Capital management: reinsurers assume a defensive posture
How have 2010-2011 claims affected your capital management strategy? Is closer attention being paid to capital management in the current environment?
David Cash Industry losses over the last 18 months have been colossal, impacting both balance sheets and, to some degree, the way people think. For our part we suffered around $300 million worth of cat losses during the period, but positively we have grown our value per share by about 18 percent, and so we see recent events as significant, but not the sort that impairs capital. I think that as a result of events there will be some change in pricing—driven as much by model changes as by losses—but events have not proved to be the existential threat that is required to create a wholesale change in pricing. Rather, there is probably as much supply of capital today as there was 18 months ago.
William Pollett Whereas prior to the 2011 events we were very much in capital management mode, with excess capital being deployed to buy back shares at a discount, we are now taking more of a waitand- see approach to the rest of the year. Nevertheless, events clearly haven’t had a material impact on our balance sheet and we continue to have plenty of flexibility to write more business or to buy back shares and deliver value to our shareholders.
Stephen Manning I would argue that close attention to capital management is a core competency and so, despite the impact of first quarter losses, matters haven’t really changed in that respect. In terms of capital management, Solvency II dominates our life in London at the moment and is driving a lot of what we do. I spend about two days a week on Solvency II and that is all about risk and capital management and ensuring that you can meet the regulators’ expectations, while at the same time ensuring we are enhancing the value of our business. At its core Solvency II makes absolute business sense and the regime is driving thinking at the senior level: how do you structure yourself and how do you allocate capital.
John Andre From our risk-adjusted view of capital, the industry is still robustly capitalised. In fact only one negative outlook was issued as a result of first quarter losses, and we issued a few positive outlooks—the average rating for the sector remains a robust ‘A’ despite events in 2011.
Cash While the industry has done a good job in managing its capital, I think that reinsurance and some of the specialty lines are inherently cyclical. The cycle will ultimately turn when capital is destroyed or when people’s view of risk is changed. However, that event is still in front of us.
How has your investment strategy changed in the face of the low interest rate environment?
Cash At Endurance we are apprehensive about inflation, but at the moment that does seem a little misplaced given the fear of a double dip recession. In the main we are running our portfolio short with an emphasis on high credit quality and it is very much a US-centric portfolio due to us matching our assets with liabilities. We don’t have particular exposure to Europe today, but what is happening there may cause a change in debt markets globally, so not being there might not be protection from that. We are shorter than our asset-liability match would indicate and our asset-side approach is what you would term ‘defensive’. For many companies in our space the asset leverage we carry is less than that of other companies, we are 2:1 asset surplus to leverage. Many of the larger US casualty writers are at 4:1, so our portfolio requires less investment income than that of others and it enables us to take up a more defensive position.
Manning We have deliberately diversified our portfolio and have spent a lot of time on that side of the balance sheet. We have reduced our exposure to sovereign debt, which is principally US treasury and UK gilt, while at the same time increasing our exposure to corporates. Second, we have added a very small amount of high yield bonds and we have also moved into commercial property, hedge funds and small amounts of equities, diversifying our portfolio, but in a clearly defined risk budget. Again, it is a defensive play—with an emphasis on short duration—and is very much a capital preservation approach. The situation is helping to remind our underwriters that they don’t have investment income any more as protective capital.
Robert Quinn Corroborating the defensive position you have spoken about, I see increasing numbers of clients putting cash into trust accounts and simply leaving it there as cash. There is enough risk writing reinsurance—the last thing people want to lie awake at night worrying about is their trust money. Instead, in this troubled investment environment, we are seeing people putting their money into a trust earning zero investment return because if your cash is in a trust uninvested, you have a 100 percent FDIC guarantee on the balance regardless of size.
Andre After the US downgrade we stress-tested the Bermuda and US reinsurers for asset declines and as a group they fared well. There will be stresses emanating from southern Europe, but it seems that the threats will be largely limited to those geographies.
How significant a threat does the present sovereign debt crisis pose to the industry?
Cash From an asset perspective, because we hold a lot of highquality US fixed income assets, we have seen those actually increase in value, and that’s quite a contrast to where we were in 2008. And yet some of the events affecting the market are an echo of 2008. From the asset side we feel reasonably comfortable, but I do see this as being a real dampener on demand for our product. The cycle is about supply and demand, with the Holy Grail being reduced supply of capital at the same time that demand grows—that was the World Trade Centre and that was KRW. We are in a spot where capital bases are pretty solid and demand is suppressed and that really points to a tough few years. If $50 billion worth of losses in 18 months doesn’t change demand, what will? It is not so much an asset issue, as one related to market conditions.
Pollett But in this historically low interest rate environment, isn’t it inevitable that the situation will have an impact on some of the long-tail lines? When do you think that we will begin to see price hardening on those lines?
Cash We are going to see hardening in some places, but not in others. There have been modest price increases on smaller US accounts of 1 or 2 percent and there is a realisation that there needs to be some price rises. Also on excess and surplus lines losses tend to be a little catastrophic in nature—you either have losses, or you don’t have losses—but on these super long-tail lines the margins have historically been higher, from 20 to 50 percent, meaning that their ability to sustain price reductions is therefore greater. At the same time, we have seen significant price increases when people have realised that the cover they sold is dysfunctional or when people are landed with surprising loss accumulations—Enron and Worldcom, for example, caused very significant price changes on some of the professional lines. We all experience the general cycle, but individual lines all move in slightly different ways. For some of the core lines in Bermuda, absent catastrophes or the emergence of defective lines, I don’t see that sufficient pressure is there to prompt increases in the short term. But it has to happen—it’s like the law of gravity, right?
Is there concern within the industry that there may yet be a double dip recession and how are players preparing for such an eventuality?
Cash Yet? In the US we saved the debt at the expense of the recession. I don’t know if that was the tipping point, I just don’t think that the conditions for sustained demand are there. If I look at many Western economies, it is clear that they are unbalanced and it is my belief that they need to significantly reallocate their efforts in the economy—there needs to be a widespread retooling of the economy if we are to move away from present conditions.
Paul Markey The reinsurance industry’s risk management capabilities have proved to be considerably stronger than the wider financial world and I suspect that this fact has surprised a lot of people. Nothing works well without insurance and reinsurance—the reason people buy our product is the stability it affords—and I think that it would have been very well received had the same level of risk management been used in the banking fraternity. There are a lot of challenges in the global economy, with events there having an evident knock-on effect all the way up the food chain, so the prospect of a double dip recession tempers everything we do relative to events.
Which capital raising instruments have proved to be the most efficient in the current environment?
Cash It is essential to ‘keep it simple, stupid’. For our part, we have equity, some perpetual preferred, senior debt and have at times used contingent boards and what I’d call bridge capital in the form of cat bonds. On balance, I feel that some of the complexity that emerged across financial companies in the early part of this century has started to go away and people are pushing for simpler capital structures. Some of the structures that they have been using to try to conjure up capital by trading through liquidity pools is neither helpful nor productive. Firms are instead trying to wean themselves off contingent capital as it is more expensive than what they can achieve at the front end. The insurance-linked securities (ILS) market is more the domain of large insurers, than Bermuda reinsurers.
Markey From a broker’s perspective, the ability to raise capital in different forms has been aided by much better data, and while it is necessarily never perfect, most of our clients—whether they are insurers or reinsurers— have the ability to select from a pretty good array of products. We need very secure markets in which to sell products—that is fundamental—and when claims occur the ability to pay claims and to pay quickly is really the whole point of the exercise. And we have been pleased with how well capitalised and how flexible our trading partners have been.
Andre Capital strength goes a long way with us as a rating agency. If there is a need for capital, there are plenty of options now, far more than five years ago. And the reason that positive outlooks outstrip negative ones for the sector is that we recognise that the industry is soundly capitalised, with the ability to replenish if necessary.
Markey The element that offers a challenge for our reinsurance partners is the valuation question. Both existing investors and potential new investors are looking for a more rapid strategy, creating a slight dislocation in the equation, with capital tending to head for collateralised plays, industry loss warranties or sidecars in order to add book value. There will be a permanent place for that capital.
Cash Long term, our key investor is Fidelity, but on a day-to-day basis the person who buys our stock is very different. They may be a hedge fund, they tend to be very event-focused and so they are trying to understand how events play into potential returns. And at present they are very much de-risking. It is important for us to be public so that we can access capital should we need it, but at the same time we are exposing ourselves to a trading environment that is not necessarily as focused on long-term fundamentals as we might want it to be.
Pollett The old cat reinsurance model was to write lots of risk, make good returns, pay out when a big loss occurred and then raise more capital to take advantage of rising rates; that model has proved to be unsustainable in the long run. We cannot now expect to access the equity markets at a reasonable cost, and we definitely need to factor the high opportunity-cost of capital into our risk management framework and capital management strategy.
Have instruments such as sidecars, letters of credit and reinsurance trusts proved their worth in recent months?
Cash Letters of credit (LoC) are vital, and considering how difficult they were to get a few years ago, we are happy to have that capacity back. Sidecars are a harder product to work with. The attractive part for investors is that the structure is temporary, but it is hard to hold that capital at terms favourable to both investors and yourself—it’s a tougher balancing act. LoCs on the other hand are a great product— simple, straightforward, well priced. Sidecars are a complicated beast.
Pollett We learnt in 2008 that LoCs were not necessarily plentiful and cheap, and that they weren’t available at any price in some cases. As a result, we changed our strategy to include an alternative to LoCs, which is the regulatory trust. Once you get through the initial paperwork and regulatory filings, multi-beneficiary trusts represent an attractive cost-effective, long-term solution which is also advantageous to our US cedants. On sidecars, they can either be an opportunistic short-term play to take advantage of a particular market dislocation, or alternatively a longer-term component of our capital structure. Sidecars become a more permanent feature of our capital structure by aligning our underwriting philosophy and modelling capabilities alongside sophisticated third party capital who determine it is more efficient to participate through the underwriting cycle by partnering with a cat expert like ourselves than build their own capabilities from scratch. This type of approach provides us additional capital flexibility to navigate through market cycles and represents a win-win for our clients, our capital partners and our shareholders.
Quinn If you are getting good rates on LoCs, you are not alone, but you almost are. They are cost-prohibitive. Trusts on the other hand are being deployed as an alternative in the collateralised reinsurance and ILS space. For those reinsurers that are collateralising deal after deal you can pay almost nothing for a trust or you can pay a lot for a letter of credit. And by the way, those using LoCs are more often than not compelled to cash collateralise them. So they are putting up their cash as collateral, one way or another. I am simply suggesting that by using the trust in lieu of LoCs, one might eliminate most of the costs and all of the redundancies.
Do you expect to see greater emphasis on capital alternatives going forward?
Cash I feel that the period leading up to 2007 was the greatest period in terms of creativity in capital and contingent structures. It’s not that I don’t expect future evolution, but as a company we are comfortablewith our current structure and don’t feel that there is a void that needs to be filled with new products.
Pollett For the last decade we have heard how the securitisation of cat risk through the cat bond and ILW industry would destroy reinsurers’ margins, but that hasn’t come to pass—those derivative markets are still only scratching the surface in terms of providing real capacity. However, we are starting seeing a fundamental shift in demand for cat products from a different investor set—private equity and hedge funds were first, but increasingly longer-term investors such as pension funds and endowments are waking up to this attractive asset class. Cat risk is a great high yielding non-correlated asset class that fits really well into their portfolios. While this trend undoubtedly represents a significant longer-term threat to traditional cat reinsurers, it also represents a terrific opportunity to provide better access to these new investors. The challenge we face is to leverage our established franchise to provide access to these investors.
Cash If they can help you strengthen and support your business model, then they have a place in the industry; if they don’t, they are a competitor. If you consider how much of the industry’s income comes from the cat product, if you see a meaningful portion of that moving outside the industry, it would be incredibly damaging to our financial results.
Do you expect to see more share buybacks and the return of capital to investors in the coming 12 months, or do you think it unlikely in the face of 2011 claims?
Cash We’ll be doing some share repurchasing, but in modest amounts. This will be supportive of our stock price, although this isn’t the goal of repurchases. If you completely absent yourself from the activity, it is not a positive sign for investors. That said, the casualty market is entering a destructive phase and the idea that you would shrink your capital base at the point of greatest peril simply doesn’t make sense.
Pollett From our perspective, our primary objective is to build book value per share and when you are sitting there on excess capital and your stock is trading at a significant discount, the marginal benefit expected from allocating that capital to writing every extra contract needs to be weighed against the benefits you can get from buying back your shares. If we don’t see the market hardening at 1/1 wedefinitely will consider share buybacks. Active capital management continues to be an important part of our long-term strategy.
Andre We see prudent capital management as a product of cycle management. As a rating agency we look back over the last 10 years and can see how firms have fared in accumulating and returning capital. This view has led us to be confident in how the industry manages its capital position.
Manning The challenge when deploying surplus capital is how do you generate the return? We have explored opportunities in mergers and acquisitions, which is a significant part of our business model and is something that we are particularly good at, and we think that deploying capital to develop possible synergies can really enhance value to book. I also think that we will see a trend towards more private equity coming into the marketplace.
Cash I think that it may yet prove a challenge getting private equity in, if it exits at 0.7 of book value.
Markey For our part, we are pretty convinced that there is going to be greater demand for product in the near future, particularly in emerging geographies. A lot of that will be cat-related, which is largely under-insured or not reinsured at present, but once demand for re/insurance does free up, we believe that as an industry we really need to cut loose and take on that new business.
What is the key to maintaining the approval of the ratings agencies?
Andre Communication. I like to think we are transparent. We have a team in New Jersey that writes the lion’s share of the reinsurers and they are in constant communication with these gentlemen and their associates. If we have a question we will call them up and hopefully if these gentlemen have a question they will call us. We like to get ahead of concerns and our approach places us very much on the front line.
Finally, are we now in a hard market?
Cash In some places we see continued hardening, in others some softening. On the cat side I would expect to see some price increases at January 1 in Europe and the US—I think the safe range is 5 to 15 percent, or at least that is what people want. On other classes, particularly casualty classes, it is a little more varied. We see places where we are getting rate increases and equally others where we are not. My general view of thecasualty market is that it is a soft market bouncing along the bottom of a trough, but it is one that will take some while to correct.
Andre I guess you are never going to see a full hard market any more, you will see segments of hardening, but not the whole market any more.
Markey Until the insurance market sees further demand from the wider economy I think it is unlikely we will see a hard market in the terms of post hurricanes Katrina, Rita and Wilma or the World Trade Centre any time soon. There are going to be adjustments and there is some psychology coming from reinsurers that they would love to see US increases, but I just don’t think at the end of the day that we are going to see that.
Pollett No, outside of cat and a few pockets elsewhere, we are still in a soft and further softening market. In the catastrophe reinsurance markets, although there appears to be an adequate supply of capacity, it is all about fi nding a price that provides a high enough expected return for reinsurers to be willing to expose their shareholders’ capital. From the capital providers’ side, there is a general consensus that factors including model changes, losses and the increased cost of capital need to be refl ected in pricing. We expect cat pricing to correct upwards by at least 10 percent in January. We see no signs of a market turn in longer tail-lines and the best short-term scenario is that we continue to bump along the bottom until we hit a much-needed correction, which we expect will result from much pain and the return of fear.