14 October 2013

The shape of things to come

Gone are the halcyon days of reinsurance, when bricks and mortar players could expect to achieve around 24 percent pre-tax return on equity (ROE). Today, caught in the crossfire of historically low investment returns, rising levels of alternative capital, soft market conditions and reduced levels of leverage, ROE sits at around 8 or 9 percent.

That is the view of Don Kramer, chairman and CEO of ILS Capital Management, who, after decades in the traditionalreinsurance arena, is building an impressive offering in the alternative space. As he explained, “going back 20 or 30 years, starting an insurance company was a potentially very profitable endeavour”. You were able to write two dollars of premium to every dollar of surplus, anticipate a 21 percent pre-tax return on investment income and a combined ratio sitting around 98 percent. “All this led to a valuation of at least 120 percent of book value— not a bad deal,” he explained.

Today, such conditions are but a memory, with “exceptionally low yields and rating agency restrictions on risk having reduced premium leverage and accordingly investment assets dramatically”, said Kramer. He said that even running a great company, traditional players in the current environment can expect high single-digit ROE. As Kramer explained, the only way to materially boost ROE and market valuation is by taking greater risk. Doing so hardly seems the panacea to the current situation facing the traditional reinsurance market.

A shift of focus

For those in the alternative space—such as Kramer’s ILS Capital Management—conditions are rather more conducive. As he explained, insurance-linked securities (ILS) are an attractive, uncorrelated and short-duration asset class that has established for itself “a valuable place in portfolios as an alternative asset. This has proved a real boon for interest rate-starved portfolios”. Interest in the space has been fierce as a result—particularly over the past 18 months—with institutional investors evidently gaining something of an appetite for reinsurance risk.

Ease of entrance and exit has been one of the major attractions for investors, Kramer explained, with liquidity, diversification and strong returns proving a heady mix. “If we or our investors feel the risks are not priced adequately we can exit the sector generally within one to one and a half years,” he said, whereas traditional reinsurer investors are dependent either on a third party buying their share or are “at the mercy of the equity market”. While alternative money is relatively footloose—able to react to market softening as well as dislocations— traditional players are more wedded to the whims of the cycle.

Conditions are certainly making satisfying shareholders a challenge for traditional reinsurers. As Kramer explained, reinsurance valuations are “based on growth in book value, return on equity and external market conditions”, but as he outlined, conditionsare far from conducive. Kramer said that reinsurer performance is largely based upon three factors, namely: “market conditions and underwriting skill”, investment returns and financial leverage. While the former can be controlled—at least in part—by the capabilities of the reinsurer, both investment returns and levels of leverage permitted are outside their control—and damagingly so. As Kramer explained, with investment returns at historically low levels and financial leverage having come under pressure due to the influence of the rating agencies, reinsurers are facing a unique squeeze—one that hasn’t been helped by the influx of alternative capital.

Not that it is all bad news. Reduced leverage has helped to “increase reinsurance demand, by forcing primary insurers to buy more reinsurance coverage while reinsurers retain less”, Kramer outlined. This changing dynamic was one of the reasons for the rapid growth in ILS, he said, with alternative products on hand to “support market demand”. What does seem apparent is that traditional players are adapting to a new norm.

Another flagship venture

Launched in July 2011, ILS Capital Management is looking to harness considerable investor interest in the reinsurance space, and with an experienced team with deep and longstanding relationships with key reinsurance market participants and considerable technical capabilities, it is well positioned to thrive.

As Kramer explained, players such as ILS Capital Management are bringing to bear reinsurance expertise and applying similar metrics to their understanding of ILS underwriting as they did in the traditional reinsurance space—“focused on diversification by type of risk and probability of loss, as well as geographic diversification”. The key lies in portfolio analytics helping to control volatility, explained Kramer. Nevertheless, the sector can expect to experience two bad years in 10, although he added that such a ratio of success would result in “very satisfactory returns”.

He explained that far from being a commodity—as some worry it may become—alternative reinsurance requires considerable technical expertise. He said that firms such as ILS Capital Management need to have a firm understanding of probabilities of loss, property and liability exposure and a highly analytical approach to risk. Alternative capital—when well guided—can deliver all of this within a framework and timescale that is proving increasingly attractive to a broad array of investors.

"Management needs to have a firm understanding of probabilities of loss, property and liability exposure and a highly analytical approach to risk."

Kramer said that buoyant investor interest has meant that by year end the company expects its 1609 Fund and managed accounts to have between $250 and $500 million of assets under management. He said that the company is looking to explore opportunities in sectors of the market where it has a “competitive edge, and that we believe will offer our investors a high risk-adjusted rate of return”. Citing the marine and energy sector as a case in point, Kramer said that the company has two partners who have worked in the sector for over 15 years, with the expectation being that prices will “continue to rise next year”, along with opportunities for ILS Capital Management. All this should help the company work towards its five-year target of $4 billion of assets under management.

Kramer predicts that barring a major catastrophe event during the closing part of this year—particularly a US windstorm—ILS investor returns “may come close to top alternative asset performance outpaced only by the rising equity market”.

A new landscape

While many worry about the implications of alternative capital on the traditional reinsurance industry, Kramer is rather more philosophical. “Reinsurance demand is basically inelastic … primary insurers and businesses need to purchase coverage. Further growth in exposure is linked to the economy which has been flat to moderate, but the industry can expect continued growth in reinsurance demand from emerging markets.” He admitted, however, that the supply situation has gone through significant change in recent years.

“The leverage that reinsurers can achieve has been restricted by the rating agencies, excessive regulation and solvency,” he said, which has in turn moderately reduced reinsurance capacity. “On the other hand, the flood of new capacity from non-insurance company investment managers seeking higher returns in a low yield economy has been significant.” This has helped to change industry dynamics, particularly pressure on rates.

The influx of new capital has helped to head off a recurrence of a hard market—particularly in the face of events such as the international catastrophe losses that punctuated 2011 and Superstorm Sandy—said Kramer, which may well have come about if capacity had “been limited to reinsurance companies”. With strong levels of alternative capacity finding its way into the market and willing to take on peak zone perils, potentially sharp upticks in pricing are now less likely, he said. This has in turn helped to create “more stable reinsurance costs” for buyers. Stability in pricing—one would hope— will result in more buying.

Addressing the impact of alternative capital on the offering of the brokers, Kramer said that it will enable them to “serve their clients successfully in a concentrated environment with less volatility in pricing, and in spite of continuing volatility in underwriting results”. Brokers’ agnostic attitude to alternative forms of capital is likely to persist in the face of the potential of convergence interest.

It is apparent that alternative capital is no flash in the pan and with industry stalwarts such as Kramer throwing their weight behind the convergence space, it seems likely that alternative capacity will continue to gain ground in the reinsurance space. The success of new ventures such as ILS Capital Management will undoubtedly be watched with interest. Where men like Kramer tread, others inevitably follow.