EY talks with two leading figures from the Bermuda re/insurance sector about key developments affecting global players and the market.
EY talks with two leading figures from the Bermuda re/insurance sector about key developments affecting global players and the market.
Moderator: Pete Cangany, partner and Bermuda insurance leader, EY financial services
Panellists: Dave Hollander, EY global insurance advisory leader; William Pollett, president and CEO, Blue Capital Management Ltd; Matthew Wilken, president, Argo Re
Pete Cangany: Are we at the start of a continued softening market, being penalised by our own success, or is it just that the wind is not blowing?
Matthew Wilken: Yes, we are in a softening market that is hastened not only by a benign cat year but by an influx of capital and a continuing trend for systemic use of insurance underwriting tools. The models are also aligning and more than anything else the impact from the external economic environment is encouraging investors to look more closely at returns in re/insurance.
When I look at the returns made within the insurance industry, they are not always the most exciting when compared with other assets, but they are looking much more attractive than they used to. Whether that continues into 2014 and beyond is a function of many factors, but the insurance industry is in fact good at creating its own issues with regards to pricing.
We continually talk to all of our stakeholders, whether they are investors or customers, and everyone purports to want continuity, sustainability and lack of volatility, but we still nevertheless create for ourselves our own mini cycles again and again, which prove a challenge.
William Pollett: Clearly headlines have been focused on the cat space and with what is going on with alternative interest. There had been a hope that outside of cat there were some areas that were starting to bottom out and maybe could benefit from some firming. When you’re in an environment where interest rates are as low as they have been over the last couple of years you would hope that would be when people would get their act together in terms of underwriting discipline. However, our sense is that maybe that momentum is turning away again and maybe we are going into a softer market across the whole industry.
In the last number of years cat has been almost subsidising some of the other lines in terms of margins, but with cat margins coming in a bit it is putting more pressure across the board.
Cangany: Bill, did this pressure on the ability to generate underwriting income make it easier or more difficult as you launched Blue Capital?
Pollett: Clearly trying to raise money in the face of a market where pricing is coming off makes it a little more challenging.
We would explain to investors that we believe that the margins are still pretty attractive relative to other asset classes. From our perspective it is all about disclosure. You have to tell them what we expect the returns will be and what the downside risks are and they can then make their own decisions.
The interesting issue is going into a market that is softer. You get very smart underwriters and actuaries that always find a way through a model describing how the world has changed. They need to try to justify lower prices to the hierarchy in their organisations. You start to see terms and conditions slip a little and you have to be cautious and disciplined going to market.
Wilken: One of the pillars of underwriting is not just looking at the legal and contractual aspect of the slips and how they are constructed, because that can be a challenging and time-consuming role. You rarely discover an issue until it goes wrong and then when it does, there is a tendency for it to be a systemic risk. Business is transacted by the brokers in an increasingly standardised manner and as such there is a tendency to see terms stretched more and more. Meanwhile there is significant systemic risk regarding model usage because there has been a levelling of the playing field.
We have three basic main models that are used throughout industry and one of the concerns, particularly when I speak to many new capital providers, is that they are very well attuned to model usage and what they do and how they are delivered. However, the conversation generally revolves around expected losses (ELs) and how they compare relative to the risk and relative to the guy down the street.
Sometimes there is a risk of a belief that the EL actually reflects what happens in any one single period. They do not realise that there is huge volatility within the EL, so people should not base their entire underwriting remit on an EL ratio because there will be issues. It’s not like dealing with a bond issuance. They behave in a very different way.
Whenever we have losses there is always a level of understanding and relearning of what the models actually told us.
Pollett: We have actually developed our own proprietary model and our own view of risk. There is this belief in the industry that you can buy the newest model off the shelf, set up business and you are as good as the next person. That is wrong.
It is about data, not models—it is about model output and understanding what it means. Setting up shop and subscribing to a particular model, you are never going to be as good as the guys who have been in business for 20 years, but whether investors coming in understand that is another matter.
Cangany: You both mention the discipline that needs to go into the underwriting and Matthew talked about the terms and conditions and how they have changed. As you look at the January 1 renewal season, are we seeing rates holding and the terms and conditions loosening, or do we expect that rates will fall in 2014?
Wilken: Yes and no. Rates will fall, unless it happens to be on a loss-affected line. There will inevitably be pressure on the rates. The terms and conditions are definitely slipping from the early signs we are seeing. There are amendments to many clauses, whether they are hours or contract-related, there’s a continued erosion of those.
It is trying to measure the unmeasurable and the unquantifiable, but 20 years of re/insurance underwriting leads one to know exactly what is and is not acceptable. You need somebody on the ground who is experienced, but there is no model to reflect the underlying cost inherent in the changes in terms.
There is still discipline, don’t get me wrong—you start off with a standard reinsurance slip with well-constructed clauses that have been tried and tested over many years, so it’s not that it is the Wild West where people are trying to trip you up left, right and centre. But it is a concern that there is continued erosion.
Pollett: You are still seeing some discipline and you hope that holds. You put in place limits on behaviour. There is a market cycle where you need to have the courage to say no and to walk away from business. The danger here is where people are remunerated based on the reduction of our profit. The behaviour in this current cycle suggests the contrary.
Cangany: Do you think some of that pricing pressure is coming from some of the hedge fund money that is coming into the market? Maybe some less experienced underwriters are looking to make the money from the asset side versus the underwriting side?
Pollett: Yes, of course you’ve got that element. You’ve got a lot of new capital coming in. One of the interesting topics you are seeing at present with the IPO of Greenlight and Third Point is a number of hedge funds looking to participate in the space more because they want to get hold of the float, rather than any interest on the underwriting side.
In terms of cat itself, there are markets that are putting down lines. If you look at the cat bond market you saw spreads decline by as much as 50 percent. The question is who is doing that, and the answer is that even with spreads falling 50 percent, investors still believe they are better than corporate bonds or emerging markets.
There is also money out there that will take the bond whatever the price and that’s a little bit alarming. One of the big advantages delivered by Blue Capital is we have all the data and relationships to help us navigate the market. Most of the market faces significant barriers to entry. If cat bonds are coming down 5 percent then that is obviously going to have an impact on other markets. It places pressure across the board.
You have to be more inventive and look for ways to leverage your franchise more effectively and clearly that is what we are trying to do and it is what a number of our competitors are trying to do as well.
Wilken: There is no doubt the impact of new capital has negatively impacted price. From what I see at the coal face the reduction in pricing has actually come more from the traditional markets’ fear of what may be out there, rather than what actually is.
Alternative money has moved from simply being in the retrocessional space and worked its way down into more traditional catastrophe lines. It will inevitably spread beyond reinsurance which is still economically speaking a relatively small part of the world, into direct insurance.
We will need to watch this space because over the next three to five years that is what they will be targeting. Maybe naively and wrongly, it makes you question where the funds are coming from. Pension funds have deep pockets of capital, but many are already invested in insurance anyway. To take their money out of that business and put it in another vehicle which competes with existing allocations is a little difficult to digest. But speaking with investors they seem happy with the situation, regarding it as a different section of the market.
Cangany: I was at a meeting where someone brought up an interesting theory that the industry every now and then comes up with inventive ways to do things. They mentioned Florida and how the insurers there are now prefunding big losses and not waiting on the governments to post-fund them after a big event. Do you see the industry becoming more innovative with things like that?
Pollett: Absolutely. That is one of the exciting things about convergence. Some of the products we have been offering over the last few decades have been pretty staid. Bringing smart guys in from an investment banking background looking for different ways to provide solutions has been very exciting and is one of the benefits that we bring to our traditional offering.
To give you an example: one very big client out there in the US has a sophisticated programme. I was on a panel with a risk manager there and he said we buy $2 billion of cat protection for events from traditional markets. We love cat bonds, but we don’t want to issue too many of them because it is not a tried and tested market. We would like to buy another $1 billion on top of that $2 billion because the company buys up to 1 in 100 or 1 in 150, but we believe that next year that 1 in 200 might happen and we don’t feel we are adequately protected and cannot find anyone to provide that coverage.
The reason is that the red line is too low for the cash markets, you cannot issue a cat bond with a spread of 100 basis points, and too low for the traditional rated guys. That is an area where we are developing a product and others are looking at bringing in a capital markets-backed reinsurance that understands the risks to lay off some of that high layer stuff. It is a new solution to the market that has not been there before.
Wilken: The reality is that we are facing a global challenge where we are seeing increasing frequency and severity of events, as well as increasing population. There is an opportunity to expand the scope of insurance, whereas previously there has traditionally always been a brake on whether the process is adequate to be able to expand into these high layers.
The innovative capital, which has deep pockets, will be able to do that because they are diversifying themselves into a much greater body of capital and within the insurance space we can be good facilitators of that.
Cangany: Earlier we discussed capital management. We hear rumours that the M&A market is going to start heating up in 2014. After you seeing signs of that?
Hollander: It is happening now. It varies a lot around the world, but there is no question everyone is looking at growth, it is a top 2 or 3 issue for companies. There is no doubt the industry has been gearing up for a while.
Pollett: Investment bankers have been hitting the street every year passing the rumour around that there will be consolidation. We are however seeing a lot of bolt-on type acquisition—bringing in expertise in particular areas, rather than transformational acquisitions.
The wider trend seems to be you either need to be specialised and very good at what you do and continue to look at ways to optimise your capital, or you need to build scale.
Our sense is that there are guys in the middle range in terms of size that are trying to be all things to all people and that is going to be tough. If you want to be in reinsurance, insurance, long tail and short tail across 40 different countries, you need to be big to be meaningful.
Cangany: Have you seen more issues with respect to being able to sustain those double digit returns on equity?
Pollett: Yes, absolutely. The reality is that you have a target which is a long-term target over a cycle and there will be periods in the cycle where you will not make those returns.
From our perspective, we have three publicly traded vehicles in our group and it is important to make sure you communicate that to your investors so they can make their own choice, but clearly if rates come off 10 percent then you can expect your returns to come down.
Clearly with competition coming in, one of the areas that has been subsidised in this business is the cat space. When they are looking for their plans for next year and they are seeing cat rates coming down they have some interesting challenges. How can they meet that cost of cat?
Wilken: Our 10 is the new 15.
Pollett: Ten is pretty good actually.
Wilken: One thing you touched on very astutely is that there has to be realism in this space. If you go in setting unrealistic targets you will self-spiral into problems as people try and achieve the unachievable.
M&A, which was the start of our conversation, just does not make sense at times. There are far too many players in this space and far too little business, so it must exist, but every time we have looked at the opportunity for M&A it has not strategically made any sense to us.
Cangany: The big headline was that Goldman Sachs had downgraded the P&C sector. Is that a short term view? I know we are working through the cycle, but ROEs are better than many other sectors. Did they miss something in their report?
Pollett: There has been a tremendous run up in stocks, we are not trading as a group at 10 or 20 percent discounts any more. I am not going to agree or disagree. I thought it was interesting that at the same time Deutsche Bank was upgrading some stocks. Everyone has a different view.
We would not mind if share values come off a little bit again in this environment as it creates opportunity to buy back stock. It is all about relative value at the end of the day and having management teams that can steer through the troubled waters to continue to deliver shareholder value and to be patient and disciplined.
If you take a longer term view, there are plenty of opportunities so I would not agree that you should sell all reinsurance stocks across the board following Goldman Sachs’ advice. There are still some great companies out there that deliver value and have a history.
Wilken: Therein lies the difficulty—on the one hand they are saying sell out insurance and reinsurance stock and on the other hand they are saying we want to come into the reinsurance space. There is a lot of confusion.
Cangany—2014 has started out pretty much as expected: rates are soft, competition for good, quality risks has increased, and
the “noise” of merger & acquisition activity is increasing. Alternative capital continues to make its way into the reinsurance space, which is likely only to increase the competition for good risks. Although the April 1 renewal season looks very similar to the uninspiring January 1 renewals, the good news for reinsurers is that the 2014 cat season is predicted to be below average.
Wilken—We did indeed see a reduction in pricing at the January renewals as predicted and more accurately the pursuit of materially broadened terms and conditions. We furthermore expect continued reductions throughout the year in the absence of a significant market event.
The widespread flooding in the UK and the severe winter storms witnessed in North America (while not specifically impacting reinsurers) are a constant reminder as to the vulnerability of large insured populations to what appears to be an ever-increasing trend of record-breaking weather-related catastrophes. This trend when combined with the simultaneous systematic reductions in price and broadening of terms can ultimately result in only one outcome.
EY, insurance, reinsurance, Blue Capital, Argo Re