Approaching models with a healthy dose of scepticism
When talking with Stuart Bridges, chief financial officer at Hiscox, it is evident that regulation and tax, rather than the fallout from the financial crisis, are the major issues confronting the industry post-2008. As Bridges makes clear, the responsibilities of management have not markedly changed since 2008, although ongoing regulatory projects such as Solvency II have created complex challenges that have proved to be a signifiant distraction from the day-to-day running of a re/insurer.
"The non-life side of the industry traded its way through the financial crisis remarkably well," said Bridges. "We can be proud that we were not hit by the exposures that troubled the wider financial industry. Our focus on liquidity and high quilt investments put the industry in good stead. We did not get involved in the poor quality structured products that the banking industry tried to sell us over the years. We were successful in rejecting the kind of investments that so troubled the financial sector following the financial collapse of 2008." Nevertheless, the industry has been caught in the dragnet of regulatory and tax developments that have gained pace following the financial crisis."
While issues associated with the financial crisis have been relatively slight for the re/insurance sector, Europe’s great regulatory project has been rather more problematic. “From a regulatory perspective Solvency II has eclipsed the impact we have felt from the financial crisis,” said Bridges. “Solvency II is the biggest change to regulatory regimes for some time and places significant pressure on the industry to instil a systemic approach to risk within the organisation.” Europe and proponents of Solvency II evidently think that such an approach will help head off another financial meltdown, encouraging better risk management practices and greater capital allocation. Bridges for his part, is evidently not entirely convinced.
“Our fear is that Solvency II will create an over-reliance on models and encourage the industry to place too great a faith in their validity,” said Bridges. He agrees that models—be they catastrophe, capital or underwriting models—have served the industry well, and “they represent an excellent basis for looking at the risks we take, but if we all move in the same direction and use the same models it actually introduces systemic risk into the system. As such, it is vitallyimportant that we maintain individualism and a healthy scepticism of the models”—whether they are overseen by Europe or presented as risk management tools by third parties.
“Solvency II is pushing the industry towards a belief that we can model and run companies on a mathematical basis. However, when you examine the reality of the situation, it is evident that these issues are much tougher and more complex than the ‘reality’ envisaged by such regimes.” Models simply cannot visualise and understand these complexities, said Bridges. Rather it is human capital—a real strength of the industry—and its ability to understand risk that will be central to navigating a route through the European regime and applying a risk management approach that is not slavishly monolithic.
"We responded to the crisis by being more cautious with our asset base, but such an approach has served to deplete the capital cushion needed to respond to catastrophic events."
Bridges cites the Bermuda Monetary Authority’s (BMA) approach to Solvency II equivalency as just such an approach—one that is less prescriptive in its application. “The BMA has been sensible in making solvency models and their application realistic—its approach has not been dictated by political expediency. In fact the BMA comes out very well if you compare it to some of the European regulators, who have begun to follow the letter of the actuarial law a little too closely.” The BMA has taken a step back from the full onus of the regime and taken an informed view of its application, said Bridges. Such an approach has served the industry there well, as it has the jurisdiction. It may well be hoped that Europe and European regulators will draw lessons from the Bermudian approach, enabling firms to interpret and consider more closely the application of Solvency II to their individual companies.
Turning to questions concerning capital structures, Bridges said that one of the major challenges facing the industry is determining the correct level of capital to hold. There are numerous positions on the matter with no definitive answer. “There is no right or wrong, only a myriad of ways of looking at capital. It is for management to decide which way they look at a company’s capital position and then to stick to their knitting. It is a fine balance.”
Bridges believes that while shareholders are interested in a capital position dictated by return on equity, and regulatory and ratings agencies look at capital requirements for policyholders and risk management, companies such as Hiscox focus very much upon their internal risk appetite. “We want to be able to survive a major reinsurance event and be trading happily the next day. Our capital position needs to reflect that fact.”
However, while the views of regulators, rating agencies, shareholders and management can be quite divergent, a range of insights can provide a good all-round indication of necessary capital. Like the dangers associated with overdependence upon a particular regulatory model, multiple viewpoints on capital requirements enable the industry to move away from a single, myopic view of required capital.
Bridges believes the decision on a company’s capital level should lie with management. “One of the challenges is not getting dragged too far down the route of believing that a particular capital model is right; rather we need to challenge them ourselves. The key question regarding capital remains: what level of capital do I believe we should hold, given that I have all these information sources providing data to inform that decision?”
A range of information sources and divergent views have certainly been beneficial in informing the industry, but this capacity may be diminishing. As Bridges explained, there is an increasing convergence of views, as “sensible attitudes to capital”—following a rocky few years—prevail. This should mean that appropriate levels of capital are more easily reached, but could again raise the spectre of a single— possibly flawed— industry position on capital adequacy.
“Another issue—and one that did emerge from the financial crisis—is that the cost of raising equity capital has increased. Not only in terms of fees, but also in terms of the discounts you would necessarily have to take. Here at Hiscox, management owns a large amount of the company’s equity capital—this is pretty consistent across the industry—and it has helped the company realise just how precious that capital is.” Greater shepherding of equity capital will likely be the order of the day until the capital markets recover. That could be some time coming.
The risk of security
Addressing the twin issues of risk and liquidity, Bridges said that in response to market conditions the industry has necessarily pursued a very short duration strategy. “The industry is simply not being paid sufficiently to go long on its investments,” he explained, although such an approach is not without its concerns. “As an industry we responded to the crisis by being more cautious with our asset base, but such an approach has served to deplete the capital cushion needed to respond to catastrophic events”—be they on the underwriting or the investment side of the book. The investment environment has created a spiral of lower risk appetite generatingless capital cushion, which has prompted still greater caution on the asset side of the book.
"In the reinsurance world there are certain price-takers and price-setters and those that determine the level of rating will inevitably hold the levers of profitability."
Bridges said Hiscox has actively sought to break this spiral, by “putting a pot of capital aside to allow us to place some risk in the portfolio in the form of equities and corporate bonds”. He said that the industry needs to be sensible in its response to the troubled investment environment. “There is a need to take stock and say ‘let’s trade sensibly and reassess what the risk in our investment and underwriting portfolio is’.” Being risk-averse, simply for the sake of it, could prove counterproductive.
That is not to say that the industry has not been obliged to shy away from certain troubled investment classes and geographies. As Bridges outlined, “If you trade in euros, you need to be cautious about where you hold them. There are considerable concerns regarding the concentration of bonds or cash that sit with particular banks post- 2008.” Institutions that were previously regarded as a safe pair of hands have been bowed low and counterparty risk has encouraged greater caution—particularly in Europe. For Hiscox, the focus is on national champions, although even these are watched carefully in today’s troubled investment environment.
Reaching for the levers
Facing a market characterised by many as overcapitalised, and capital markets that promise meagre investment returns for a time to come, the levers of profitability for the industry seem scant. Bridges agreed, “I always say that re/insurance is a simple business and that there are very few levers that we can pull. In a sense—although at times I would hate to admit it—rates remain the leading lever of profitability and an indicator of how companies trade and perform. In the reinsurance world there are certain price-takers and price-setters and those that determine the level of rating will inevitably hold the levers of profitability.” However, the growing maturity of the industry has meant that the cyclical nature of profitability has been less marked. “With the industry now better capitalised, rates are far less influenced by the ebb and flow of capital. This is indicative of the increasing discipline of the industry and trading in a disciplined environment has got to be a better place for our industry to be.”
Stuart Bridges is chief financial officer of Hiscox Ltd. He can be contacted at: email@example.com