ILS comes of age: BDA roundtable part two

Participants:

1. Brad Adderley, partner, Appleby

2. David Brown, senior partner, EY Bermuda

3. Kathleen Faries, chair, ILS Bermuda

4. Sean Kelly, partner, PwC

5. Daniel Malloy, chief executive officer, Third Point Re

6. Andre Perez, chief executive officer, Horseshoe Group

7. Nicolas Plianthos, senior vice president, Marsh

8. Adria Richards, head of property catastrophe–global clients, RenaissanceRe

9. Anup Seth, global leader, underwriting solutions, Aon

10. Ariane West, director of structured finance, Nephila Climate

11. Gavin Woods, partner, Carey Olsen

12. Wyn Jenkins, managing editor, Bermuda:Re+ILS (moderator)

Part Two

What’s your take on the hard market? Are you prepared to give any predictions on rate increases, or how long it may last?

Richards: Pricing in the P&C markets was already facing upward pressure due to capacity constraints and increased demand—even before the emergence of COVID-19. This dynamic was caused by several factors.

In the property markets, we’ve experienced heightened cat activity causing large losses and trapped capital. On the casualty side, we’ve experienced significant loss inflation.

The resulting impact on price has only been accelerated by the uncertainty of COVID-19 and this should further drive the demand for reinsurance at a time when retro capacity is also constrained.

So you’ve got this combination of factors that’s driving significant rate increases, and we think that this should create opportunities for us for some time.

Malloy: We’ve been playing defence for eight-and-a-half years and I’m naturally an offensive person, so the idea of being able to lean into a market and find opportunities that have profit associated with it is exciting.

Prices are up 40 or 50 off a starting point that is probably 50 percent less than where it was five years earlier, so you can say prices are up, but is it enough? I was very impressed with whoever at Munich called a hard market, I respect that.

I was talking to a broker who said ‘my definition of a hard market is when I can’t get deals done’. And he added it’s not a hard market, yet. Depending on what Mother Nature throws our way over the next 90 days, we could have a very hard market or we might just have a hard market.

Investment income in 2020 is a very different situation from buying a bunch of bonds and having them yield 5 percent. Ninety-day Treasury bills on March 1 were yielding 2 percent and they’re yielding nothing now.

We had $300 million to $400 million in 90-day T bills that were the safest investments in the world—that is returns the shareholders aren’t going to be getting going forward, that we have to find elsewhere.

You’re either going to take more risk on the investment side or you’re going to continue to work on the underwriting side to increase your profitability, so we need that market on the back of the reversion to the mean that’s occurring on the property cat side, the unwinding of 10 years of laziness and sloppiness on the commercial insurance side, and COVID-19. That additional rate is needed for our business.

West: Noting that I’m on the climate side of things, and so am more of an observer, I would say that one of the things the hard market is evidence of is appropriate discipline in underwriting and that managers are being good stewards of capital.

That’s certainly something that we think a lot about: doing the work to support a view of pricing, as well as being proactive about creating alternative channels for capital with attractive expected returns.

In terms of investor sentiment, there’s still a good appetite for allocation to non-correlated risks that are well priced on a risk-adjusted basis and continued interest in diversified risks.

From our point of view, there is a lot of opportunity out there and it’s just a matter of continuing with that disciplined approach as well as looking for other ways to deploy capital, to allow for that balance to occur in the market.

Faries: I’m trying to be optimistic but I’m sceptical. We’ve seen there has been quite a bit of capital coming in. Reinsurers are still in a very challenging environment, and you then layer on a changing climate. Secondary perils are not so secondary any more, we’ve got a cyber environment that is dynamic and evolving.

It’s great that rates are moving in a better direction for the health of the reinsurance industry, but we still have a way to go to get a return on equity that is sustainable. A lot of it will depend on how much capital flows in and whether the industry can maintain underwriting discipline in what will be a long-term low interest rate environment.

Seth: Prior to COVID, coming into 1/1 2020 we were experiencing a W hard market. There were significant rate increases on commercial insurance business including E&S business and specialty lines like D&O.

We also saw significant increases on the retro side, but the reinsurance market was caught in the middle and was firming but certainly not hardening as much as the other markets—hence that W shape.

Then COVID-19 hit. The primary carriers do have significant exposure to COVID claims and given the uncertainty around the magnitude of this exposure this has led to a much harder reinsurance market as well in June and July.

Looking ahead to 1/1, that W impact will probably flatten out and we’ll see a significant hardening of the reinsurance rates as well. Looking at underwriting performance over the last three to five years, if you look at Lloyd’s as the bellwether of our industry, the last three years have been at an underwriting loss.

We need significant rate increases to bring the entire market back into underwriting profitability rather than just relying on the investment income to get us through. We need to have that risk-adjusted return now that interest rates are so low, looking at it as a relative measure, a ROE anywhere between 8 percent and 12 percent is a decent return, but we need to have a sustainable model at those sort of levels.

Plianthos: When you have a company that was buying $4 billion of limit for property coverage, it can now only get $2 billion and it has to pay more for that $2 billion, people will definitely be arguing that it’s a hard market.

As a result of that, a lot of our clients are writing new lines of business in their captives and that’s keeping us very busy. If you looked at the BMA registration and statistics, that’s only talking about new companies. I’m pretty certain if you had to ask the BMA to divulge all the applications they get in for new lines of business coming through their captives, you would see a significant increase because of the hardening market.

What are your expectations for the response of ILS to all these market conditions?

Perez: I will start with the negative because I like to end on a positive note. We’ve had a number of years of heavy losses, we had the California wildfires which brought a bit more uncertainty in terms of non-modelled risks being assumed. Now you have COVID-19 and potential seepage within the property cat area—again it wasn’t modelled and probably wasn’t even priced, and it makes investors worried. There’s always uncertainty.

I know a lot of investors will ask ‘what are you doing about climate change in terms of the modelling?’. All of those factors combined, which led to trapped collateral, losses coming from different areas, have made some investors nervous about this sector.

The positive side of it is that investors who are well informed understand the opportunity that ILS brings to this market, and already in January we had some pretty significant rate increases. Certainly, we’re seeing more rate increases in June and July and as that trend continues, there are always going to be opportunistic investors.

Despite all of the negatives, ILS is still very important market. The cat bond sector has probably had a banner year this year and will probably have a banner year next year as well.

It’s too big to ignore and I’m encouraged about the fact that we’re getting existing ILS funds, raising additional capital, we’re seeing new ILS platforms being formed.

The future is still bright. From Horseshoe’s perspective, we are the busiest we’ve been since Horseshoe was born. That gives you a sense of the market activity.

Adderley: I’m with Andre on this. Normally, you’re busy after Monte Carlo but it’s been crazy through COVID-19. I thought after we all went into lockdown it would be quiet, but I’ve seen none of that. The amount of business that’s come in the summer for cat bonds coming early is huge.

This is along with the startups we had pre COVID which haven’t hit the press yet, and then you add into that all the management teams and people we’re talking to now about raising capital.

Looking at the year round, I will be interested to see how many new classes there are for reinsurers, new ILS funds, who’s raised capital. Even life reinsurers, there’s some unique things going on right now in this space, which people will look at and go wow.

There’s a lot going on and it’s going to be absolutely crazy.

Seth: If you look at the different solutions that the ILS industry is offering, on the cat bond side we’ve certainly seen an increase in demand and given the increased liquidity that investors like, that side of the business is doing really well.

At the other end of the spectrum, some of the larger ILS funds are transitioning from special purpose insurers to commercial reinsurance companies, for example a class 3a licence.

This enables them to obtain a financial strength rating and compete with the traditional reinsurance companies and benefit from capital leverage.

The other piece to mention is traditional carriers have accelerated their third party capital strategies to leverage their underwriting and distribution infrastructure and earn additional fee income.

We’re seeing a lot more enquiries about how to facilitate a third party capital strategy.

West: A key element and advantage of ILS is the ability to be very nimble in terms of how the capital is deployed. You have enhanced flexibility to seek out the best value, and to look at new risks and new strategies and have quite a broad playing field and vision in terms of which way you’re going to focus at any given time, given where rates are and how we’re viewing the risk in any market for a given season.

With respect to challenges such as climate change, that is something we devote significant resources to in terms of our analysis and looking at evolving climate trends.

This has been thrown into sharper focus for society at large, particularly in terms of the past five to 10 years, but it’s something our industry has always been highly attuned to. It’s fundamental to our view of risk.

Managing that effectively is key to ensuring that we’re getting the right returns for our investors and seeing the full board when we make underwriting decisions.

Richards: There have indeed been a few consecutive years of trapped and lost capital and then you’ve got COVID-19 and the uncertainty that this brings from a potential exposure perspective. I agree that there are some headwinds for the ILS market that could persist into 2021.

We’re always going to use ILS capital and, despite some of the dislocations in the market, we successfully raised third party capital in support of the recent mid-year renewals.

However, the events of the last few years have forced ILS managers to truly understand the risk they’re taking and partner with companies who have a track record of performance and execution: a flight to quality.

Brown: In terms of ILS: we’ve seen a bit of a slowdown over the last couple of years just with some trapped capital, etc, but we’re continuing to be very bullish on the ILS sector generally going forward.

It’s encouraging to see some recent potential new launches, so longer term you’re going to see some successful standalone ILS players, but you’re also going to see the use of third party capital with the teaming with traditional reinsurers or as part of their organisations and leveraging their underwriting.

Bermuda has such a strong reputation on the asset management side and that’s a key ingredient to the success of ILS as a leader so we just need to continue to leverage that and hopefully with some of the economic substance and those types of things, the ILS industry can stimulate the additional growth on the more traditional fund space.

Perhaps the ILS industry can also play a role in addressing some of these pandemic-type risks going forward.

Are we likely to see more M&A activity?

Woods: The expectation is that there will continue to be a lot of M&A activity—there is already a lot going on, keeping in mind that there’s a finite number of companies left with which to consolidate. What’s driving that is opportunity—in part, companies taking advantage of the existing financial conditions.

Kelly: When we’re having conversations with some of the PE houses that are looking to potentially enter the market in 2021, the question they are asking themselves is whether to start up as a brand new shell or look to acquire something, either a piece of an existing organisation, or an actual company itself to get you straight into the market, if you buy the right business.

When we think about what’s likely to drive M&A in the immediate term, it is that ability to quickly access the market that attracts incoming capital to some of these existing companies.

Brown: We’ve seen a number of transactions, some have been fairly large. A number of the others are more niche or strategic acquisitions so we’re going to continue to see that, we’re seeing a good pipeline of deals in our practice currently so that’s encouraging.

It’s going to be interesting to see whether the hardening rate environment slows some of the activity on the property casualty side, that’s what you would probably expect, but it’s also the sector that’s seeing a lot of activity right now.

Some of these new startups are going to be driving some of the activity in that they quickly want to gain scale and take advantage of the hardening market. We talked a lot about the property casualty side of business, and we’re seeing a significant amount of activity on the life reinsurance area as well, which is exciting for Bermuda.

Perez: I agree in terms of the newcomers needing to buy companies because there’s no way they’re going to be able to take advantage of the general renewals.

The problem again is COVID-19 throwing a bit of a monkey wrench in the valuation side, so that has slowed down activity a bit. From what I see on the market the newbies, in order for them to gain scale are going to have to make some acquisitions.

Adderley: I agree that size is important to the amount of capital the insurance company has on startups, and that startups are buying platforms in other jurisdictions, but I wonder how much M&A activity will actually be in Bermuda.

First off, existing players have been so busy raising capital taking advantage of this new hard market, they might not be necessarily focusing on external growth—they’ll be doing internal growth. We’ve seen that with people specifically coming out saying ‘I’m raising capital to take advantage of this market’.

On the new startups that will come, will they be big enough players to lead the market? Probably not. I don’t know what the new startups will be, but I don’t think they’re going to be at the Convex size. But they themselves have been so busy trying to implement the structures and management teams and trying to get on to lines of business, they won’t have enough time or capacity to think about who else they could buy, and they’ll be the smaller players in the marketplace.

They could buy stuff externally, but internally, in Bermuda, I don’t know how much M&A we’ll see. We might see rights agreements instead: people taking over people’s books of business without buying the company, but taking the rights to that book of business. That might occur more.

I’d be curious to see if there’s a lull for a year and a half, because new startups will be crazy just trying to get systems in place, and everyone else will be trying to take advantage of the hard market.

Plus, in Bermuda, how many more entities are there that you can buy?

Seth: A few years ago, the motivation for M&A was the lack of organic growth opportunities so companies were buying other companies and it was more an expense or efficiency play because they couldn’t go out and underwrite and meet those profitability targets, so they bought other companies and drove the efficiencies that way.

Now, if you’ve got some spare capital, you can underwrite and generate good organic growth going forward. What is driving the M&A now is more PE firms searching for yield. With interest rates being so low, they’re looking around saying ‘what is the best risk-adjusted return?’.

The acquirers are different, and the motivation is different as well.