The road ahead - an outlook of the P&C market
Chief among concerns troubling the sector is the lack of returns traditional rated reinsurers can achieve on the investment side of the balance sheet, which—coupled with the demands of regulatory capital—is helping to drive the rise of alternative capital. That was the view of John Berger, CEO of Third Point Re, speaking at the event in Hamilton.
Berger, who was joined by David Cash, CEO and president of Endurance and Brian O’Hara, former CEO and chairman of XL Capital, on a panel moderated by Pete Cangany, partner and insurance sector leader for Ernst & Young’s Bahamas, Bermuda, British Virgin Islands and Cayman Islands’ region, said that regulatory measures following the financial crisis and poor investment returns were placing increasing pressure on the industry and encouraging capital into the alternative space. As Berger explained, “sidecars and unrated market-facing cat writers simply don’t obey the same rules as traditional players”, enabling them to navigate the current investment environment more nimbly, while the demands of rating agencies and regulators have all too often constrained traditional players.
Cash concurred that greater regulatory emphasis on capital management has reached such a point that in some instances business decisions are being taken simply to reflect capital requirements. The connection between underwriting and capital management has grown increasingly close over time, he said, with underwriters now not responsible simply for underwriting risk, but also for protecting the underlying balance sheet. Cash argued that while regulation has brought many benefi ts to the industry, “there is a certain amount of regulatory and rating agency fatigue at this point”. Regulatory measures that have constrained capital, limited investment returns and encouraged alternative plays into the reinsurance space are certainly proving disheartening to rated players.
Berger added that following the fi nancial crisis, the insurance community has too often been lumped together with the banks, with increasing regulatory scrutiny an inevitable consequence. “Even strong fi rms will be challenged by regulatory pressures,” said Berger, with one of the likely consequences of such pressure being the disappearance of certain smaller players.
Beware of bubbles
In the current troubled macroeconomic environment, close attention to asset management has become all the more pressing, particularly considering the regulatory framework around cost of capital. As Cash explained, the industry is grappling with regulatory demands on quality of capital and the need to eke out more returns on the asset side of the balance sheet. While typically 90 percent of the assets of a rated reinsurer are in high-rated fi xed income assets, Cash said that companies are looking at ways to maximise returns on the remaining 10 percent, which has traditionally been in equities, commodities and alternates.
He explained that companies are actively experimenting with investment strategies and seeking investment managers who can satisfy a growing demand for increased investment yield. He did caution however that the pursuit of higher grade fi xed income instruments “feels like a bubble, which isn’t entirely sustainable. For now no-one quite knows when the music will stop”.
Berger also advised against more traditional players pursuing an aggressive investment strategy, something that Third Point Re—with the backing of New York-based hedge fund, Third Point—is itself adopting. He said that considering levels of leverage in the industry, traditional players would find it difficult to pursue an aggressive investment strategy. Experimenting with even 10 percent of the asset side of the balance sheet could prove costly for some, said Berger, if you are levered to two, three or four times your level of capital. He added that if the industry faced another 2008-type scenario and you lost up to 25 percent of equity, “you’re going to get slammed by investors. Traditional players are in a tough box right now”.
Turning to industry valuations—which have proved troubled of late—O’Hara said that they are largely a function of macroeconomic conditions, rather than poor performance. “Insurers aren’t alone in this—look at the banks. It is a function of the zero interest rate environment.” Lack of investment returns, coupled with a low growth environment, are creating troubling conditions for the industry, he said, but there is little that can be done to change matters. “All you have left is managing your capital,” said O’Hara, “with one of the big temptations being to buy back stock when companies can’t cover their cost of capital.”
Cash added that current valuations are a product of the volatile risks that Bermuda companies take on and of analysts’ temptation to respond reactively to changes in the market. He said that Bermuda players’ involvement in the cat space and in the most cyclical portion of the casualty space inevitably means that analysts tend to be “gun shy”, with their opinions tending all too often to dent valuations. He added however that with reserve redundancies drying up, pricing remaining weak and interest rates fl at-lining, the industry is “at the bottom of the cycle”.
Current low valuations and the bottoming-out of the cycle are unlikely to spur the creation of a new class of reinsurers in Bermuda, as Berger made clear when asked whether one would materialise. “I doubt the fabulous home runs of the class of 2001 will be achieved again. Private equity is pretty shy about supporting a new class on the Island, while alternative cat capacity has served to take the top off opportunities in 52 Spring 2013 Bermuda Re/insurance the space.” Instead, it will largely be a question of how existing companies can better put existing capital to work. For Cash, this will involve developing specialty lines business, but such business and the opportunities it can generate will inevitably be dwarfed by cat, casualty and investment side risk.
A bigger shoe
Despite decidedly troubled conditions, Bermuda players are nevertheless exploring ways to strengthen their positions as they ride out the worst of the cycle. Many are pursuing an increasingly diversified footprint. As Cash outlined, Bermuda players—which have traditionally focused on cat business—are taking on more international business. The emphasis of the rating agencies on diversification has certainly helped, with a diversified book allowing companies to “re-use their balance sheet multiple times and drive down their cost of capital”. The challenge remains in building expertise locally. As Cash explained: “It is a tradeoff— you improve capital efficiency through diversification, but create challenges for yourself in terms of internal management efficiency.”
Berger concurred that diversification can prove troublesome. He argued that rather than diversity of book, “the key is to have wellpriced business”. Citing examples such as the Chile and New Zealand earthquakes, Berger warned that simply spreading your business around the world is not a sound business model. He added that China is a case in point—“everyone wants to be in China, but no-one is making any money”. “You may have to be there for the long term, but between now and then, there is all too often little to be made in such emerging markets,” he warned.
Other players have opted to become dedicated cat specialists, but even they are looking to reduce their cost of capital, said Cash. About the only means to do so is to turn to managing third party capital, he said, with such an approach enabling them to deploy more capital while receiving management fees to offset the cost of capital. Again, such plays are helping Bermuda players strengthen their positions in the face of cyclically troubled conditions.
Regarding Bermuda’s future, the panel were rather more bullish. Cash highlighted the Island’s beneficial tax position, its robust capital and its underwriting expertise in the cat space, adding that such strengths will stand Bermuda players in good stead as they develop increasingly international footprints. O’Hara added that the Bermuda Monetary Authority continues to be the envy of jurisdictions internationally, while few domiciles can match the “capital history achieved by Bermuda”. Troubled though the times may be, it would seem the Island is well positioned to ride out the current storm.
Ernst & Young refers to the global organisation of member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited does not provide services to clients. Ernst & Young Ltd is a client-serving member firm operating in Bermuda.