunistic interest rate play. While investors may experience some temporary disruptions, the opportunity to achieve portfolio enhancement, through targeted investment in catastrophe reinsurance, is a compelling argument.
Entrance and exit
Could this new reasoned and rational capital, allied to the disciplined traditional industry, signal the end of the cycle – or at least the end of a vicious cycle – and the advent of a more mature industry? As previously mentioned, the pricing cycle has been dependent on outsized events resulting in significant value destruction that leads to capital making an entrance and exit on a regular basis. The last decade, which saw record cat losses in 2005 and 2011, has shown that the industry is much better able to quantify and manage risk.
The ILS market has participated in this with the growing sophistication of products and the increasing acceptance of indemnity cover. The sidecar structure has also played an important role in the rise of alternative capital. This has broadened the opportunity for capital to enter the market beyond the traditional quota share structure. The use of sidecar vehicles, which can be ramped up and discontinued with relative ease, has limited the scope for the traditional hard market.
The ease of entry into the property catastrophe market has reduced the period of pricing opportunity in both timing and extent.
Models may also play an important role in the eventual outturn. To an increasingly model-dependent world, they do at least provide a logical framework and a transparency to the prevailing pricing rationale. It goes without saying that the models can only be as good as their assumptions and while significant progress has been made on the flexibility and architecture, the quality of data and interpretation of that data is paramount. If models are able to continue to prevent cataclysmic shocks for this alternative capital, then it looks as if that capital will have become a stickier commodity.
This might be the beginning of an industry with much more dependable, even dull returns. Adrenalin junkies who rode the shifting supply curve may have to be satisfied with a more esoteric asset class as an alternative.
Increasing maturity is not just about supply, but also impacts the demand side of the equation. Insurance companies have made significant strides in the area of data modelling and risk management and acute understanding of complex risk is no longer the preserve of reinsurance companies who historically were able to cherry pick the best business. Insurers are retaining more risk and employing better techniques for exporting the risk they do not want.
Playing to strengths
Reinsurers, however, have shown they are adept at dealing with change whatever its guise. A winning strategy is still required which will depend on superior underwriting skills with an efficient operational infrastructure and capital structure to support it. It is not just the pricing environment that shifts. Society is always changing, legal systems evolve and economies develop. This continually throws up new risks, threats and opportunities which the successful reinsurer can identify and capitalise on. Experienced management that has a track record in the market can leverage this expertise with both the new entrants and new markets.
Opportunities depend not simply on offering capacity, but intelligence and innovation. The new entrants may in fact encourage a trend that I have suggested previously. The dynamics of the marketplace need to accelerate away from short-term reactionary responses to a more sustainable approach. More fluid and flexible capital will help.
The business of insurance and reinsurance (i.e. risk transfer) is essential to economic activity. The world is forecast to become one of urban dwellers with a large proportion of the population living close to natural hazard regions. That suggests a need for insurance capacity on a scale not previously imagined, particularly given the current backdrop of sustained economic austerity. If one takes GDP as a proxy for property value at risk it suggests potential for increased insurance penetration.
The new entrants can play an important role in meeting these global capacity requirements. While (US) peak zones may increasingly become the domain of alternative capital, traditional insurers can leverage their underwriting franchise, increase their operational flexibility in the capital markets and provide investors with direct access to underwriting expertise. Geographic reach is also important and reinsurers also need to be prepared to make an investment in serving global clients. The formation of Aspen Capital Markets and the regional approach adopted by Aspen Re should allow Aspen to take advantage of these developments as well as secure a high returns “pump”.
1. Bob Dylan, Subterranean Homesick Blues, 1965.
2. Guy Carpenter, Catastrophe Bond Update: First Quarter 2013, May 2013.