For many years there was (54 years in fact!) a daytime "soap opera" called "As the World Turns" on the CBS Network in the US. You could sometimes go for years without watching it but then happen to see it and in a few minutes you'd find yourself up to speed on the current plot. The characters and story line were so familiar that if you had ever spent some serious time watching it you could easily pick it up again. What's going on in reinsurance these days is anything but familiar.
To an outside observer what's going on seems more like a bitter war of ideologies between so called "traditional underwriting markets" and ILS markets. In the meantime the stakes just keep getting higher and higher and the risks seem to be becoming more pronounced.
Happily for some coverage purchasers premium rates remain largely flat or are actually decreasing. Unlike normal markets where many people would view increased competition between suppliers to be a healthy signal some observers view this competition as simply the last step before an industry-wide collapse of a number of markets. Such a collapse could leave buyers facing claim payment problems and sky-high premiums in the future --should only a few healthy reinsurers survive it.
We feel as if we're writing the narrative for a movie trailer designed to entice the viewer to see the film. Don't blame us. We'll outline what we saw this month and you decide if we're overreacting.
The biggest news was the return of John Charman as the new CEO of Endurance. Charman has plunked down a considerable sum of his own money (approximately $30 million) buying stock in Endurance. He has made no secret of his desire to get back into the reinsurance business after his tense exit from Axis.
So, David Cash is out (with some $23 million earned by selling stock options) and John Charman is in.
Charman says that he is "hell-bent on making sure that Endurance becomes a great global insurance and reinsurance franchise over the next three years." Endurance, he is sure, will be one of those survivors.
Survivors? Is the entire industry stumbling through a hot desert on the brink of dying of thirst? Aren't natural catastrophe claims relatively light right now? Didn't we just see a press release from Hannover Re, the third largest reinsurer, stating that their profit guidance of $800 m Euros for 2013 remains spot on? Aren't big reinsurers lining up to participate in newly formed London broker facilities to write even more business?
Yes to all of the above. But scratch the surface, press the "ground floor" button on the elevator, and the door will open to a melee reminiscent of the
Great Pie Fight in the Mel Brooks movie "Blazing Saddles".
Let's start with the now notorious Aon-Berkshire Hathaway broker underwriting facility that will see Berkshire receiving a 7.5% slice of Aon Re Solutions Lloyd's placement.
Charman is "horrified" by the Aon-Berkshire Hathaway broker facility quote share deal. Stephen Catlin "can't think of any broker facility lacking underwriting controls that has ever stood the test of time". Tom Bolt thinks that the Willis Global 360 broker underwriting facility, aiming to cover a fifth of its broker-led London book, would only "rearrange the deckchairs on the bottom 20%". The UK Financial Conduct Authority has begun an investigation of the broker underwriting facilities devised by Aon, Guy Carpenter and Willis for signs of conflicts of interest.
On the other side, despite warnings from Lloyd's that broker facilities will be scrutinized with the full power of the Lloyd's regulatory apparatus, both Guy Carpenter and Willis quickly followed Aon with announcements of their own facilities. Aon's Steve McGill says that the "take-up rate" for the new Berkshire facility is high, with 90% of buyers remaining on board. And, despite some mollifying public exchanges between Lloyd's and Aon, the big broker says it has no plans to change the facility. Aon says it was set up only in the best interests of its clients in the first place.
As if the war of words about broker facilities isn't enough to cause concern this battle is being played out against a much larger and more important backdrop. Sitting like the proverbial elephant in the room remains the very real fact that reinsurers are seeing more and more of their premium dollars headed away from them toward the new ILS markets.
Worse yet, is that the reinsurers are crying "foul" because, they claim, ILS markets are underpricing risk due to their exclusive reliance on modeled data to set premiums. (Hence the disapproving term of "plug and play" underwriters.) If reinsurers are to compete against ILS markets, they claim, they will need lower their own premiums below levels that are already the barest of minimums.
Since general economic conditions have flattened investment returns, and since some observers believe the reserve release sponge has been wrung dry, reinsurers believe they have little choice but to base premiums high enough to ensure an underwriting profit.
It's an ugly dynamic that requires the steeliest of nerves to not be tempted to lower premiums to take in cash -which is why small and medium-sized Lloyd's players really cried "foul" when Aon pulled back the curtain to reveal Berkshire sitting there with 7.5% of the quote share before it even hit the market. Essentially Lloyd's underwriters saw their GWP from the Aon Risk Services book cut 7.5% before they even received it in the market.
If the Willis 360 facility becomes operational press reports indicate that it will "dwarf" the Aon-Berkshire deal further reducing the size of the pie. How long will it be until we read that broker facilities will include specialty ILS sidecars set up to draw off Lloyd's business before it hits the market? Not too long, we think. After all Nephila Capital, which is at the vanguard of the ILS market, is already the fox inside the chicken coop at Lime Street and is writing excess insurance and CAT XOL through Syndicate 2357.
We need to be objective. What exactly is wrong with a fully escrowed ILS solution that offers a better price than a traditional reinsurer? Probably, on a deal by deal basis, there isn't anything "wrong" with it.
It would be hard to argue that buyers and sellers of reinsurance need to be protected against themselves (this is familiar, isn't it?) With reinsurance, and the level of sophistication involved with both the buyer and seller, (don't forget to add in to the mix the expertise and advice provided by brokers too) one would be hard pressed to argue that the doctrine of caveat emptor should not apply.
So what's the problem?
Several pretty rational people have made a case that can only be viewed as warning against that inevitable implosion of the reinsurance market if current trends continue.
Before being named as CEO of Endurance, Charman was warning of the "hot money" represented by third party capital providers providing the support to ILS reinsurers. Charman warned that the underwriting for the ILS markets was being driven purely on model results and the concept of "uncorrelated risk", or the idea that the chance of an earthquake or severe hurricane occurring are disconnected from financial market events, was providing a false sense of security to ILS investors.
Charman went so far as to warn traditional reinsurance underwriters that they should not dare to match the depressed premium prices offered by ILS markets because when a severe loss event did occur they would run a real chance of insolvency.
Figuring both that capital market investors would have long since headed to the exits after a severe loss event, and certain-over eager reinsurers would have been shattered, he was concerned was that there would not be enough reinsurers left in the game to provide the total amount of global coverage needed. He viewed such a result to be the end of reinsurance as we know it.
Should events unfold in what would admittedly be a very worst case scenario we may not recognize what comes next. Hopefully, Charman's entrance with Endurance means that his view has modified slightly, or it could just mean that if and when the worst case does arise, he will be sure that Endurance will be one of the reinsurers left picking up the pieces. (Now that would be a seller's market!).
Next, and we sometimes use this example to remind ourselves how obtuse we are, we remember Tom Bolt's warning back at the CATEX London Reception earlier this year. He warned that underwriters had better be comparing model results with their own actual historical loss records for the same peril and the same location. He indicated he would have little sympathy for Lloyd's underwriters beseeching him for relief from a filed business plan if they hadn't bothered to do this bit of homework.
Sure, he was talking about the syndicates, but was he only talking about the syndicates? Tom Bolt has become adept at talking to specific audiences about specific problems but in his position he is aware that there is always a broader audience listening to him.
Bolt's remarks began to come into focus last month when Kean Driscoll was talking about "plug and play underwriters" but his remarks really came into focus when we read what Gen Re's Tad Montross said.
We've known Montross for a long time and can say he's a pretty straight shooter. He's cordial, direct, and you will always know where he stands on an issue. So when Montross was quoted by Bloomberg as saying that the new ILS funds are relying too heavily on catastrophe models in making their pricing decisions we took note.
Then we read the next paragraph. The models have "lent an aura of credibility" to pricing, Montross said. "Anyone who's in the industry knows that the models are always wrong. Directionally, they're helpful, but we are trying to price a risk today that we do not know the cost of".
Tad also did not overlook the "uncorrelated risk" bromide invoked by so many ILS investors. He noted that investors who lose their principal in a catastrophe may have an "emotional reaction" and head for the exits. "What happens after the $150 billion earthquake, when Nevada is basically the coastline to the Pacific?" Montross asked. "This whole issue that it's a non-correlated asset class, which makes it so attractive as people look at their risk-return profiles, is one that needs to be thought through very, very carefully."
US With New Pacific Coastline
Wow. If Nevada becomes the new California that sure would seem to be a candidate for a Charman-styled worst case scenario, right? Someone would have to pay claims for everything destroyed in the "old California" wouldn't they? Montross' point, presumably, is that if God forbid such an event occurred the idea that there would not be correlated events throughout all the global financial and equity markets is na´ve.
Unfortunately, to Montross' point, much of the ILS money is underwriting very big loss event risk. If claims are ever triggered, because such a very big loss event actually occurred, then losing your principal might be the least of your concerns. Financial indicators globally would presumably be taking a nosedive and, of course, if you did happen to be in what would then be "old California" you could face even bigger problems.
On the whole though there seems a sense of inevitability in the industry. It's as if even the most severe critics of the so called "hot money" know that it will ultimately have to run its course on its own. Industry veterans know that sooner or later there will be a large loss event and they know what Charman says is right.
As this newsletter goes to press we've noted the drop in share price for many of the large CAT reinsurers. The combination of flat to lower premiums (see Florida) ,and the fear of analysts that ILS competition will steal future premiums, seem to be causing revisions to recommendations from stock market gurus.
Any reinsurer that went and underpriced their own underwriting profit margin to simply take in premium is going to be put through the wringer. Past reserve releases, poor investment returns and generally flat to declining premiums mean reinsurers will face a challenge.
As for the ILS markets who can say how effectively the claims will be paid? What uproar will be generated by investors as "claim-creep" first wipes out profit and then begins to eat away at principal? We may see new levels of vigor in contesting claims and, when finally forced to pay them, doing so very slowly and reluctantly.
What will the "blowback" be against the modeling companies, who despite their repeated warnings, have to be aware that some markets are relying exclusively on their model results to set premiums?
No wonder people like Charman, Montross and Bolt are nervous about what's unfolding.