In what is a very competitive environment, reinsurers are weighing their options—which include mergers and acquisitions and diversification. Bermuda:Re+ILS invited leaders from a number of Bermuda players to our annual Monte Carlo Reinsurance & ILS Round Table to debate the options available to reinsurers and describe how they see the future.
Around the table:
Andrew Barnard, head of international property catastrophe and retro reinsurance, Markel Re
Kathleen Faries, CEO, Tokio Solution Management
Timothy Faries, partner and head of insurance, Appleby
Bradley Kading, president and executive director, ABIR
Robert De Rose, vice president, AM Best
Bill Pollett, president and CEO, Blue Capital Management
Maamoun Rajeh, president and CEO, Arch Re Europe
Charlie Thresh, managing director, KPMG
What is your view on the tough market conditions and how the industry is adapting to this?
Bradley Kading: The issue is abundant capital and a great deal of interest from the capital markets in reinsurance. We have to make this work and that means expanding market opportunities, expanding into emerging markets, into different product lines, and developed markets—whether that means taking on more flood insurance, building the Asian markets and fighting back the trends for governments to be more protectionist, localising capital. Those are the challenges we see: to grow markets, grow opportunities for the capital to be put to work.
Timothy Faries: One of the levers for growth we’re likely to see more of in future is scale. There has been evidence that worldwide in the industry acquisition activity is starting to heat up again after three years of downward trend. One of the ways in which one can grow in this market is achieving scale, so we are likely to see more of that going forward.
Maamoun Rajeh: I am a bit more cynical. To me, the idea of growing profitably in a soft market is incongruous as buying more scale simply gives you a larger share of weaker economics. The arbitrage favours the primary companies today as ceding commissions guarantee an over-ride return and expose the reinsurer to any adverse experience. Ironically, what is saving reinsurers from themselves today is increasing levels of client retentions.
Kathleen Faries: That’s why a lot of organisations are trying to partner with alternative capital—because of the pressure to grow and be relevant.
Andrew Barnard: We don’t want to grow for growth’s sake. That’s the challenge we are all looking at. Internationally trying to grow is a challenge—you don’t want to weaken yourself at all.
Is it acceptable to shareholders for carriers to say they are not going to grow this year, because it’s a bad time to do it?
Robert De Rose: From a rating agency perspective shrinking can be a positive thing, especially given the market dynamics. Growth for growth’s sake is a foolish thing and can end in a lot of tears. Taking advantage of new opportunities could be prudent but you need to do it from an intellectual capital base that’s robust. You need to know what you’re doing, know how to manage accumulations and how to price new products and new aspects of risk.
When we see top line growth in a soft market we become quite cynical. Using capital market capacity, if the return hurdles are lower, could be a smart thing, providing a source of fee income that can help mitigate expenses that are fixed through a period when an organisation has to, and should, shrink.
Chris McDowell: It’s interesting—it is obviously a tough market environment right now but there are areas of the business that could be priced and covered. For example, since Hurricane Andrew in 1992 Transmission and Distribution lines have been excluded from cat reinsurance. I think there are still opportunities out there.
Charles Thresh: It’s interesting hearing the executives around the table talking about the pressure to grow because I remember reading the commentary on Q2 results where some of the reinsurers said they are not writing for growth—they are making sure that they can stay profitable and as a consequence their top line shrank. But there was some adverse comment around that.
The capital markets find it difficult to accept lack of growth so the pressure must be very keen if you are an executive in the market.
De Rose: It’s interesting you should say that. Equity analysts historically always look for top line growth—they felt the top line growth was a metric for future earnings. I think they have become much better educated, perhaps living through prior soft cycles and seeing what it can do for earnings.
From my point of view, from what I hear they are much more tolerant today than they ever have been, and they’re willing to see organisations shrink—and actually the stock price can react more positively to a shrinking top line. So that’s encouraging quite frankly.
Barnard: There is a difference between public and private ownership, of course. If you’re public it’s pretty obvious to see what’s going on. If you’re private you can shrink without any pressure. So where’s the pressure coming from to grow?
Bill Pollett: You’ve heard from the underwriters here that they would prefer to shrink in this type of market rather than grow and I would agree. From our perspective this is the sort of market where you want to be extremely cautious, very selective and hunker down.
A driver of M&A is a need for scale, plus there is the drive to get to the point where you can offer something more than capacity—you may be buying in expertise or modelling. Will those things be a driver of M&A?
Kading: If M&A is done for a strategic change in the operation or to add to the business line, or get some diversification, there is some business sense to that, but insolvency history is littered with companies that have made bad M&A decisions just trying to consolidate a market to take advantage of opportunities.
Rajeh: Today there is homogeneity in the way reinsurers are run, everybody wants diversification; nobody is a pure cat writer any more, so to go out and acquire a peer reinsurer is really just doubling up on what is already there.
De Rose: You’re more likely to see a reinsurer acquire a primary insurer to build scale there. Having a new mode of distribution can be beneficial and provides for the oscillation. That model has worked very well—it is beneficial to have it through a soft market. If you are part of a large conglomerate obviously you can afford to take a step back, but for those reinsurers that are operating and trading on the exchanges independently, having the ability to diversify between insurance and reinsurance can be a tremendous benefit.
Barnard: We found that at Markel, that’s exactly what happened to us—we were primary to reinsurers.
Kading: That was the 9/11 example in the US. The efficient insurance model prior to 9/11 was to have your capital bases as an insurer used to support a reinsurance operation; post 9/11 all the companies which had that model abandoned it—they had doubled up on their cat exposure. Not to say that that predicts the future...
De Rose: You have to make sure that you understand your accumulations across the enterprise, there is no doubt about that. In fact, the larger and more complex you become, the greater investment you have to make in your enterprise risk management.
Kading: Everybody does it better today, I think that’s the assumption—greater tools, greater knowledge, more skilled people.
De Rose: You can even run that risk between direct and facultative and treaty—within an insurance operation you have to make sure you are controlling your accumulations across the spectrum of risk you’re taking in.
Kading: I want to throw in a regulatory point or two. In addition to the rating agencies looking at companies, the international regulators are looking at the development of this market. Bermuda is the centre of the activity and the Bermuda Monetary Authority (BMA) gets lots of questions from its regulatory peers.
The questions directed by other regulators about alternative capital are: what is the quality of the asset, where is the asset held, when is the asset released? And then the alignment of interest question: is the underwriter having some skin in the game to create a sense that the capital providers are not just being used as naïve players in the market?
“Today there is homogeneity in the way reinsurers are run, everybody wants diversification, nobody is a pure cat writer any more.” Maamoun Rajeh
So there is a regulatory question that grows over time until there is a sense that the market has been sufficiently tested. Those that have been in it for a long time probably think the market has been sufficiently tested, but it’s just that the greater addition of capital coming in has raised the regulatory antennae around the world and is causing lots of questions to arise right now.
I think regulators understood what insurers did and now they don’t understand what these new capital providers are doing. So if the reinsurers are just becoming managing general agents (MGAs) with all the risk being held in their capital providers then that’s a different model that they have to look at differently from a regulatory perspective.
Might there be any consequence of that? Are they pondering any guidelines that we at this stage are unaware of?
Kading: Guidance certainly around the holding of the collateral, how it’s held, what the asset is, and then the release of the asset seems to be where most of the regulatory tension is, and that gets to the tail of a product that’s sold, so if the capital provider wants the money returned at the end of a two-year period for hurricane loss, maybe that makes sense, but they don’t want there to be pressure for release of that if the cedant still thinks losses are developing.
And if you look at an earthquake tail, Northridge continued to produce losses for 14 years after the event occurred, and there were at least two cases of regulatory intervention in the Northridge quake where policies were reopened and coverages expanded. That’s the kind of thing the regulatory tension is focused on.
De Rose: What is your sense of purchasers of protection from the capital markets? They should be sure that they are getting good collateral to back the future regulations. Do you think they are doing a good job in making sure the collateral is good?
Kathleen Faries: There certainly is a trend because now there is so much, particularly in the collateralised reinsurance space. From the buyers’ perspective they are looking at it now as they’ve got to manage all these credit risks, so there is a frictional cost and an administrative burden around building up so much collateralised reinsurance.
We’ve heard from a couple of large buyers of collateralised reinsurance that that is starting to become an issue, particularly in the soft market, so now they have a choice with traditional reinsurers that are able to give them that capacity without having to manage all that—they have one counterparty to manage—versus lots of separate trust agreements with different trustees, with different collateral release mechanisms.
It is going to become a bit of a burden, particularly in a soft market, so things are coming full circle and the cost is going to be an issue because the margins are reducing for everybody. Even for the collateralised re market it’s going to be costly to manage all that. It’s going to be interesting to see what happens.
Pollett: On the quality of the collateral, it’s typically a negotiation between the reinsurer, the broker and the cedant, and typically the quality needs to be very high. The issue is more what happens after the event and the drawdown of that collateral and the conditions around that which haven’t been fully tested.
McDowell: I totally agree. Rated paper is a great advantage rather than having all those little trust accounts.
Pollett: The quality of the collateral is something cedants often raise when they do this for the first time.
McDowell: The issue is more the release of capital once the contract has expired. An earthquake late in the year could give smaller funds issues with trapped collateral and impair their ability to trade forward, having to get existing investors to reload post-event.
And what are you seeing in terms of the regulatory enquiries that Brad described?
Timothy Faries: Brad is correct. In Bermuda that’s been a priority for us in terms of staying at the vanguard of regulation and that will continue to be a key focus going forward.
Pollett: I believe that regulators are more interested in the hedge funds’ intent, making sure they understand the rationale for a particular structure. On the property cat side it’s a fairly simplistic model and it makes a lot of sense that long-term sophisticated investors are tapping into an asset class that’s uncorrelated, and they’re doing it in a very professional way. So we don’t see any significant changes there.
De Rose: It’s an alternative investment strategy that is aligning itself with the diversification aspects of reinsurance risk and if it’s put into a model where those risks are balanced and taken in a measured way, it can be successful. Can it go out of line? Sure, it could, but we focus on the management, the intellectual capacity that’s backing these organisations.
They’re intelligent people, they’ve been in the business for a long time, they know how to manage risk, the potential correlations across the enterprise and they work to make sure those risks are taken in balance.
Kading: In terms of the hedge fund-backed reinsurers, the BMA is taking the wisest path in regulating them as commercial insurers and reinsurers with a class four licence structure, so it means the capital is committed, the reinsurance risk is on the books. It’s not an opportunistic play where you get your money back fast—the capital is committed and the risk-based capital charges are commensurate with the higher investment return you are trying to achieve so that’s been a wise regulatory decision that affects that market and provides some additional layer of credibility.
De Rose: People say that the hedge funds have a two or three-year time horizon. But the reason they are investing in these structures is for long-term float; they want permanent capital. In 2008 one of the problems the hedge funds experienced was that investors wanted out.
A reinsurance client is not going to say: ‘give me the assets back’ while it still carries reinsurance liabilities.
Float is a good thing as long as it’s free—that means you have to do it at an underwriting profit. And that’s where you have to make sure you have the management and the underwriting structure that can generate an underwriting profit.
We talked about how M&A might deliver diversification, we’re hearing more about reinsurers moving into primary lines, into casualty, into specialty. Where is the diversification going to come from and how realistic is that?
Pollett: There has been a push over that last decade, since Katrina, for companies to diversify from certain quarters. Our view is that diversification for diversification’s sake is not a good idea—you need to be careful about where you add lines, to make sure you understand the risk inside out—the reality is that new entrants tend to get the less attractive business.
That ties into the scale thing too—if you want to be all things to all people you need significant scale, but there is still room for smaller specialists who are focused on a handful of lines of business. We believe it is wiser in markets like this to have a more focused centralised approach.
“The capital markets find it difficult to accept lack of growth so the pressure must be very keen if you are an executive in the market.” Charlie Thresh
De Rose: I agree, diversification for diversification’s sake can be an extremely bad thing. Diversification is good if you have the skillset that supports a diversified platform, it provides you with the ability to oscillate between different classes of business. When one class is soft you can go to an alternative class that might provide better opportunities so for the specialist they have to be able to pull back capacity and withstand the prolonged soft market.
If they don’t have the ability to diversify outside their skillset, to do so without the intellectual capacity behind it would be foolish.
Rajeh: If you think about it on a reinsurance level, the soft market is indiscriminate. It’s a fallacy to think one can depart from an area they’re an expert in and have infrastructure around and pop into another area. Reinsurance buyers aren’t typically going to cede out or demand certain price dynamics on one product line and then on another product line say: ‘we’re ok ceding out more profits here’.
You can hide behind new business, and generally when you diversify you’re writing a lot of new business and there are return dynamics, rate change dynamics that are just unknown to you.
In reinsurance there are more levers you can pull. In a market like this most players of scale put themselves up as doing most things: insurance, reinsurance and all product lines and all territories. So within that world the idea of sneaking in and grabbing business doesn’t make sense to me.
Some of the global reinsurer CEOs talk about moving capital around and finding the best returns in different parts of the world, would you be sceptical that that is as achievable as they say?
Rajeh: It can be achieved but in this market we would be kidding ourselves to think we could do this wholesale. On the margin you can make changes and redeploy capital, but not wholesale. What we are doing is on the periphery of the core P&C market.
Pollett: You’ve got to put those nice graphs into perspective—it’s all relative and you have to remain very selective about where you are deploying your capital.
Barnard: We’re not going to diversify for the sake of diversification. It’s bitten the market where it hurts, I think we’re trying to become more expert in the areas we are in and navigate our way through a very tough market using the present expertise.
McDowell: There are all sorts of initiatives companies are pursuing. Cyber seems to be a buzzword at the moment. I don’t know how one can predict future cyber claims and therefore price that, but it’s certainly one of the new areas of business that are being talked about.
Monte Carlo Rendez Vous 2014, roundtable, reinsurance, Markel Re, Tokio, Appleby, ABIR, AM Best, Blue Capital Management, Arch Re Europe, KPMG