Testing the water
The influx of so-called ‘alternative’ capital into the reinsurance space has raised many questions. Arguably the biggest of these remains unanswered: does this alternative capital really know what it is doing, and how will it respond to the big losses that will inevitably come?
As Larry Richardson, senior vice president at Arch Capital Markets, points out, the vast majority of alternative capital is lucky to have entered the property cat market during a run of benign weather years during which industry cat losses have been well below modelled levels.
“This has led many investors to expect high profits and that a given investment will roll from one year to the next, like purchasing a series of short-term bonds,” he says.
“We suspect that there are many investors who have not focused on the reality that models are imperfect and that a large event can cause a total loss. We also wonder whether investors are clear that while the exposure period may be one year, even if not ultimately used to pay losses, their capital may be retained for a number of additional years as losses develop.”
The speed and enthusiasm with which the capital markets have entered the reinsurance space may be evidence of naivety but it is important to view it in the context of the size of the capital market as a whole.
“Personally, and broadly speaking, I don’t think it’s naive at all—the capital market as a whole is much larger and much more efficient, and it’s a tough place in which to operate,” says Paul Markey, chairman of Aon Group (Bermuda).
“Most of the people from the capital markets who are looking at insurance objectives have accomplished an enormous amount in their own right. It’s natural for them to look at opportunities in our sphere.”
Tatsuhiko Hoshina, outgoing CEO of Tokio Millennium Re (TMR), takes a similar view. He agrees that five years ago there was a significant amount of naive capital, but believes that the picture has changed. He says the entry of new investors into the reinsurance space has to be viewed in the context of their entire portfolios, and the investors’ broad experience operating in the large and aggressive world of the capital markets.
“If you compare the size of the capital market against the reinsurance market, the investment that’s made to the reinsurance market is just a drop in the ocean from their point of view. The amount of capital that’s coming in seems a lot but if you compare it to what they have in total it’s only a few percent. It’s a small portion of a large portfolio, so it’s not a big investment to them.”
Hoshina adds that considerable reinsurance expertise is now being brought to bear in order to facilitate the investments from capital market players.
“You can expect to see more and more non-naive capital,” he says. “They know what they’re getting into; a lot of reinsurance experts are getting into play. We deal a lot with the hedge funds and they are definitely getting more and more sophisticated. They have people who have been working for the reinsurance industry, who know about reinsurance.”
The capital markets’ attraction to the reinsurance space is easy to understand: there is the low correlation with financial markets; the fact that insurance-linked securities (ILS) still generate more favourable returns than in some other financial markets; and the fact that during the financial crisis of 2008/09 all financial markets were negatively impacted, whereas the small ILS market stayed fairly stable.
Some reinsurers have responded quickly to the capital markets’ appetite: Hannover Re has engaged with capital market players from the start. It buys protection from ILS investors for life risks and P&C risks—not only recently but since 1994, when it issued the first catastrophe bond.
It also offers services to third parties—so-called ‘transformer’ services—to facilitate the transfer of reinsurance risks to capital markets. This includes catastrophe bonds as well as collateralised reinsurance, life and P&C.
“I don’t think it’s naive at all—the capital market as a whole is much larger and much more efficient, and it’s a tough place in which to operate.” Paul Markey
On top of this, as anchor investor in Leine Investment, a dedicated ILS fund domiciled in Luxembourg, Hannover Re also acts as an investor in ILS.
“This assures full integration into the world-wide ILS network,” says Henning Ludolphs, managing director of retrocessions and capital markets at Hannover Re. Ludolphs believes that most of the new investors know what they are getting into.
“Most ILS have built up expertise or bought expertise by recruiting reinsurance experts so generally they are informed,” he says. “Many ILS investors—and those who stand behind the ILS investors and provide the funding—have been in the business for a while by now and understand the consequences, including the probability of losses.”
Hannover Re has embraced this new source of capital, but other reinsurers are biding their time. Jed Rhoads, president and chief underwriting officer, property reinsurance for Markel Re, suggests it may be wise to look a little closer at the reinsurance expertise that is guiding capital markets investors.
“Some of the alternative capital companies are employing a number of people who have worked in the traditional space, but it appears to me that only a small handful have more than 20 years of individual underwriting experience in the US cat market,” he says.
“This is not a lot of underwriting experience relative to the amount of alternative capital (estimated to be around $30 billion) being deployed. Markel Global Re has seasoned underwriters, including one with 40+ years of property underwriting experience. If underwriters haven’t lived through a variety of US cat losses and underwriting cycles, that will likely lead to shortcomings when they analyse and price risks.”
Use of commercial models
Rhoads is also worried about the tendency for alternative capital to rely on commercial models and a number-crunching approach to pricing.
“Certainly not all alternative capital is naive but I think there is proportionately more naive capital in the alternative space than there is in the traditional space,” he says. “Much of the alternative capital comes from highly intelligent and highly quantitative people.
“However, most of them have not worked in the re/insurance industry, and I believe they are relying too much on commercial models. I don’t think underlying policy form differences, insurance to value, and varying ceding company claims handling practices, etc, are being adequately factored into their qualitative analyses.”
He tempers this by adding that obviously there are some very qualified underwriters in the alternative space, but adds that given the large amount of money being deployed, he perceives a general over-reliance on ‘black box’ underwriting rather than qualitative underwriting.
“Being a good underwriter is not all about the numbers coming out of a commercial model or a blending of commercial models. That’s not true underwriting, that’s ‘black box’ underwriting. Most traditional underwriters are not black box underwriters, but that doesn’t appear to be the case in the alternative space.
“With what we call black box underwriting you put the data in and it kicks out a number that solely determines whether the risk is adequately priced. They wouldn’t be pricing the business the way they are if they did more qualitative underwriting. The cost of capital differential doesn’t justify the pricing differences we’re seeing between traditional and alternative capital.”
When the big loss comes …
Rhoads says that, because of the lack of detailed qualitative differentiation between cedants, he is not convinced that alternative capital is going to perform post-event exactly as advertised.
“Until it’s been tested by three or four major US events, we have some concerns about its viability, performance and how long it’s going to endure. If there were more grizzled underwriting veterans working in the alternative space, I would have a different view.
“There appears to be a lot of really smart, aggressive, yet somewhat inexperienced people from the US cat side who are throwing out very large lines, but may be lacking some of the qualitative underwriting skills that only come with experience.”
Markey predicts that some areas of alternative capital will fare better than others, and that those who work with experienced advisers or cedants should do very well.
“It’s going to be really interesting to see how people feel about event losses as and when they occur, but I don’t worry about it or think there’s any chance that all the alternative capital will disappear.
“The traditional re/insurance market has, over many years, proved itself able to respond to a wide variety of events, and maybe, when an event occurs, one or two areas of the alternative side will be shown to have had some naivety in their strategies.”
Markey adds that the scale of the capital markets means there will not be any long-term diminution of capital. What is perhaps less predictable are events in the financial world—such as the fall in oil prices—that are nothing to do with insurance but are global or systemic.
“Until it’s been tested by three or four major US events, we have some concerns about its viability, performance and how long it’s going to endure.” Jed Rhoads
“Those sorts of issues are external to the insurance industry, but will they have an impact? Perhaps temporarily.”
Ludolphs believes some of the new investors will be deterred when they experience a big loss, but that this kind of investment will endure regardless.
“Not all investors are in the market for reasons of asset diversification but for relative better returns compared to some other financial markets. Some of these investors may leave once interest rates go up.
“Nevertheless, in our view this will not have a major impact on the ILS market, as others may be waiting on the sidelines to come in, in particular when reinsurance pricing goes up as a consequence of the big loss.”
So who will stay, who will go, and who will move into the space following a loss? Richardson anticipates that the large pension funds that have a small cat allocation with a long-term investment horizon are likely to remain after the inevitable losses, and have the mindset and financial resources to replenish their investment accounts. Smaller institutional investors, on the other hand, may have a harder time replacing trapped capital, and would seem more likely to reduce exposure after a large loss event.
“Retail investors who accessed cat risk through recent mutual funds similarly may not have the mindset to make additional investments after losses,” he says. “Less sophisticated investors may not have focused on the fact that, unlike an equity mutual fund that could regain value, once the losses occur in a cat fund, the capital is truly gone.”
He says one question that will not be answerable until after a large loss event is whether this alternative capital would have best been deployed alongside a traditional reinsurer, such as Arch, which underwrites and retains a meaningful share of the same risks with its own capital, creating a strong alignment of interests.
Hoshina agrees that the real question is not how long the capital markets are here for, but how the industry can best engage with them in the long term.
“Some of the players may change once we have, say, a $100 billion US hurricane industry loss but some players will see it as an opportunity—so while some pull back, others will come in. The capital markets in general are here to stay—it’s more about what we as reinsurers are going to do with the entry of the capital markets.”
Bradley Kading, president and executive director of the Association of Bermuda Insurers and Reinsurers (ABIR), believes the answer is growth.
“Alternative capital has converged with traditional capital and is here to stay. The challenge for our business is to grow markets. We do that in the developing world by working with policymakers to move risk out of government funds into the private sector.
“Florida and Texas property residual markets are examples of this and the UK Flood Re programme is a good example in Europe. In the developing markets we have to increase insurance penetration, get those skyscrapers in Shanghai insured, as an example, and expand crop insurance, etc.”
Proceed with caution
Rhoads believes that while the future of alternative capital within the reinsurance industry is not in question, the way it can best be deployed will be decided in the light of future big losses.
“There’s a place for alternative capital and whether it continues to expand at its current pace will depend largely on how well it performs after US cat events. Until it’s proven, the market is going to be cautious about deploying heaps more alternative capital.”
However, there is no doubting the impact the capital markets are already having on the industry. Take the rise of the sidecar for instance: Hoshina says that the relative ease with which money can be removed from a sidecar means that these will increase in popularity, while new reinsurance companies are few and far between and will struggle to survive in a soft market environment. In light of this, he believes, new business models and diversification will be the key to engaging with the capital markets in the long term.
“If you’re a monoline writer, writing cat business it’s no longer profitable enough to be sustainable as a company. That’s how much the market is being squeezed—while TMR originally was established as a monoline property cat underwriting facility, we decided to diversify to other non-cat lines of business in 2010 and are now into the casualty arena.
“I personally think the business model for the property cat segment should be more like an investment bank: we take the risk, package it and cede it to third party capital while taking commission. This business model makes more and more sense to me at this period of the cycle and I believe will succeed going forward.
“The property cat business is no longer producing the profits it did in the old days. It adds a lot of volatility to the portfolio. If the margin is large enough, the volatility can be accepted but if it’s thin it takes up too much of your capital without the required return, so by ceding it off to third party capital and taking a fee out of it, it reduces the volatility of the portfolio. You may not have the high upside in years without major cat losses but you don’t have the big downside.”
Hoshina adds that TMR is working to balance its earnings using Tokio Solution Management, its management vehicle which acts as a conduit between the capital markets and the reinsurance market.
“We are increasing the fees and stabilising our earnings by reducing volatility. You take the risk, restructure it, cede it out and arbitrage it.”