Richard Lightowler reviews the difficult state of the Bermuda market.
These are the best of times and the worst of times for large Bermuda re/insurance companies. They face a range of challenges, some stemming from past success—excess capital being the most obvious—and others from a lethargic economic climate and regulatory changes in the wake of a global financial crisis that, for the most part, did not bite the Bermuda companies too deeply.
No one is as well-positioned to see the overall picture as the large accounting firms, and so Bermuda Re/insurance turned to KPMG, which has one of the leading Bermuda re/insurance practices, for an analysis of the state of the Bermuda market as the companies approach 2011.
Bermuda Re: What challenges does the Bermuda market face?
Lightowler: Right now, the market is relatively stagnant. Looking at the market to the end of 2011, rates remain flat or in decline, and pricing discipline will be severely tested. Opportunities for growth in the US are very limited and with some Bermuda groups with newer US platforms already retrenching. Investment markets remain challenging, with threats of double-dip recession in certain countries, inflation and foreign currency volatility. Opportunities for growth are limited.
BR: The first half of 2010 saw record insured losses. Why hasn’t that translated into a harder market?
Lightowler: Two main reasons. Firstly there’s a general belief that the reinsurance market as a whole is overcapitalised, as is evidenced by the amount of share buy-backs, special dividends and reductions in Lloyd’s capacity. Secondly, whilst there has been an accumulation of some fairly sizeable losses, there hasn’t been a market-shifting loss. Even if such an event occurred, it’s difficult to see that having a significantly positive effect on rates. I think, under those circumstances, we’d see an inflow of short-term capital, as we have before, dampening rate increases.
BR: There have been some departures from Bermuda, including one announced last week [the beginning of October]. What’s driving that?
Lightowler: Firstly, let me clarify that these are moves of head office rather than operating platforms. Key drivers of head office domicile are typically tax, regulation and legal infrastructure, but there are others—sometimes quite bespoke to a particular organisation. There is significant change, and therefore uncertainty, in both tax and regulation across the globe as governments and regulators attempt to deal with the fallout of the credit crisis through fiscal policy and regulatory change. We have seen two redomestications from Cayman to Switzerland and Ireland, and two from Bermuda to Luxembourg and Switzerland. I would suggest that most of these were designed to manage uncertainty and risk; however, the fact that there hasn’t been a consistent response in choice of domicile demonstrates that there is no right answer.
The redomestication debate has been happening in earnest for a number of years. All of the larger companies in the Bermuda market have looked at domicile, and continue to do so. The vast majority have concluded that remaining in Bermuda is the better position currently. Bermuda remains a very active and globally significant marketplace.
We are in a constantly shifting dynamic, but there is no sea change right now. The BMA is moving forward with its Solvency II equivalence programme, relationships between government and business continue to strengthen, and the tax threats are being actively managed. US Attorney General Eric Holder was just in Bermuda; he stated that he does not consider Bermuda to be a tax haven. We’ve not heard that from a US government official before.
BR: Is the Bermuda companies’ underwriting discipline as strong as it should be, given current market conditions?
Lightowler: We’ve seen fairly active capital buy-back programmes, so there hasn’t been an ambition to over-write. Companies are pulling back from individual deals and wider programmes, and very much attempting to maintain pricing discipline. The strongest companies are those that, in a soft market, are prepared to sit on their hands when that’s called for, rather than pushing into new markets or chasing premiums.
More companies are using this opportunity to focus on infrastructure. When companies were enjoying a growth period, the focus on infrastructure wasn’t as strong. Plus, regulation is becoming more demanding and some fairly sweeping accounting changes are on the horizon, which are causing all sorts of headaches. The key to dealing with these will be better infrastructure systems and data. It’s a time for some of the newer companies to mature.
BR: Do the Bermuda companies take the position that more regulation enhances their credibility?
Lightowler: I’d turn that around and say that less regulation is seen as detrimental to their reputation. Appropriate regulation is important and is embraced. Overregulation and invasive behaviour by regulators is not business-friendly. The insurance industry as a whole has been at pains to articulate to regulatory bodies around the globe that the insurance industry (particularly the P&C sector) does not present systemic risk and should not be wrapped up in the consequences of the banking crisis.
BR: Will Bermuda achieve Solvency II equivalence?
Lightowler: We’re in a good position to obtain reinsurance equivalence. The development of the long-term business regime is key, as is group supervision. The Bermuda Monetary Authority (BMA) is very focused on the development of its group supervisory regime, which is a very complex area. Group supervision, for regulators around the globe, presents some very real challenges. I think we’ll have to see some pragmatism and better communication between regulators, regardless of equivalence, or it won’t work. There are also the political aspects to consider, as ultimately, the granting of equivalence is by the EU Commission—for that reason, Bermuda is actively lobbying in Europe.
"The vast majority [of larger companies] have concluded that remaining in Bermuda is the better position currently. Bermuda remains a very active and globally significant marketplace."
We’re only a little over two years away from the advent of Solvency II and regulators are starting to face up to what it means for them. As well as placing huge demands on companies, it is placing significant demands on regulators. An advantage for Bermuda is that the BMA has strong interfaces with other regulators, particularly with the UK, US and Switzerland, and to a lesser extent with Germany and Australia, which represent five key jurisdictions for the Bermuda market and the groups within it. I think, ultimately, we’ll achieve a good regulatory model, as long as there’s good communication between the BMA and the market, and between the BMA and other regulators.
BR: KPMG must have been through a similar process of achieving equivalence among its component firms around the world.
Lightowler: Yes, but the difference is that we have the same set of procedures and rules as to how we behave and provide services across the globe. Regulators have to contend with different bases of legislations and, unfortunately, in many regulatory environments, there is a political angle as well.
BR: In the captive area, is Solvency II going to be as easily achievable?
Lightowler: Solvency II in the captive sector is a real challenge, as can be seen by the amount of lobbying in Europe by European captive domiciles and captive organisations. Captives are largely self-insurance vehicles that don’t typically write a large amount of third-party business— if they do, it’s on a reinsurance basis—and therefore neither present systemic risk or trigger individual policyholder protection requirements. Bermuda has been a leading captive domicile for decades, with no major failures—we should not lose sight of that. I expect there’ll be some change in captive regulation, but from a policyholder protection perspective. I don’t think there needs to be a dramatic change.
Some other captive domiciles have stated that they won’t follow a Solvency II model. Bermuda is the only major captive domicile to also have an important commercial reinsurance market, which presents a challenge—one sector seeking equivalence, the other arguably not needing it. It is a challenge that is very much understood. Let’s see where Europe gets with Solvency II and captives first.
BR: What has Solvency II meant for KPMG?
Lightowler: It is keeping our insurance group very busy across all disciplines—audit, actuarial, IT, risk advisory and tax. I said earlier that as part of their maturation, companies either are, or should be, focusing on development of infrastructure. Solvency II is providing the catalyst for a lot of this.
Solvency II is a massive topic with continuous development of guidance, making it a challenge to manage. The fundamental, however, is that if you are a smart organisation that really understands risk, and has the data, systems and governance to demonstrate it, you are well on your way to compliance. Implementation therefore can still make business sense. Having said that, the details are complex and in some cases, not yet complete.
We are helping clients in all areas of implementation, including education, capital modelling (build and validation), development of technical assumptions, risk and governance frameworks, group restructuring, group risk frameworks and interaction with regulators. The value that we really bring is translating the detailed rules into pragmatic solutions that actually make business sense. Enterprise risk management, three words that few people have really understood, and which has been over-consulted, is now becoming clearer, with some practical requirements appearing under Solvency II. We help drive ERM frameworks, validating the data and helping to build the models. Many of the models in place were underwriting models; Solvency II requires a much more holistic view.
We’ve hired resources locally in this regard—process specialists, regulatory specialists. We have a complete risk analytics team, including modelling skill.
BR: The proposed International Financial Reporting Standards seem almost incomprehensible. Will they stick, and if so, will they help or hinder?
Lightowler: After a 15- or 16-year journey, from academia to practicality and back, we’ve still ended up with a complicated proposition, which is not as convergent with US GAAP as everyone had hoped.
There is a widely held recognition that the life insurance accounting model was broken. There is also a general view that, by and large, the property/casualty model is not broken. Unfortunately, in seeking a unified approach under IFRS, the proposed model for the property/ casualty segment has been overcomplicated. The purpose of financial reporting is to provide transparency of financial performance in a manner that enables comparison between companies. I think the proposed model leaves us some distance from that primary objective.
A central concept under IFRS is that fair value is the best measure of financial performance. The biggest departure from this concept currently is that loss reserves do not reflect the time value of money— they are undiscounted. My personal opinion is that if we get some consistency of approach to discounting, we would have a sensible model. We have general agreement in the marketplace on discounting;where there is a disconnect—and opposition, and confusion—is in the proposed approach of fair value accounting, which completely changes the presentation of insurance company financial statements.
This is one of the accounting standards that should receive attention from not just chief financial officers, but also chief executive officers, because the potential impact is to completely change the way the results of the company are reported. It will likely mean significant education for the investor and analyst communities.
I do believe that fair value is the right model, and it will enable companies to become more streamlined in terms of their financial reporting and risk functions. It’s also how the regulators should regulate—using consistent sets of numbers—and investors can trade off numbers that make more economic sense. Fundamentally, to make sense, it needs to be transparent and consistent.
We are currently spending a lot of time with clients helping them digest the guidance and deal with the practical consequences. We’re also encouraging clients to provide feedback to the standard letters on the practical issues arising. This is a proposal that does not just affect finance—it impacts the actuarial process, pricing, systems and data. Dealing with this in conjunction with Solvency II and avoiding multiple reporting models is a challenge for companies.
BR: Will those depressed share prices lead to further consolidation in the Bermuda market?
Lightowler: I think the answer is yes and no. Yes, because they make targets attractive. And no, because buyers’ currency is devalued. Solvency II will also have an effect. Not in the Bermuda market, but perhaps in Europe, where we will see some small Syndicates being swallowed up, and perhaps some smaller companies unable to deal with the rigour of Solvency II, or not having the necessary capital.
BR: When the turn comes, will there be an alternative to Bermuda? In terms of speed to market, the Island has no competition.
Lightowler: Speed to market remains the Holy Grail for Bermuda, not just in terms of new entrants, but for existing companies too. The ability to start a new line of business, to make an acquisition—the regulatory process in other jurisdictions is very burdensome.
BR: Would a significant loss, on the scale of a Katrina or 9/11, result in a Class of 2010 or 2011?
Lightowler: I personally don’t see it. I think you’ll see short-term capital again; the equivalent of sidecars, when the need arises the next time—bolt-on capital. The availability of human capital of quality is a barrier to new starts in the industry. The returns generated, and the fact that a number of the 2005 private equity investors have yet to exit those relationships, conspire against a de novo group of companies.
BR: Final thoughts?
Lightowler: From a markets perspective, the industry is somewhat in the doldrums and 2011 looks set to be a challenging year. Internally, there is much change as we have discussed—infrastructure, regulation and new accounting standards will drive significant change. Those that invest now will be best prepared to benefit in the future.
Richard Lightowler is a partner and head of insurance at KPMG Bermuda. He can be contacted at firstname.lastname@example.org
Bermuda, KPMG, challenges, accounting, domicile