XL: protection in an uncertain world
Whilst 2010 was a troubled year for some Bermuda reinsurers—with combined ratios increasing almost across the board— XL Re managed to buck the trend, recording a 2.4 percent decrease in its combined ratio. 2011, however, looks set to be a challenging year— for both XL and the wider reinsurance industry—but speaking with Charles Cooper, it is clear that the lessons of a strong performance in 2010, and years as a leading international player, will place the fi rm in good stead to cope with the challenges of a troubled landscape.
Enviable results
We began our conversation with the success XL Re achieved in 2010 in strengthening its underwriting performance despite the fi erce competition and overcapitalisation that characterised the Bermuda market last year. Cooper said XL Re’s success relative to its peers could be attributed to a number of factors, the fi rst of which were the “manageable” losses associated with events in Chile, which were indicative of the company’s “disciplined underwriting approach”, and its caution when it comes to territories “where we have a more dim view of the validity of the catastrophe models”. XL’s cautious approach to cat lines in emerging territories is indicative of what Cooper described as the company’s “conservative view on pricing tail risk”, which he said for some too often fails to take into account the probability of events, particularly in emergent geographies. “The lesson that we in the industry keep learning is that extreme peril events are much more likely than we anticipate, and are currently pricing for.” Examining accumulative loss fi gures from Australia, Chile and New Zealand, results would appear to bear out such conclusions. And it would seem that such an attitude to the value of models in more marginal geographies has helped to protect XL from the full extent of the losses in emerging regions in recent months and may yet protect it from further potential unforeseens should they materialise in 2011.
The second major differentiator Cooper highlighted is the make-up of XL Re’s portfolio, which comprises a good mix of US and European property catastrophe and casualty as well as international catastrophe business, with its diversity enabling the company to avoid those levels of volatility that have affected more line and geographically focused firms. The company’s long-standing diversity has meant that it has not been obliged to pursue new business “outside of the peak territories”—or felt it necessary to do so in order to leverage its capital base—enabling XL to avoid “writing business at margins that are potentially too thin to support the business”, particularly in emergent geographies. The size and diversity of XL Re’s book has meant that the company was wellpositioned to withstand the accumulative losses of 2011 events, with figures from Aon Benfield putting the firm’s catastrophe losses at the lower end of industry results as a percentage of shareholder funds. Figures from the broker put XL Re’s losses from Australia, Japan and New Zealand at 3.8 percent of 2010 shareholder funds, well below the Aon Benfield Aggregate average for leading global reinsurers. Looking at the figures, it would seem that the reasons behind XL’s decision to opt for a diversified portfolio have been borne out by experience.
Addressing XL Re’s impressive underwriting results for the year, Cooper said that this was partly “driven by positive reserve developments”, and was a consequence of a “prudently conservative approach to setting our reserves and our disciplined, consistent underwriting approach”. The firm’s impressive results are all the more significant given the conditions that characterised 2010, with ceding insurers “willing to retain more risk”, strengthened investment returns and increasing levels of capital combining to create a competitive market dynamic. With everyone “looking to deploy capital”, there was a “very aggressive” pursuit of market share and new business that had evident implications for Bermuda reinsurers. Examining results from the Association of Bermuda Insurers and Reinsurers, the characteristics of 2010’s aggressive market are evident in the figures of almost all of the Island reinsurers—with combined ratios rising despite increasing levels of gross written premiums—but XL Re was able to buck the trend, recording good results, as others pursued business down and into the margins. Again, XL Re’s success is indicative of its conservative, diversified approach that has borne the company fruit in the soft market conditions of the last 18 months.
Lessons from a crisis
Following the aggressive market of 2010, events in the first quarter of 2011 have brought about something of a sea-change in attitudes, Cooper said. Whilst 2010 was characterised by a pursuit of business and market share, he said that even at January’s renewals, there was evidence of a “much more disciplined market” following a relatively busy 2010, with the cat events in Australia, Japan and New Zealand generating still further impetus for change. Whilst the effect of cat losses on XL Re had been limited thanks to the company’s prudent conservatism in setting its loss reserves, a number of lessons could been drawn from events, Cooper said. First of these was that “as a market, we consistently underprice tail risk”. Considering those catastrophe events that struck Chile, Japan and New Zealand, Cooper said that it was evident that a significant amount of business has been written at “very, very low rates on the line”, with reinsurers assuming—incorrectly—that the “probability of...such occurrences is very remote”. Christchurch, Maule and Tohoku proved industry probability estimates and pricing to be largely wrong, Cooper said, with events prompting “people to re-evaluate their measurement of tail risk” in such geographies.
"Raising funds from the capital markets or through sidecar investors-- having capital ready and avaliable, but not on your balance-- is the Holy Grail of reinsurance."
Events likewise prompted greater scepticism regarding the “validity of models, particularly in those areas where the modelling companies have not invested the same level of resources in calibrating theirmodels, and the science that goes into them”. The perceived, and actual, weakness of model data in emergent geographies—particularly considering the battering that more marginal markets such as Australia, Chile and New Zealand have taken in recent months—appears to have vindicated XL’s conservative approach to the pursuit of diversification in non-core territories.
Addressing the impact of 2011 events on more core business, Cooper said that events had resulted in a “very disorderly renewal” for US lines at the April 1 renewal, with Tohoku encouraging reinsurers to re-evaluate pricing and not “simply cut the price by 5 to 7 percent and renew”, as had been the expectation at the start of the year. 2011 fi rst quarter events, coupled with RMS model changes—which look to have had a signifi cant impact on US cat loss estimates—have meant that reinsurers are revisiting their portfolios in the light of events, Cooper said. In response, April 1 renewals were largely repriced, with some prices fl at, others rising and a few “very marginally down”, with the market for US cat pricing “largely fl at at April 1”. Looking forward, Cooper said that it was XL’s expectation that there would be “rate increases in the low double-digit range going into June and July” on US cat lines, as the full implications of model changes and “horrendous fi rst quarter results” are factored into rates on the line. A turn on US cat lines may yet be on the cards.
Taming the cycle
Addressing ongoing soft market conditions and prospects for a turn, Cooper remains philosophical: “The cycle is the cycle. History has a way of repeating itself.” Nevertheless, the industry is “getting better at dealing with the cycle” and coping with the challenges and opportunities that it presents, with Cooper citing greater “capital mobility”—exemplifi ed by sidecars and other forms of “just-in-time capital”—as being a key step the industry has taken in taming the cycle. Companies have become far more “aggressive in their capital management”, with unused capital quickly returned to investors or used for share repurchases, as fi rms have sought to maximise their capital position.
The trick in maximising a company’s capital position is in “striking the right balance between getting an acceptable return for your shareholders’ investment”, and having enough money to write new and existing business and “appease the rating agencies”, Cooper said. By recognising and responding to growth opportunities as and when they emerge—and Cooper was clear that in the cat space, these can happen overnight—reinsurers can look to maximise returns on investment, whilst not overloading the balance sheet with unused capital. Raising funds from the capital markets or through sidecar investors—having “capital ready and available, but not on your balance sheet”—is the “Holy Grail” of such an approach.
Continuing prudence
Looking into the rest of 2011 and beyond, Cooper said that XL’s approach would be “consistent with how it has always been”— prudently conservative with a view to underwriting to profi t. He said that XL Re Ltd was fortunate in that its balance sheet of $4.7 billion of shareholders’ equity and the backing of the wider XL Group had placed it in good stead to ride out the soft market that characterised 2010 and the troubled fi rst quarter of 2011. With a signifi cant balance sheet—one of the largest in Bermuda—and “a cat portfolio that is frankly under-leveraged”, it seems that the reinsurer is in a good position to record another strong year. Cooper agreed that XL “has room to grow”, but said that “if the opportunities are not there, it might well not”. After the troubles of recent months, it would seem prudent not to pursue business, and with 25 years of experience and success, it would seem XL has little more to prove.
