Bermuda's prospects: achieving success in adversity
The challenging environment for Bermuda’s re/insurance market came under the microscope at the Ernst & Young Property/Casualty Year-end Outlook 2010, held at the Fairmont Hamilton Princess hotel on December 9. The conference opened with a CEO panel featuring some of the leading lights of the industry, who took part in a frank discussion on what is proving to be a difficult period. The group touched on the difficulties of achieving growth when faced with the combination of a lingering soft insurance market and low interest rates, the likely impact of Solvency II and how Bermuda is standing up to increasing competition from rival domiciles. The discussion was moderated by Jonathan Reiss, a partner with Ernst &Young Ltd. in Bermuda. A summary of the wide-ranging conversation follows:
Jonathan Reiss: Given the state of the US economy, depressed asset prices generally and premium volumes decreasing, growth for the industry is a challenge. Under these conditions, is growth an achievable target?
Michael Price: Revenue growth is not what matters most. It’s not the top line and it’s not the bottom line either. In my view, it’s the growth in tangible book value per share of your company. That’s what you should be seeking to grow. With revenue growth, you have to take into account the potential rewards and risks. You have to take into account market conditions, the company’s capabilities and your attitude toward risk. Just as with trying to grow tangible book value per share, but in the latter case, you have more options, because it involves not just your underwriting strategy, but also your investment and capital management strategy. It’s the metric that, I think, most closely approximates the value of your company and tends to track most closely with the share price over time.
Just by example, our company, since 2005, has decreased premium revenue by more than 50 percent. Yet tangible book value per share, during that same time, has more than doubled. We do care about growth, but it’s not revenue growth we’re focused on, it’s growth in book value.
Marty Becker: There’s no doubt that growth is tough right now. The industry, as a whole, has probably had two or three years of net premium shrinkage, which is almost unprecedented. We have the combined headwinds of a pricing market that hasn’t reached the bottom yet and a customer base where sales and payrolls are depressed. That inhibits growth.
I agree with Michael in terms of the focus on book value growth.That being said, you can’t grow your book value indefinitely unless you grow your top line. You can do it for a period of time, but to be sustainable, businesses need top-line growth.But in our industry, there are times to grow and times not to grow. Growth is going to be penalising at certain stages of the market cycle and that’s where we find ourselves today—particularly with companies in Bermuda being heavily focused on reinsurance. Reinsurance is a much more accordion-like business. It expands quickly in good times and it shrinks quickly in tougher times. There probably aren’t many companies here that will grow their top line in 2011.
David Cash: Endurance has made the choice to be a diversified player, because we believe that, financially, this is a robust model that will afford us opportunities to grow. We’re a diversified organisation— we have three reinsurance groups and four insurance groups, and at any given time, some of those operations are growing while others are shrinking. I don’t personally believe in the strategy of shrinking to greatness, but shrinkage is a normal part of the economic cycle that our industry understands and accepts. That said, there are a few re/insurance companies that are relatively new to the market that are under real pressure to grow to ensure their relevance. That probably is a necessary part of the strategy of building a start-up, but it’s a particularly high-risk strategy at this point in the market cycle.
Peter Porrino: Cycle management is all about growing at the right time. When I talk to companies today, some of them look at the market and comment that it’s not really robust, but they feel that this is exactly the right time to invest. They are saying: ‘We’re going to come out of this and I don’t want to be building my teams at that point. I want my teams in place, so when the market turns I can hit the accelerator.’
Jonathan Reiss: Can the industry underwrite profitably in this environment of extraordinarily low interest rates?
Peter Porrino: The reserve releases have been talked about considerably and they show that we didn’t really realise how hard the market was. This is the gift that keeps on giving. This year, it’s worth about eight points on the combined ratio. That’s a huge impact. Personally, I think it’s going to stop sooner rather than later, although when you look at the trends, the reserve releases are decreasing at a slow rate. With that taken out, you’re looking at about a 95 percent combined ratio for the market and a return on equity (ROE) of 6 to 9 percent.
David Cash: You can underwrite profitably with appropriate discipline, but not all lines are created equal. Casualty is particularly challenging to manage through the cycle—it’s the source of the cycle. Short-tail business is not really subject to the cycle to the same extent as casualty business is—you have somewhat stable pricing, punctuated by events. Today, I think most re/insurance companies are significantly more diverse for that reason. Looking at our book of business, it’s roughly a third short-tail property with a pronounced skew toward catastrophe-exposed risks. A third is specialty, which in our case includes aviation, personal accident, surety, crop insurance, and a few other lines. The balance is casualty insurance and reinsurance.
My own take on this is that the property book is capable of generating returns of 10 to 15 percent, if you’re willing to take catastrophe risk. In the specialty book, our margins have been relatively stable over time and we’ve never had a loss year. If we could write more specialty risk we would, but it’s a hard business to access. Again, you’re probably looking at double-digit returns in the current accident year.
Casualty is a different story—you have to expect you’re in singledigit territory. Why do you stay in that marketplace? The business has been profitable in the past and you believe that when you have a client for a period of time you’re likely to keep them. Client retention in the casualty business is about 80 to 90 percent. That said, I think most people in this marketplace are trying to skew themselves awayfrom casualty, because the cycle’s more pronounced there. As long as you can diversify your book, I think that now is a perfectly fine time to be underwriting.
Marty Bec ker: When you look at where you are in the underwriting cycle, it’s like the guy who sees the light at the end of the tunnel and it’s the train coming at you. If you take out the reserve releases, which don’t last very long at this point in the cycle and you continue to roll over the duration on your investment portfolio, it doesn’t take long for a 9 percent ROE to become mid single-digit. While that may not be a 2011 phenomenon, we may see it in 2012.
The temptation now is to write more property catastrophe. It’s theoretically the best priced business in the marketplace. At the same time, how many more years are we going to go without a major hurricane in the US? That extracts capital pretty quickly from the system.
The market will change; it’s just that nobody knows when. It’s a very tough time to be managing these companies and it’s also a tough time as an investor in this marketplace. That’s why you see investor interest in Bermuda companies at an all-time low. Most people are trading a fraction of the daily volumes they were trading a few years ago and everybody’s trading at a discount to book. That means the investor world is voting that none of us have any value. We’ve got capital and all these underwriting teams, and investors are saying that the dollar is worth 80 cents.
Michael Price: The margin for error in the casualty market is a lot lower now than it was in the past. If you construct your balance sheet so you have a minimal level of investment risk, only the risk that you’re being well compensated for, and you’re confident in your reserving for your unpaid claim liabilities, then I think you should take that dollar of capital and buy back that share at 80 cents on the dollar and side-step some of the risk we’re seeing here.
Jonathan Reiss: Many Bermuda companies now are diversified multi-line companies. What are the challenges of diversification?
David Cash: The Bermuda insurance and reinsurance products are two of the most profitable products in our industry, so it begs the question why you’d want to go beyond Bermuda and build a diversified business on-shore? Our motivation is simple, even as the Bermuda products are profitable, they are both volatile and cyclical, which means that while the returns are high on average, it is possible to have years when one’s results can be significantly down. At such times, even a very profitable Bermuda company can be vulnerable and will likely lose market share to the more diversified underwriters that might weather those events better. Hence the focus at Endurance is on a diversified underwriting model.
Three challenges of diversification stand out to me. Firstly, moving abroad is expensive. Opening operations in London and Zurich costs money. If you try to build out an admitted insurance platform in the US, it’s not a cheap or quick exercise. We started that journey six years ago and we are just now feeling that we have arrived. Secondly, while the barriers to entry in Bermuda are low, in general, overseas insurance markets are harder to penetrate and, as a consequence, you either have to be extremely patient or you must be willing to enter into mergers and acquisitions which imply greater risk to the company. Finally, when a company makes the shift from being a focused local player to having many offices around the world, its internal governance processes need to become significantly more robust. It changes the culture of your organisation and you risk becoming less entrepreneurial.
Jonathan Reiss: What are your predictions for mergers and acquisitions (M&A) in the marketplace in 2011?
Marty Becker: If we had as many transactions as we had conversations about M&A, then we’d be trading deals every week. The deal that Max did with Harbor Point was the headline transaction in 2010, but there’s been lots of small M&A. In fact, by the number of transactions, it’s been a pretty active year.
When you’re trading at 80 percent of book value, then M&A is really tough, because sellers don’t want to sell at those prices and buyers can’t afford to pay much of a premium. If you consider M&A, there’s a lot of reasons why there ought to be more. Frankly, a little more M&A would probably be healthy for the market, in terms of the supply and demand equation.
The transaction we did with Harbor Point to create Alterra is simplistic on paper, but it’s tough, because it’s not really a financial transaction. It comes down to how we work together to make a better company. In our case, I think the jury’s still out. Our stock’s about where it was when we did the transaction. Is it going to be worth more? We really think it will be. We think we’ve got a much better platform, additional scale on the balance sheet and more underwriting depth, but the outside world hasn’t paid us for it yet.
The smaller cash transactions are pretty easy. You have a clear buyer and seller. One party wins in terms of incremental value, the other party wins in terms of extra scale or expertise within the organisation. The challenge is that there are fewer smaller entities. If you’re looking at the US today for a company of anything under a billion dollars, then your list might have 20 names on it, maybe 15. Half of those are in business lines you don’t want, or businesses that you don’t think are that attractive. So M&A are easy to think about, but tough to execute.
Michael Price: We have an opportunity to consolidate in this industry and achieve two major financial objectives. One is to remove duplicative costs from the system; the other is to gain capital efficiency and return excess capital to shareholders. I don’t think it will develop into a wave of M&A, and despite the fact that it should, it won’t. The Validus acquisition of IPC made a lot of sense to me. You eliminated expense and you took capacity out of the market. We need more of that, but I don’t think it’s coming.
Peter Porrino: If you look at all areas of financial services, you’ll see that the top 25 percent of players are controlling about 80 percent of the market. In personal lines insurance, it’s the same. But you look at commercial lines insurance and it’s the complete opposite. It’s begging for consolidation.
Jonathan Reiss: Bermuda has qualified for the first wave of third-country equivalence assessment for Solvency II. Will it pass the test and will it be an advantage?
David Cash: I’ve been very impressed with what the Bermuda Monetary Authority (BMA) has done. There’s always a fear of protectionism, but I believe the process is being administered thoughtfully and not in an overly political manner, and I believe we’ll get to a reasonable result. I don’t think anyone seeks to be regulated, but when it comes to solvency and capital adequacy, I believe that the Bermuda companies are better able to adjust to and thrive in such an environment than almost any other type of company in the P&C industry.
Mart y Becker: I think the BMA’s done an incredible job in a quickly changing regulatory environment. I have no lack of confidence that they’re going to achieve equivalency. It’s going to change our world a bit down here in terms of regulatory compliance.
Peter Porrino: In my view, jurisdictions selected for the first wave of assessment are expected to be successful.
Jonathan Reiss: What is the one thing that Bermuda can do to improve itself as a domicile?
Michael Price: We have looked at alternate jurisdictions, as I’m sure everyone has, but we have concluded that for our business model and under current market conditions, Bermuda is the optimal place to be. So we intend to be here for the foreseeable future.
We have observed an increase in crime in Bermuda over the past five years and that’s not a problem that we, as an international business, can solve. It’s a problem that rests with the governor and government here in Bermuda. And I believe there is a will and a desire to address this problem. It might be provocative to suggest that it’s the most pressing issue, but I don’t think Solvency II is the most pressing issue, because we’re making great progress on that. I don’t think the international competitiveness of the companies domiciled in Bermuda is the issue, because we’re all doing well on the global competitive landscape and our shareholders are prospering. The question is, ‘how sustainable is this in the long run?’ It can be sustainable, provided we can provide for the security and well-being of the people we necessarily have to employ and have reside in Bermuda. We need their spouses and families to feel good about coming to Bermuda.
Mart y Becker: Alterra made a conscious decision when we did our merger to remain domiciled in Bermuda. We looked at other domiciles around the world that were becoming popular. Based on the way the world is shaped today, and the laws and regulations in the various domiciles, we continue to feel that, for our type of business, this is the most attractive domicile within which to operate.
We need to stay competitive on the regulatory side. But, as Michael pointed out, these are people businesses. The ability to attract and retain intellectual talent in Bermuda will be the key competitive differentiator. So anything the government can do to make Bermuda an increasingly attractive place to live and work and raise your family will be the necessary factor for Bermuda to retain its competitive edge.
David Cash: There are clearly moments when companies think about restructuring and moving their companies to another domicile. What keeps us here as a financial entity is the size, significance and profitability of the Bermuda reinsurance and insurance markets. They have been, and I believe will continue for some time to be, attractive and profitable markets. For that reason alone, many things would have to unwind for us to think seriously about redomiciling our organisation.
My own perception is that the Swiss model and the Dublin model have many challenges that aren’t fully appreciated. For example, there are some restrictions on buying back stock—and one of our value drivers has certainly been stock repurchase. I’m not convinced there is a better mousetrap in our market today than Bermuda. I think that as a domicile, we’re doing a good job of managing tax risk and regulatory risk, and we have two of the great markets in our industry here.
Peter Porrino: There are not that many insurance talent hubs globally. This is probably the second one in the world—London and then Bermuda. That’s one of the key competitive strengths of Bermuda. If you lose that, you can have all the Solvency II equivalencies you want, but without having the talent here—the people who I think have made Bermuda what it is—then it won’t succeed.
For more information about Ernst & Young’s annual Property/Casualty Year-end Outlook or our services, please contact Jonathan Reiss, partner, financial services, Ernst & Young Ltd. at: firstname.lastname@example.org or visit: www.ey.com/bermuda
The views expressed here are those of the participants and do not necessarily reflect the views of Ernst & Young Ltd., Bermuda.