Nimble and opportunistic
Few would dispute that the current cycle is proving a tough one for reinsurers, with an abundance of capacity and thin investment yields creating a perfect storm of lower returns. Re/insurers have sought to navigate a route through these turbulent seas in a number of ways, but for Arch Capital its group approach has been one led by innovation.
Whether it is through innovative structured insurance policies alongside government-sponsored enterprise (GSE) mortgage risk transfer notes, or the launch of Watford Re, Arch Capital Group has sought to deliver creative solutions to the market during a tough and protracted soft cycle.
As Arch Re CEO Marc Grandisson explained, Arch Capital Group sets itself apart by its disciplined approach to underwriting risk and deployment of its capital. “Our approach is that we allocate capital where the market needs it most and is willing to provide a fair return, rather than where we allocated capital five years ago.”
Arch tends not to compete in markets where there is a “frenzy of excess capital”, but prefers instead to allocate capital in areas where it sees opportunities and dislocations.
“We don’t have a pre-set notion of what we need to write—we let the chips fall where they land,” said Grandisson. Helping to drive this strategy is a nimbleness of approach that enables Arch to make timely decisions regarding its underwriting intentions.
“We don’t take a traditional committee approach to our underwriting allocation decisions and we don’t need a huge lead time when it comes to decision-making. If you take a committee approach the opportunity may have already passed by the time a decision is cast,” he explained.
The launch of Watford Re in March 2014 is one example of the innovative approach Arch’s team has taken to the current low yield environment. As Grandisson explained, Watford Re is there to overcome the disconnect that is apparent between the return on equity (ROE) expectations of insurers (typically 8 to 10 percent ROE) and those within the reinsurance space (typically 12 to 15 percent ROE), which has served to hinder the ceding of risk.
“Primary players retaining more risk are our number one competitor. Over-capacity is as evident in insurance as it is in reinsurance.” Watford Re aims to overcome this issue by enhancing ROE generated from underwriting, explained Grandisson, by buoying up the net position through an investment strategy that assumes more risk than the industry’s traditional high grade fixed income strategies.
“Within the Arch structure we have a certain level of leverage on underwriting and investment, with the emphasis on the underwriting side, supported by our investments. Watford Re recasts the relative balancing of risk, taking more investment risk and less underwriting risk. There is an area where Watford Re can get to 15-plus ROE, while presenting clients with an underwriting position that they can feel comfortable with.”
By working with Watford Re insurers can improve their net positions where their ROE expectations are the same, Grandisson explained. It is an opportunity to “generate greater investment return, but account for it through the underwriting line”, said Grandisson.
“I would argue that this is more valuable for cedants. If they can leverage Watford Re’s capabilities, they should be able to improve their combined ratio. In an environment where it is hard for an insurer to differentiate itself on the investment side, the strengthening of its underwriting performance could be all-important.”
Watford Re will be able to create these innovative solutions by investing in fixed income assets, which provide more cash flow and less mark-to-market risk than other riskier investment strategies that depend upon capital gains within the equity markets, explained Grandisson. While Watford Re’s approach will inevitably mean more conservatism in underwriting, he believes that there is a significant middle segment of the market where cedants would like to benefit from Watford Re’s more closely balanced underwriting and investment risk.
Grandisson described the market’s response to Watford Re as having been very positive, adding that Watford Re is a “huge arrow in Arch’s quiver”. He said that Arch believes the solution is sustainable beyond the current soft cycle and will help to unlock opportunities among cedants who have not traditionally looked to the reinsurance market for solutions.
Working with GSEs
Arch continues to develop innovative approaches in working with GSEs such as Fannie Mae and Freddie Mac to expand the insurance component of its mortgage credit risk transfer programme to complement Fannie’s Connecticut Avenue Securities (CAS) and Freddie’s Structured Agency Credit Risk (STACR) cash notes.
As Grandisson explained, there was a bipartisan agreement in Washington and at the Federal Housing Finance Agency (FHFA) that federal programmes should transfer more credit risk to the private sector, be that in derivative or insurance form. CAS and STACR are unsecured general obligation debt notes that enable the GSEs to transfer credit risk from single-family mortgages to credit investors who invest in the notes.
The GSEs retain a vertical slice of the risk of each transaction sold to investors and are attempting to develop an efficient insurance market to obtain coverage on a portion of their retained risk. Freddie Mac has obtained such insurance coverage alongside the first two of its STACR transactions.
As Grandisson explained, “Mel Watt, director of the FHFA, recently told Fannie Mae and Freddie Mac to triple the amount of credit risk transfers this year, with insurance structures likely to form a significant component of that need.”
Watt told Fannie Mae and Freddie Mac to transact credit risk transfers on single-family mortgages with at least $180 billion of unpaid principal balances. It is apparent that Arch will continue to work closely with the GSEs and FHFA, but the scale of the opportunity will also create considerable business for the wider Bermuda market.
“More public-private partnerships on mortgage risk are going to happen over the next two to three years. There is a real desire to create markets and use the private sector to diversify mortgage credit risks that fell on to the government balance sheet in 2007 and 2008.”
Complementing its work with the GSEs and FHFA—but independent of insurance coverage alongside STACR transactions—Arch acquired CMG Mortgage Insurance Company and the operating platform of PMI in the US in the first quarter of this year, creating Arch Mortgage Insurance Company in the process.
Currently there are only seven players in the US mortgage insurance industry, with Arch among the most highly diversified and highly rated companies in the sector. Grandisson noted that Arch’s new mortgage business expands Arch’s already diverse portfolio of insurance and reinsurance businesses, while helping to augment the analytics on its structured transactions alongside GSE credit risk transfer notes.
It seems that the current cycle and an uptick in M&A may create opportunities for Arch to add to its bench of expertise, and Grandisson sees considerable potential to add talent. “Arch is a compelling home for individuals and teams who are rewarded for the quality of their underwriting and their ability to generate value for our shareholders.
“Consolidation frequently leads to a certain level of business restructuring and that can create opportunities for those companies on the look-out for talent,” he said.
Looking ahead Grandisson sees opportunities for Arch in global mortgage insurance risk, building on the successes it has achieved in the US. The company is also expanding its life operations, which are becoming an increasingly significant part of the group’s activities. Arch also continues its pursuit of P&C business, although with an increasingly insurance-led focus during this period of the cycle—“although that could change in six months”, admitted Grandisson.
He said there is also potential for geographic growth, with deals such as its 50 percent stake in Gulf Re indicative of the company’s ambitions to develop into new and emerging geographies. And Grandisson reiterated the company’s interest in the potential of new teams as it develops new and exciting opportunities within the re/insurance market. With its track record for innovation, you wouldn’t expect anything less from Arch. n