Unpicking capital flows
Looking back over the history of the Bermuda re/insurance market it is clear that market dislocations have played an important role in its development. From the eight companies set up in 1993 after Hurricane Andrew (including RenaissanceRe and Partner Re), to the ‘Class of 2001’ after the World Trade Centre attacks (including AWAC, Axis, Montpelier and Endurance) and the ‘Class of 2005’ after Hurricane Katrina, Rita and Wilma (Flagstone, Lancashire, Validus, Ironshore and Ariel), each growth spurt has followed a major market correction. So what will happen in the event of another hard market?
The overwhelming consensus is that capital today is more likely to flow into alternative structures such as sidecars and collateralisedreinsurance funds than into new start-up reinsurers. The sidecar business model is an attractive one for investors. They can be set up quickly, wound down quickly once the opportunity has passed, and funds can go in and come out at book value.
Sidecar resurgence
Testament to this is the fact that four sidecars have been launched so far in 2011, worth a combined $680 million, to take advantage of stronger rates in the retro market following this year’s catastrophe events. These events, including the Japan earthquake and tsunami, Christchurch earthquake, floods and windstorm in Australia and severe US weather have cost the industry around $70 billion, severely denting earnings but so far failing to lead to significant rates rises other than on loss-hit accounts.
This has an impact on how much capital is likely to flow back into the industry. “There’s been an aggregation of losses that have eroded earnings and potentially some capital and if you see a continuation of that or a large loss from a peak peril there would be some type of capital raising,” says Paul Schultz, president of Aon Benfield Securities. “If we continue to see no other losses I don’t think it’s likely that we’ll see a lot of capital come into the business. It would be used selectively but I don’t think we’ll see a wholesale recapitalisation of the market.”
While there is talk of around $10 billion of excess capital in the reinsurance sector, losses from earthquakes in the first quarter were creeping up at mid-year and it is unlikely reinsurers will deploy all their capacity given tough market conditions. In addition other dynamics are pressuring capital, including new cat model releases, low investment returns, low stock valuations, the drying up of prior-year reserves and anticipation of Solvency II, among others.
These pressures have created favourable conditions for some new capital to enter the sector, to the tune of $2 billion. This includes the four new sidecars set up by Validus, Renaissance Re, Lancashire Re and Alterra Capital (see Table 1) and capital raising initiatives by SCOR, Partner Re, Endurance and Montpelier Re.
Montpelier raised $150 million of capital through the perpetual preferred share offering in May. “It was really an opportunistic trade which provided us with greater capital flexibility”, explains William Pollett, chief corporate development and strategy officer, treasurer and senior vice president at Montpelier Group.
“The retail preferred market opened for below investment-grade issuers for the first time in many years and we didn’t believe that window would always be open to us. In addition, we had some large catastrophe events which looked as though they might have the potential to positively impact rates going forward. The additionalcapital provides us with the flexibility to either take advantage of the rate increases by writing more business, or alternatively, to buy back more shares.”
The short-tail and specialty lines reinsurer also considered doing a second Blue Ocean sidecar (the first Blue Ocean was the first of its kind to be set up in 2006, offering $355 million in collateralised retrocession). “Although we’d certainly like to do that kind of sidecar again our internal house view was the retro market wasn’t quite there yet,” explains Pollett. “So we had investors coming to us asking if we were going to do another sidecar and we told them to stay tuned as the opportunity may well be there following the next large event.”
While there is plenty of capital sitting on the sidelines, according to industry experts, it will seek to enter only if prices rise beyond the 5 to 10 percent witnessed at the mid-year renewals. And this is less likely to occur in the absence of another major catastrophe event.
“If we were to see some type of event that would lead to a need to raise fresh capital the majority of capital is going to come into the industry in forms other than new company formations,” says Schultz. “That doesn’t mean there isn’t going to be some representation with new players–I think there always will be–but I do think sidecars and cat bonds and derivatives of those would be used to attract capital.
“Katrina was the first time we really saw more capital coming in through these alternative mechanisms versus starting a new company,” he continues. “Going forward you’re going to see a more pronounced differentiation between capital raised via alternative structures from institutional money, pension fund money and hedge fund money versus the private equity-funded newcomers.”
Pockets of opportunity
There are a number of reasons why a wave of new start-up companies seems unlikely in the current environment. The barriers to entry are arguably higher than they were in 2001 and 2005. Solvency II, pressure from rating agencies to create a diversified business and the usual challenges in attracting the right sort of talent mean it would take more effort and time to create a winning formula.
"The additional captial provides us with the flexibility to either take advantage of the rate increases by writing more business or, alternatively, to buy back more shares."
“To launch a fully functional and rated reinsurer like ourselves todaywould be a lot more difficult than it was in 2001 or 2005, partially because regulators and rating agencies have much higher standards in terms of their requirements from a risk management perspective, but also because valuations of the existing companies are so low. Private equity isn’t particularly attracted to the proposition of converting a buck into 75 cents overnight” says Pollett. “And you’d fall into the Solvency II net if you were a Class 4 and there’s a tonne of work to be done in terms of internal capital models, not to mention the voluminous documentation of processes all of which cost a lot in terms of dollars and internal resource.”
Many of these conditions were already apparent in 2005 when the ‘“ticket to the dance”’ was raised to $1 billion and a number of proposed ventures failed to get off the ground. The fact Katrina failed to create a hard property market anywhere but on property cat-exposed classes also made conditions more challenging than they had been for the earlier ‘Class of 2001’.
“After the World Trade Center a number of factors created a hard market across the board. You had the soft underwriting cycle through the end of the 1990s which resulted in a lot of balance sheet impairment, the equity market crash in 2000 and then of course there was 9/11–that was the catalyst. But after Katrina it was specifically the catastrophe-exposed property side of the market – it didn’t really affect the broader casualty markets, which in our view have been softening since 2004. So the companies that started up in 2005 had a much more limited opportunity.
“Today, at best you’re getting some significant price increases on lossaffected accounts such as in Japan, New Zealand and Australia –there’s a lot of argument as to whether they’re enough,” he continues. “In June and July there was a 5 to 10 percent increase across the US cat books, better than the down 10 percent that we were projecting at the beginning of the year, but it is not at the point where management teams get excited about pushing out their risk profile, let alone raising fresh capital .”
Montpelier is watching and waiting to see if conditions will improve further before it deploys more capacity into the market. Pollett thinks rate increases of 20 to 30 percent will be needed before there is deemed to be any real opportunity for new capital to enter the market. Other companies appear to be using the same tactic, unwilling to expose their capital at a time when insurance stocks are undervalued and the direction of rates is uncertain.
“At Montpelier, we’ve been taking risk off the table over the last few years–as pricing came off the peak of 2007–to build up our cushion of excess capital to be able to take advantage of market conditions following the next big event, but also to provide the flexibility to buy back more shares. We have bought back more than 30 percent of our outstanding shares in the last few years. Are we now going to put that probable maximum loss back out again? No, but we’re sitting on the fence waiting in the hope we’ll see more price improvement as the year progresses,” says Pollett.
Savvy investors
While prices may improve further, it is more and more unlikely that we will witness the dramatic market corrections that occurred in the past. The reinsurance market is fragmenting into sub-cycles, said Martin Sullivan, deputy chairman of Willis Group, speaking at the Rendez-Vous in Monte Carlo. Insurers and reinsurers will have to adjust to a “new reality in which outsized underwriting returns will be available only on a localised basis, and even then possibly only for short durations”.
The fungibility of capital is one of the reasons for that. Opportunistic investors entering the sector post-loss provide instant capacity when it is most needed and exit before prices get too soft.
“The short-term ‘smart’ money has a much better understanding of the opportunities that catastrophe reinsurance provides,” says Pollett. “They understand the dislocation element and the opportunity to make excellent risk-adjusted returns over a short period of time, albeit with a lot of unpredictable (but uncorrelated) downside risk. So there is no doubt that capital will flood in. That’s the bad news. The good news is that a lot of that capital will be short-term money which will harvest the opportunity and then quickly exit for opportunities elsewhere.
“The inflow of short-term opportunistic capital will help take the peaks and troughs out,” he continues. “We would prefer that to happen rather than for 2005 to repeat itself when six or more companies entered the market, hired full-time teams, developed models and had permanent capital that needed to be deployed. That’s permanent capacity as opposed to temporary capacity.”
Not only is the investor base becoming more comfortable with insurance risk, but in the current environment it provides allimportant diversification. This has led to more attention from new types of investors, including pension and annuity funds. The BritishBroadcasting Corporation’s £9 billion UK pension scheme recently announced it was investing in insurance-linked securities, with Nephila Capital appointed to manage the funds.
“We believe the next big trend will be the entrance of the longerterm investors, the pensions, endowments and foundations which control trillions of dollars,” says Pollett. “These investors are constantly looking at alternative asset classes to add to their portfolios to improve their chances of generating enough return to meet their long-term obligations. When they take the time to study it, they find catastrophe risk to be a very attractive complement to their existing portfolios, but the issue is that they find it difficult to access the class through their normal channels.”
The investor base is changing and that in itself influences the type of vehicles that will be set up following the next big cat loss. The private equity investors which provided the funds to start up so many Bermuda firms have now been joined by hedge funds, institutional investors and pension funds. Those investing in sidecars need a higher risk tolerance, explains Pollett, while many of the deeper pocket investors favour cat bonds where “the risk of them losing money is much further out the tail”.
Capital reloads
While many traditional Bermuda reinsurers are trading below book, they remain attractive to investors thanks to the diversification on offer and the feeling that a hard market is just around the corner. Given the disproportional impact of catastrophe events in 2011, with some companies feeling the pain more than others, capital reloading could continue to be an option for some.
This will remain an attractive play for investors, and a preferred way of accessing the permanent market. “If you can come in, and perhaps provide some capacity to an existing player, that existing player has got everything you need,” explains Chris Klein, head of sales operations for the UK and EMEA regions and market relationships at Guy Carpenter. “It’s got the underwriters, the distribution, the infrastructure, the pricing methods and the models and tools that are required to do that. And you can put in a defined exit plan as well.
“Capital can enter, in so many different ways now,” he continues. “There’s a lot of friction in setting up the traditional bricks and mortar type vehicle. Sidecars provide a means for which investors with a shorter-time horizon can come in and be very selective. They can take out a particularly well-modelled, easily quantifiable segment of underwriting risk and back that without having to take all the other risks associated with setting up a business, including the asset risk.”
One question is whether capital market investors will show a bias to the more traditional Bermuda business models when picking insurance stocks. Whether this encourages the pendulum to swing back in favour of the monoline companies remains to be seen.
