We asked leading members of the Bermuda market their thoughts on three key questions challenging the re/insurance industry.
What strategies are re/insurers pursuing to pep up their ROEs in the current environment?
Charles Cooper: It’s a bit about math. You can work either on the numerator or on the denominator. Every reinsurer right now is working on the denominator. There is too much capital in the business and everyone is looking to manage that capital. Primarily they are doing this through share repurchases. XL repurchased $175 million in each of Q1 and Q2 this year and other reinsurers are pursuing active capital management. The ROE problem is significant because the E has become so big. One way to manage that is to reduce the E.
The other side is improving the R. Here at XL we regard improving the underwriting margin as the most effective way to build long-term shareholder value. The rating environment, particularly in property cat, is working against us as we try to expand margins, but on the primary side there are still pockets of positive rate even if we are starting to see some rate deterioration.
The question is, how do you improve your underwriting margin in a stable or declining rate environment? It is primarily achieved through risk selection and portfolio construction. At XL we are seeing continued year-on-year improvements to our accident year combined ratios and that’s what we’re focused upon.
Others are focusing on other levers. Investment income is one of those, with some reinsurers pursuing aggressive investment strategies in the current environment—investing more in the alternative space, the equity markets or higher credit risk instruments. Diversification is another option, leveraging your equity to write more non-correlated business in an effort to increase your income. You are seeing some traditional property cat players pursuing M&A or entry into specialty lines in order to pursue diversification strategies.
Jeremy Pinchin: The first priority is to manage exposure in the face of reducing pricing, especially when it is additionally impacted by broadening terms and a continuing low interest rate environment. It is at this time of the market that quality underwriting, supported by good analytics and risk selection, are more important than ever. Remaining disciplined will always have a greater impact on your long-term ROE than any short-term attempt to “pep up your ROE”. When the risk remains the same but the amount you are earning reduces, you must sell less risk.
Jerome Faure: For reinsurers, margins have been under pressure for some time due to the influx of additional capacity from the capital markets—with conditions proving particularly acute in property cat. However, when you look at reinsurance results for the last few quarters there have been few major catastrophes, reinsurers have been able to benefit from prior year reserve releases and results have been generally good, even as margins have been under pressure. The insurance side has generally seen less pressure and the environment has been more favourable.
At Endurance, our strategy has been to continue to build a diversified book of insurance and reinsurance business. We have built a London-based international insurance platform and expanded our US business with additional teams and products, diversifying away from crop insurance which has been dominant at Endurance in the past. We have recruited the best underwriters in the market and the momentum from these new teams has already been evident in our financial results.
On the reinsurance side we are following a similar approach, hiring top-class underwriters—particularly in specialty lines such as trade credit, marine, engineering and agriculture—so that we can attract more specialty business which typically yields better margins. In doing so, we are building a portfolio that is diversified across lines of business and offers our clients multi-line capabilities. We have sought to differentiate ourselves in the market by selecting the best risks and clients and building strong relationships with those clients over time.
Matt Wilken: Strategies vary, but fundamentally we see four specific directions. The first is growth through diversification. Capital optimisation by leveraging the balance sheet with risks that are accretive to profit without adding additional exposure to the capital intensive accumulations that drive the ‘tail’.
Second is the deployment of capital on behalf of third parties by using multiple mechanisms, eg, traditional reinsurances (ie, structured quota shares), sidecar vehicles, or separately capitalised independent fund-based structures.
Third is the pursuit of scale in order to protect and increase client retention and reduce expense ratios.
Last is the development of innovative products/mechanisms that enable our clients to better manage and protect their underlying portfolios from a multitude of both natural and non-natural risks over the course of multiple years.
Mike Morrison: Returns are actually still stacking up pretty well in most lines because of the lack of losses over the past 24 months. Notwithstanding real downward pressure on rates, bottom line returns are reasonably healthy even if people agree that this is not sustainable given that events will occur. That said, we have seen real discipline from players who have seen their top lines come under pressure, typified by an unwillingness to write lines that are loss-making.
If this cycle continues re/insurers will have to reduce expenses, because this is about the only lever they have. Everyone is on the look-out for new business—with some Bermuda players buying diversifying entities—all seeking a sustainable return on capital through less volatile lines.
Charlie Thresh: Companies have been using prior year releases to prop up current year earnings, but there are signs that these are starting to run out. Adverse loss development from prior events is eroding the ability to boost current earnings, exerting added pressure on returns.
Different business models that work harder on the asset management side are also being explored. It is not necessarily a new strategy, but both the larger and more established players and new entrants are looking to get more creative in their asset allocations.
Are increasing insurer retentions now a fact of life, or can reinsurers unlock demand?
Faure: It is a true statement on a broad basis. Insurers have been retaining more risk over the past few quarters, but it is not a uniform trend across clients or lines of business. There are some insurers who manage their risk in a more prudent manner and are not simply looking at the savings from buying less reinsurance, but rather are evaluating the risk-adjusted returns and buying more reinsurance. Endurance is in that camp. We have bought more reinsurance and retrocessional coverage over the past year because we view this capacity as an effective tool to better manage our capital.
Retrocession capacity in particular has been plentiful from both traditional reinsurers and capital market players and we have been able to utilise it to reduce the volatility of our portfolio. In summary, we believe that by building strong relationships with key clients across a multi-line portfolio, we are able to optimise our position and generate more business, even while broader demand for reinsurance is decreasing.
Wilken: As our customers continue to pursue strategies to optimise returns in an ever more competitive environment attention naturally focuses on a strategy that reduces reinsurance spend. Larger clients with sophisticated capital assessment tools are able to better manage their ‘modelled hypothetical returns’ and this has catalysed a desire retain more risk. It would appear that this is a fact of life. However a number of observations could mitigate this trend:
Access to alternative forms of capital with a lower return requirement could result in the transfer of risk being more cost-effective than even the larger clients can match.
Emerging risks that are not as eminently ‘modellable’ as the current natural catastrophe risks appear to be can result in clients not being willing to accept the same degree of risk as they would have done initially. For example, cyber risk exposure could unlock demand from clients in a way not previously catered for.
Over-reliance on hypothetical mathematical models. As the industry drives towards more standardised models for risk assessment and capital optimisation the likelihood of the industry becoming susceptible to systemic risk increases. The absence of significantly large US catastrophes for nearly a decade has not tested many of the hypothetical mathematical constructs. It remains to be seen whether post-event all the strategies that have demanded a greater retention of risk in the pursuit of marginally improved returns stay the same. There is a distinct possibility that changes in appetite post-event may unlock demand from customers.
Morrison: Everyone is striving to retain primary books of business, recognising that to attain revenue numbers they need to retain more risk. On the reinsurance side the competition is coming from convergence capital.
Reinsurers are responding to traditional players increasing their retentions and to the influx of convergence capacity by dropping rates and easing terms and conditions. There is some recognition that this situation is not sustainable and many reinsurers are waiting for the next big loss to bring about a realignment within the market.
Thresh: Unless you are one of the bigger players that can almost dictate the market, conditions are proving tough. Smaller players have come under the most pressure, particularly in the more commoditised segments of the market such as property cat. It will prove a challenge for them to unlock demand in the face of competitive dynamics.
Pinchin: In mature markets buyers are more capable of retaining risk, due to stronger capital positions and greater buying sophistication. However, the reinsurance product for many has not changed for many years and there is huge scope for tailoring more effective, efficient coverage. Hiscox believes we can add real value by understanding our clients’ needs and developing products to meet those needs—not simply by selling more of the same.
We have an active product group which has generated numerous ideas and solutions for our clients. Products such as sideways cover for attritional risk excess losses and a cost-effective drop-down cat layer protection are examples of products developed in response to issues that clients have told us are real problems. It is through dialogue arising from discussion on such products that we better understand our clients’ needs and can add greater value through product design.
Reinsurance need not be the blunt instrument it is for many; it should flex to fit specific client needs and our underwriters have the expertise to deliver that level of innovation and customisation.
Cooper: No, it definitely isn’t a fact of life—and I would point to a number of factors that support that fact. In June we saw a lot of Florida companies buying more reinsurance. For the companies that we support in the state we saw more than $1 billion of additional demand for limit. People in Florida are using some of the money they have saved from the deteriorating rate environment and putting that to work buying additional limit.
Part of the reason you are seeing decreased demand in some lines of reinsurance is the underlying balance sheet strength of a lot of the large commercial insurers. Right now they are very well capitalised, but clearly that can change because of weather, earthquakes, adverse loss results and investment conditions. When conditions change, it will change people’s need for reinsurance.
There is also huge potential for an increase in demand from non-traditional buyers such as Citizens. Floridians are buying a lot more reinsurance these days and there is a tonne of risk out there in the world that isn’t being transferred into the private markets. Presently it is being retained by governments and individuals and as the current pricing dynamic works through the market I can see increased demand permeating through the system as the cost of transferring risk becomes more economically viable.
Do you foresee further permutations in the re/insurer model? What other structures and approaches do you predict in terms of structural and strategic innovation?
Wilken: We foresee more change and at an increasing pace. Accessing funds beyond the normal sphere of the insurance equity markets will, in our opinion, begin to influence the insurance space in the same way it has impacted the reinsurance space. The trend of using ‘other people’s’ capital as opposed to one’s own capital has created a new environment, one where the structures of organisations have had to adapt in order to provide access to the original business and cost-effective processes.
The marketplace has become more commoditised and we see that trend continuing. Emergence of digital platforms and the increased fungibility of capital are key drivers that will shape the face of how we do our business going forward. Customers want cheaper, faster and better services. Investors want liquidity, sustained profitability and accurate assessments of the risk:reward ratios.
Cooper: Third Point Re has dedicated underwriting and asset management teams that are integrated into one separate company. Watford Re is a different permutation of that. You have an asset manager and a liability manager, which is Arch. I expect we will see more Watford Re models going forward.
There is a tonne of capital out there and that is commodity. With the low interest environment it is difficult for investors to find yield at the moment, so reinsurance risk is proving attractive. What is a more scarce commodity however is the access to business, the underwriting talent and the ability to structure and manage that business. That is why you are probably going to see existing underwriting platforms potentially marrying up with asset managers to create more hybrid Watford Re-type structures, rather than the establishment of new, independent Class 4 entities.
Morrison: You are seeing investors coming onboard—both banks and private clients—and taking a punt in a space that has not seen that type of direct individual investor in the past. Previously it was more institutional investors, whereas now funds are willing to put their clients’ money directly into reinsurance and insurance-linked securities (ILS) entities as part of a diversified investment strategy.
That is quite a shift. There is some expectation that some of these investors will retreat following a loss, and this is right to a point, but there is little correlation with the wider capital markets and returns remain attractive compared with macroeconomic conditions.
Thresh: The pension funds have been on the leading edge of recent developments in the reinsurance space, acting as cornerstone investors. In areas such as run-off, which you might regard as risky and peripheral, they have been able to drive niches as the levels of capital they have at play is so significant. On the life side it has not been such a leap for high-net worth individuals to get involved in the space compared with P&C, particularly considering the relative returns. I expect to see further investor sets consider the space.
Faure: I don’t anticipate radical innovation, but rather an evolution of capital markets involvement and a broadening of their footprint. They will continue to attempt to get into new lines of business and the next stage may well involve institutional investors looking to own or become reinsurers themselves. The difficulty at the moment is finding enough business to deploy that capital.
Participants who are on the fringe today through funds or sidecars may well be tempted to get more directly involved in the re/insurance market by acquiring or creating companies or Lloyd’s syndicates.
Pinchin: We believe in a hybrid model balancing the use of traditional and third party capital. We do not believe in one that adopts a higher level of risk for higher returns on the asset side as we already take sufficient risk in assuming our clients’ insurance exposures. In our opinion that isn’t a recipe for long-term success.
Strong underwriting, good analytics and astute risk selection whether used on behalf of our own balance sheet to underwrite risks or on behalf of third party capital, backed by a top-class reputation for paying claims promptly is the model that we see as being in the best interest of long-term and mutually rewarding client relationships.
We will see different strategies evolving. It’s still too early to tell who will be the winners and losers, but we believe we are well placed to deliver the innovation our clients demand and the returns that ensure we continue to be a long-term player in this industry.
ROE, risk retention, reinsurance, innovation, XL, Endurance, Bermuda