Gambling on stock repurchase
Reinsurance, at its simplest, is a form of capital. For the company that provides reinsurance, the rules are no different from those any capital provider faces. The intricacies of reinsurance surely differ from those at work in, say, the capital markets, but the goal and many of the techniques are the same.
In the past couple of years, the availability of capital has been a major factor weighing on all businesses, but especially on the reinsurance community and the Bermuda majors. With liquidity sources all but frozen, capital management was, on one level, simplified: holding on to what you had was pretty much the game.
When the liquidity crisis began to ease, reinsurers faced a different equation. In summary, the dilemma became: should we hold on to capital in excess of forecast requirements, in case a situation of short supply were to reinstate itself, or should we return the excess to shareholders, since, by its very excess nature, the capital would act to deflate return on equity?
For property catastrophe reinsurers, or those whose overall book is weighted in that direction, i.e. many of the large Bermudian players, the need to find the correct answer to that question was, and remains, acute. The volatility of their business is a significant factor. An event with economic ramifications akin to those of Hurricane Katrina or the events of September 11, 2001 could make a major dent in the capital buffer.
As the Atlantic hurricane season of 2009 approached, with liquidity hard to find and expensive when found, reinsurers were forced to negotiate a tricky path: a major loss might require them to raise capital in a market that had little to offer at a price short of outrageous. The 2009 storm season proved less costly than average, and by the time the losses incurred in the first six months of 2010 were tallied—andproved to be probably the most expensive first half on record for the prop cat sector—liquidity was a little more widely available.
A different capital management problem existed by then. The retention of excess capital that saw the Bermuda majors through 2009 was no longer as easily justified. None of the companies considered returning every excess dollar to their owners. A smaller cushion remained the common-sense approach, which meant analysing ways in which to return excess capital.
Most of the major Bermuda reinsurers are valued by the stock markets at less than book value. Although some obvious reasons present themselves in a post-recessionary environment, the fundamental logic for this persistent undervaluation remains largely unclear. It presents the companies, however, with an opportunity. Buying back one’s shares has the combined effect of reducing their availability, thereby artificially increasing demand, paying down the capital cushion and recording a gain, all in a manner that enables the well-managed company to maximise the economic effect of such a programme.
It has come as no great surprise, therefore, that many of the Bermuda companies have introduced share repurchase programmes, or enhanced existing repurchase mandates. On March 9, Brad Kading, president of the Association of Bermuda Insurers and Reinsurers, said that the organisation’s member companies were “returning an estimated $7.2 billion in capital to their shareholders via stock buybacks”.
That number has probably since risen to nearer $10 billion, as the following selected deals announced since Kading’s statement show:
• May 6: The board of Allied World Assurance Company Holdings authorised the repurchase of up to $500 million in the company’s• May 18: Flagstone Reinsurance Holdings, having repurchased more than five million shares under its existing repurchase programme, approved the potential further repurchase of an additional $50 million in shares.
• May 18: The board of RenaissanceRe Holdings approved an increase in the company’s stock repurchase programme, bringing the total current authorisation to an aggregate of $500 million.
• May 20: Assured Guaranty announced the repurchase of 707,350 common shares of its common stock, completing its two millionshare repurchase programme authorised in November 2007.
• July 22: Platinum Underwriters Holdings increased the amount authorised under its existing share repurchase programme to a total of up to $250 million of its common shares. This represented an increase of about $150 million from the $100 million remaining in the programme.
• August 4: The board of Assured Guaranty authorised a new two million-share repurchase programme.
• August 8: Allied World repurchased $250 million of its common shares from affiliates of The Goldman Sachs Group, founding shareholders of Allied World. The repurchase represented about 9.4 percent of the company’s diluted common shares outstanding as of June 30. The repurchase was executed separately from the $500 million share repurchase programme authorised in May.
• August 11: The board of RenaissanceRe Holdings approved an increase in the company’s stock repurchase programme, bringing the total current authorisation once again to an aggregate of $500 million.
• August 25: OneBeacon Insurance Group declared a special dividend of about $236 million.
• August 26: The board of White Mountains Insurance Group authorised the repurchase of up to an additional 600,000 common shares, in addition to the company’s existing one million-share authorisation (of which about 840,000 shares had already been repurchased).
It has been pointed out that, by returning such significant sums to shareholders, executives are betting against heavy losses arising during the Atlantic hurricane season. Should 2010 be marked by an insured loss on the intensity of Katrina, many of the companies that have been buying back their shares may need to dip into the capital markets to replenish their firepower.
“That’s not the point,” said a senior financial executive of a major Bermudian reinsurer, who asked for anonymity since he is not authorised to discuss such matters. “You have, let’s say, half a billion in excess capital at a time when the interest rate is zero. If you keep it, you have to invest it in fixed income, at maybe two percent, or equities, at a time when volatility has the markets all over the place. Either way, your performance is potentially dragged down.”
The executive continued: “So you pay it back, on a schedule and at a price that suits you, with the opportunity to manage, to an extent, your earnings per share—although that’s a bonus, rather than the point of the exercise.
"Buying back one's shares has the combined effect of reducing their avaliability, thereby artificially increasing demand, paying down the capital cushion and recording a gain, all in a manner that enables the well-managed company to maximise the economic effect of such a programme."
“OK, now say events occur in the second half of 2010 that leave you short of capital. You have to top up by borrowing in a market that will supply capital on such occasions, and not at the murderous rates applicable two years ago, or even one year ago. Have you lost money on the cost of the repurchase programme and then the cost of the recharging programme? Sure. But those costs are tiny compared toyour losses, so no one notices. They are the cost of doing business. Idle capital results in the cost of not doing business. This is not a difficult equation to sell to your CEO or the board. Their job is to do, not to watch others do.”
The executive concluded: “And, of course, if the 2010 Atlantic hurricane season is relatively benign and the insured corners of the earth don’t shake, you’re a capital management genius; your company has not failed to keep up with its competition; and everything is hunky dory.”
The true test of management is not how it performs when the going is good. Reinsurance management is a special exercise in that regard. No two catastrophes are the same; each causes problems that cannot be anticipated; volatility, the bane of business, is a given; and almost nothing one learns from an experience can be brought to bear on the next one. The industry is anti-cyclical, making standard judgement less useful than it is elsewhere.
Giving back capital at a time of restraints in the flow of funds feels wrong, but almost everyone in the reinsurance field is doing it. As has been explained above, it is the best course of action, or perhaps the least of all evils.
The buyback is more attractive to some executives because of its flexibility. Special dividends are one-offs, and they can create larger tax liabilities in the hands of the recipient. It is usually fair to assume that companies have consulted with their shareholders before the payment of a special dividend, which is taxed in most jurisdictions as income. Shares sold to a buyback programme usually create capital gains, which are most often taxed at a lower rate than income.
The need to hand capital back, of course, follows a period of successful management, tied to a succeeding period of more difficult market conditions. The successful share buyback programme or special dividend completes the cycle that began with a shareholder’s investment. It is the original act of faith in management, repaid.