Cycle management: going through the gears
Managing the vagaries of the cycle is a challenge that has been exacerbated of late by changing market dynamics. Here we talk with Allied World and XL Group about how the two companies are navigating a course through new and uncertain seas.
While it is difficult to characterise the market in broad brush strokes, with individual lines and geographies enjoying their own mini-cycles, few would argue that the reinsurance sector is facing challenging cyclical conditions that are also being felt in parts of the insurance market. The cycle is placing particular demands on global management teams looking to navigate a course that seeks to balance technical pricing with a desire to build and maintain long-term relationships and market share. Doing so in the current environment will prove no mean feat.
The reinsurance space is facing particularly troubling conditions. As Mike McGavick, CEO of XL Group explained, “When I speak with Jamie Veghte [chief executive of XL Group’s Reinsurance Operations], he says that there have been few times in his career history when there has been more discipline on the primary side than on the reinsurance side of our business.” Cyclical dynamics and pressure from rising levels of new capital—both traditional and convergence in form—are exacerbating this situation.
Levels of traditional capacity continue to grow, non-traditional capacity is being added into this mix, while larger and more geographically diverse insurers are retaining more of their own risk, explained McGavick. “These factors are working to create a fairly significant imbalance between capital and those risks that capital can be applied to—simply put, too much capital is chasing too few risks.”
The concern is particularly marked among short tail and property cat reinsurance lines, explained Frank D’Orazio, president of Bermuda and international insurance at Allied World. He said that with direct carriers tending to retain more of their underwriting risk, and competitive pressures from convergence capital and its impact on traditional pricing exerting further downward pressure on rates, conditions have helped to create a “buyer’s market” that is testing the resolve of reinsurers.
McGavick warned that while cyclical features are placing pressure on reinsurers, “present conditions do not obligate companies to be foolish. Reinsurers should continue to approach the market with rigour, and recognise that they can still work to create products that are attractive to clients and establish the kinds of relationships that endure through market cycles”.
The temptations of alignment
Not that Allied World and XL Group—with operations spanning the insurance and reinsurance space—are unable to benefit from the ‘competitive indiscipline’ of reinsurance. Present conditions are the “classic double-edged sword for global re/insurers with both treaty and direct operations”, said D’Orazio, that will inevitably require them to balance the demands and opportunities facing their insurance and reinsurance units.
Many re/insurers are looking to realign their focus towards their insurance operations, seeing opportunities to buy reinsurance at competitive prices and grow their primary book. This will inevitably drive some of the competitive dynamic felt in the reinsurance space into insurance lines, with a corresponding impact on rates. This appears to be an inevitable feature of the cycle and McGavick is sanguine about the move, arguing that “we like the ability to realign our operations and so we shouldn’t be surprised if others also pursue that option”.
Thomas McKevitt, executive vice president, global catastrophe strategy and Bermuda reinsurance at Allied World, is equally circumspect, arguing that realignment among those with a reinsurance focus will be no easy task. “Making the move from writing exclusively reinsurance to starting up an insurance operation presents numerous challenges regardless of the time in the cycle. We are fortunate at Allied World to have a significant presence in the insurance space.” Others have likewise warned that a realignment without an existing footprint will prove challenging.
Calibrating your strategic focus
D’Orazio suggests that the best means to calibrate your focus across your re/insurance book is to pursue a holistic approach to enterprise risk management (ERM) that encourages carriers to consider “all the levers at their disposal.” “It’s not just aspiring to produce excellent underwriting results and managing client and portfolio dynamics, it’s optimisation of the investment portfolio in a low interest rate environment and learning to compete with and/or utilise the new forms of capital that have been attracted to the industry. The carriers who get the most out of all of the tools in their toolbox will win most often.” Players need to consider insurance, reinsurance and alternative capital within the context of this toolbox approach and apply capital and focus where they believe it will deliver the best results.
Conditions require close attention to the deployment of capital right across the group. As McGavick explained, “When setting budgets at XL we allocate capital to grow those products where we think the opportunities are best and accept that we may need to shrink to maintain our profitability in those product lines that are under pressure.” These demands are constantly shifting in line with developments in the cycle and the emergence or closing of opportunities, but the intention must ultimately be to “create a portfolio that is resilient and increasingly stabilises our earnings”, said McGavick.
D’Orazio explained that Allied World relies heavily on group-wide ERM to inform its view of the marketplace. By doing so the company can look to grow “those segments of the portfolio where we feel adequate risk-adjusted margins exist”, while for less attractive segments there is a willingness to “push rate and terms, or walk away from the business where necessary”. To ensure the success of such a strategy, Allied World’s underwriting managers are actively involved in the business planning process, he said, ensuring there is no disconnect between business planning and execution.
Key to navigating a way through tough periods in the cycle is the need to maintain underwriting discipline right across the group, explained McGavick. “There is a headline that we operate to all the time—technical underwriting discipline—that is an unchanging feature of the company.” And this discipline will at times manifest itself as a “willingness to walk away as conditions deteriorate around you”. McGavick said that at its height, XL Group’s reinsurance operations were writing around $3 billion of premiums. It is down to around $2 billion of underwritten premium today, providing a telling indication of the company’s “willingness to see our business shrink when market conditions aren’t appropriate”.
Ties that bind
There may however be instances where re/insurers continue to seek to nurture relationships in spite of prevailing market conditions. As McKevitt explained, “Regardless of the rate environment, relationships always factor into our underwriting decisions.” He said that Allied World closely considers the attributes of clients that may not be directly applied to pricing decisions. Losses are particularly significant, said McKevitt—“was a loss within what we would expect considering the event itself?” The ability to accurately estimate losses and communicate them in reasonable time to reinsurance partner is an important part of this relationship, he added. “Following an event is one of the best times to learn more about those companies you support. What we learn then will play a major role in our decisions regarding pricing and where we set our ‘walk away point’ on a particular company.” Relationships can—if conditions are right—trump market dynamics.
McGavick likewise said that XL Group works hard to establish lasting relationships with its clients. “While fads and new products come and go, deep trust is enduring. It will cause people to respect our mutual balance sheet needs and not just a point in time in the cycle.” Such relationships are incredibly valuable when dealing with challenges thrown up by the cycle and are proving a point of differentiation within the market. “We are seeing a tale of two cities—you either have the relationships and quality of underwriting to maintain lines even against this pressure, or you don’t. XL has that capability.”
McKevitt admitted that profitability remains the key determinant in its underwriting decisions. He explained that Allied World had been lucky that its goal of generating underwriting profits had coincided with its expansion as a diversified global re/insurer, adding that while there are opportunities for growth in the company’s existing book, “we feel the headwinds and set our expectations accordingly.”
The convergence challenge
The complications of cycle management have been further exacerbated by the recent influx of convergence capital into the reinsurance space. While most companies view this new capital as an opportunity, it is nevertheless exerting downward pressure on rates in those lines and geographies where it has found a home. This may be more a case of traditional players panicking in their rush to the bottom on lines they would likely not have lost to convergence capital, than the effect of that capital directly, admitted McGavick, but whatever the dynamic, it is changing the cycle.
McKevitt said that while alternative capital is nothing new, the way it is being brought to bear is. Whereas in the past it was directed at specific segments of the market without causing major disruption, things “changed rather quickly last year during the US wind renewal season”. He explained that traditional programme submissions “started arriving with varying percentages of them ‘pre-placed’ with convergence capital”. The impact of this new capital caught many by surprise—particularly considering markets such as Florida are “near and dear to most traditional cat books”.
As McKevitt explained, while there may have been some expectation that Florida rates would come under pressure thanks to another loss-free year, “the downward pressure was magnified and the cycle sped up as a result of this new capital”. Convergence capacity also helped to shorten the memory when it came to Superstorm Sandy, with US April and mid-year rates barely registering losses from the previous October, said McKevitt.
McKevitt said that convergence capital has served to extend, deepen and break up the momentum of the market cycle. Looking at conditions from the perspective of a traditional US property cat reinsurer, he said that convergence capital “broke up” what might have been characterised as a hard market at the start of 2013. The capital then proceeded to “deepen the ensuing soft market” right through from the mid-year renewals to the January renewals of 2014. McKevitt estimates that if this trend continues it will likely extend the downward cycle—although he agrees with McGavick in considering the downward pressure to be as much a product of perception within the market as tangible dynamics.
Not that it is all bad news. McGavick said that there are reasons to be bullish about the influx of new capital and what this may mean for the long-term development of new risks. “Attracting alternative capital implies that there is opportunity and profits to be made within the industry. I love being in a business that is attractive to capital,” said McGavick. The industry should view convergence capacity as an opportunity to unlock and find solutions to new risks, he said.
Putting capital to work
The cycle also throws up opportunities to put capital to work through share buy-backs—which have proved particularly popular among Bermuda players of late—and M&A. As McGavick outlined, share buy-backs have been an attractive option within the industry as profits have been good in recent years while firms have tended to keep their capital positions neutral—with many looking to “buy in profits”. He predicted that such a pattern will be sustained—XL Group having recently authorised a $1 billion share buy-back—although he suggested that re/insurers are keeping some powder dry in order to take advantage of potential opportunities in M&A and organic growth.
“There is a feeling that we could be hitting some kind of M&A period,” said McGavick, although he admitted that potential synergies are not without their challenges. Any acquisition is “fraught with peril” because the balance sheets of re/insurers contain considerable judgement and are often distinctly opaque, he explained. Such issues are of particular concern during soft parts of the cycle “when you need to have heightened wariness as you don’t know how much damage the cycle has done to an operation—and you may not know for some time”. Such moments in the cycle are a “treacherous time for M&A, but acquisition rises among the choices to create growth when the organic options are limited”, said McGavick.
This isn’t the end
While it is possible to establish an informed view of where the cycle is heading, McGavick warns against making predictions. “Cycles are about two big ideas—that you are constantly looking in the rear view mirror in order to establish a view of risk, and that you are able to know your own risk. With the rate that the world is changing accelerating, it is difficult to believe that the past will be as good an indicator of the future as it used to be. That implies that we will get it wrong and when we get it wrong, it will require a correction, and the degree of that correction will create cycles.”
He added that “to claim the death of cycles is to believe that we know our risk—I don’t believe that for split second”. McGavick warned that terrible and unforeseen events will continue to plague mankind and that when they do there will be an inevitable re-pricing of risk that will sustain the cyclical nature of insurance. While the maturity of the industry will mean that volatility will be less marked during much of the cycle, there will be no death of cycles, said McGavick. Instead the industry will continue to navigate an uncertain path—better informed and equipped—but inevitably subject to the whims of existing and emerging risk.