Counter-culture defies old beliefs

21-09-2015

The reinsurance industry is currently going through an extraordinary series of counterintuitive developments that defy historic perspectives, says Bermuda:Re+ILS panellist Donald Kramer, chairman and chief executive officer of ILS Capital.

Primary companies are purchasing less reinsurance despite the fact that prices have declined significantly and we are currently in a ‘soft’ market.

Generally you would think that purchasing reinsurance represented inelastic demand in that primary companies need to purchase reinsurance In order to mitigate risk. When prices decline in a soft market you would expect primary companies to increase their purchases of lower cost reinsurance. Instead the exact opposite is occurring. The reason for this counterintuitive development is historically low interest rates. To offset the decline in their investment income primary companies are taking on greater risk rather than shedding risk in an attractive soft market.

Consolidation in the industry has led to the creation of several giant reinsurance companies but this has created amazing opportunities for smaller companies.

Historically, purchasers of reinsurance like to spread their reinsurance agreements over several counterparties so that the decision of one company or another to leave the market would not hurt them. Lloyd’s has always been composed of numerous smaller individual syndicates, each of whom took a piece of a risk thereby spreading the counterparty exposure. Today Lloyd’s is represented by several larger members as well as numerous smaller ones. 

For example, one of its members, following a merger, now accounts for 9 percent of the entire market. This wave of consolidations has led to greater opportunities for smaller non-Lloyd’s companies to take pieces of the reinsurance business, thereby spreading the counterparty risk—certainly a ‘counterintuitive’ development. Normally you would think that more business would go to the larger companies

"Publicly traded hedge fund reinsurer shares wound up at the bottom of the pack of publicly traded reinsurers, while numerous conventional companies hit new highs."

Publicly traded reinsurance shares are outperforming the broad equity market despite low interest rates and declining premium levels.

Reinsurance companies earn income from two sources: invested assets and profits from risk assumption. Both of these sectors are currently at rates somewhat below previous levels. Interest rates are at their lowest levels since 1947, while reinsurance premium rates are also at relatively low levels (the soft market). 

Now let’s look at some facts. Since year-end 2013 the S&P 500 stock index rose 13.8 percent, while the S&P Reinsurance Subindustry index rose 21.1 percent. From year-end 2014 to date (August 2015) the S&P 500 index rose 2.2 percent while the S&P Reinsurance index rose 9.3 percent. I think you would have to list this performance as very favourable but again, counterintuitive.

Hedge fund reinsurers (as well as many hedge fund managed investment portfolios) have significantly underperformed the equity market.

The concept of the hedge fund reinsurer was to write low risk reinsurance, generate additional investment assets beyond surplus and manage those assets for a premium return, thereby generating double digit returns on equity. The next step was to go public, with the shares priced at a high premium to book value. Great idea, but as of July 31, 2015 the publicly traded hedge fund reinsurer shares wound up at the bottom of the pack of publicly traded reinsurers, while numerous conventional companies hit new highs through mergers and other forms of consolidation.

Since year-end 2013 two publicly traded hedge fund reinsurers declined 20.9 percent and 22.9 percent respectively, while as mentioned above the S&P Reinsurance Subindustry index rose 21.1 percent. Counterintuitive indeed. 

Donald Kramer, ILS Capital, Bermuda

Bermuda Re