"Take Your Stinkin' Paws Off Me You Damn Dirty Ape!"
To say we've been waiting for a long time to use this headline would be an understatement. Really, how often does one see this headline in a monthly reinsurance newsletter that purports to be serious?
But we couldn't think of anything better. Of course it's Charlton Heston from the 1968 movie "Planet of the Apes" reacting to the efforts of his simian captors to restrain him. Heston's voice had been damaged during his earlier captivity and upon finally healing he was able to shout out this epithet.
His captors, who had thought him to be mute, stupid, cowed, inferior, etc. like all other humans, were stunned by this outburst. It simply wasn't possible that a human could talk. He was intelligent and it forced the apes to reevaluate their thinking.
It wasn't that long ago that it could be read in this very publication about so called "hot money" originating from ILS sources coming into the reinsurance market place. This capital, popularly thought to have been "goosed up" by savvy investment bankers, based a premium price on the running of an inadequate loss prediction model and was able to undercut traditional reinsurers by offering cover at a reduced price. It was also referred to as "dumb money".
Prejudices die hard and perhaps this writer at least should have been able to look past a generation long effort by the capital markets to insert itself into the reinsurance industry. That effort, and its promise of virtually unlimited money available to back risk, came with subtle criticism of the reinsurance industry as being too conservative, too slow, too antiquated and too used to dealing with "clubby" regulators.
Maybe that perception of "criticism" wasn't even the result of statements or criticism (subtle or not) from capital markets players. Maybe, like those apes outside Heston's cage, admitting that the capital markets were even a tiny bit right could stem from a deep recognition that in your heart you knew that some of the criticism, imagined or not, was deserved.
Reacting to that fear that fear by approving massive IT investments helped for a while. Maybe the sale of Industry Loss Warranties, the industry's chess move against the binary CAT bond triggered products, helped for a while too. But in the end the capital markets didn't go away. They remained waiting not so patiently at the gates.
Finally, today, despite some lingering criticism, and possible embarrassment, we've seen the industry take major steps in the direction of welcoming the new capital through the gates. The access the new capital has demonstrated to the pension fund markets provides a hitherto undreamed of amount of capital and the ILS underwriters deploying that capital to underwrite risks are not as fast and loose as once portrayed (even, we must admit, in this newsletter).
On the northeast corner of the National Archives building in Washington, DC is this inscription: "What is past is prologue". (Our UK friends will recognize it as a Shakespeare quote from The Tempest). The point is that we have seen this all before.
It's not so much that new money is coming into the market --new money has always come into the market. What's happening though is that the nature of reinsurance itself is transforming. We can debate the reasons behind it all we want but it's happening right now in front of us.
You will recognize why we thought of the Charlton Heston quote. Chris O'Kane, CEO of Aspen Insurance Holdings, Ltd. said in a February 13th speech that the new reinsurance capital is "actually quite intelligent."
Kane is now at least the third senior industry figure to suggest that the "new" underwriters are not so na´ve as we once thought. Both AXIS CEO Albert Benchimol and XL Group CEO Michael McGavick recently said the same thing.
This publication, like others, admit to having obtained some mileage from classifying these underwriters as simply "plug and play underwriters". In fact O'Kane suggested that the new capital is "more quantitatively driven, more numerate and more dictated on getting right returns than the traditional capital is".
O'Kane did note however that not all the new capital is quite so intelligent and that "Soon there will be another major loss, some of the naive capital will be destroyed, some people would make mistakes, we'll find out the mistake they've made and they'll be cutting back or eliminating it from business."
It's probably a fair point but, really, is there a traditional underwriter who doesn't lie awake sometimes wondering if such a critique could also apply to them too?
We noted the continuing return of capital to shareholders via stock buybacks by reinsurers --this time by Munich Re. While returning money to shareholders is always a good thing in principle we found ourselves scratching our head a bit at this move. If Munich Re is giving back money to shareholders it means that it's decided they see little chance of maintaining an adequate return by deploying that excess capacity.
We've all been on diets before --some of us have been on more diets than others -- and are probably familiar with throwing away cookies or chocolate to avoid eating it! We couldn't help think about that watching Munich Re return that capital. By returning the over $1 billion Euros, it will be certain, they will never deploy that capital to support business at an inadequate premium. They won't have it any more even if tempted --not that Munich Re ever would be of course.
But we were surprised that in a company as vast and as diverse as Munich Re there were no mergers, acquisitions, initiatives, etc that that capital could be put to work supporting. Then we read Warren Buffett's annual letter.
Before we get to his letter remember that one reason insurers are struggling with the low interest rates is that they need to keep their reserves in very highly rated securities which are unfortunately the most affected by the low rates. Bigger companies have flexibility and can move that money around a bit compared to smaller less diversified insurers. Money is after all fungible--cash is cash --which is why we were a little surprised to see a company as diversified as Munich Re planning to return over $1 billion Euros this year.
One company which will not be returning capital is Berkshire Hathaway. Buffett's letter makes clear that one of the main engines driving the success of his conglomerate is the return he derives on the $77 billion of "float" represented by the premiums paid to all of Berkshire's insurance and reinsurance business.
Let's be clear on this. Here is what he said "Our float, money that doesn't belong to us but that we can invest for Berkshire's benefit, has grown to $77 billion." If it doesn't belong to Berkshire then who does it belong to?
Here is the answer --again from the Oracle of Omaha. "P&C insurers receive premiums upfront and pay claims later. In extreme cases, such as those arising from certain workers' compensation accidents, payments can stretch over decades. This collect-now, pay-later model leaves P&C companies holding large sums --money we call "float" --that will eventually go to others. Meanwhile, insurers get to invest this float for their benefit."
You can be sure that Warren Buffett is earning returns on that $77 billion of float far north of the prevailing 4 or 5 percent returns normally earned on safe, conservative investments. Berkshire's goal is always to keep the amount of float at a number higher than the total liabilities that his insurers have to pay but because Berkshire is so diversified they can meet any A.M Best review examining the sufficiency of claims paying ability with flying colors.
Oh and underwriting profit? Here is his answer. "If our premiums exceed the total of our expenses and eventual losses, we register an underwriting profit that adds to the investment income our float produces. When such a profit is earned, we enjoy the use of free money --and, better yet, get paid for holding it.
It seems that Buffett's main goal is to get as much investable float as possible as compared to the goal of most other insurers which is to produce an underwriting profit. He seems to think that the results of intense competition amongst insurers and reinsurers is lower premium prices which inevitably lead to underwriting losses which when coupled with traditional, paltry returns (today's market) on the float combine for a double whammy on most traditional risk bearers.
What does he do when he thinks an underwriting profit is not possible? Well, he doesn't return the money to shareholders. In fact he simply walks away and deploys the money elsewhere.
In a US television interview earlier this month he said Berkshire has pulled back on its US catastrophe business because premiums are no longer adequate to match the risks. He said "We actually in the United States have almost eliminated our catastrophe insurance business."
Instead Berkshire has "written quite a bit over in Asia" and with the launch last year of Berkshire Hathaway Specialty Insurance is after the US commercial P&C space.
The key to the whole success though, and he is very clear about this, are the proceeds Berkshire makes from the float. Let's think about this. A traditional insurer or reinsurer that is not well diversified and concentrates on only several lines of business effectively is at the mercy of that market for two reasons.
Because that firm is a traditional reinsurer its reserves are monitored to ensure they remain liquid enough that they are available in the event of claim. If this firm's sole function, is to underwrite risk (and worse yet, a single class of risk) it means that all its float comes from a single source --and one that requires very safe investing.
That insurer does not have the flexibility of a broad base of assets and investments, as does Berkshire or a fund manager, that would allow credit for its float to be marked against "safe, available" investments within the overall portfolio while earning higher returns in other slightly less safe and less liquid investments held by the portfolio. Remember, money is fungible.
The second reason such a traditional carrier is at a disadvantage is the old rule of supply and demand. If there is too little demand or too much supply the price of the good will decrease. If the investments of a traditional carrier are already at a disadvantage because of the need to keep liquidity and security what happens when those poor returns are compounded by falling premium prices further reducing the float amount as well as decreasing underwriting profit?
In a funny way the Berkshire model is a little bit of the model emulated by the ILS reinsurers. A number of the new ILS carriers are coupled with large hedge funds with a very wide diversification of asset classes. The float amount earned from the underwriting can be placed notionally within the asset portfolio of the hedge fund in as liquid an investment as needed, while higher returns can be generated by the hedge fund as a whole by freeing up the float amount for less liquid higher returning investments.
We admit we didn't quite get this at first when hedge funds began to back ILS writers. We should have discerned it though as these ILS risks are fully collateralized anyway. That full amount, or the ILS float, can then be earmarked within the expanding overall investment fund (usually a hedge fund) as a specific portion of its cash or US securities investments. The money is available as stipulated in the ILS contract but the hedge fund itself just increased in size by the size of the float amount and increases the overall return amount of the entire fund.
If you are Berkshire, and are wholly owned from top to bottom, assigning a percent investment profit to the exact amount invested into the overall entire Berkshire pool means that Geico, National Indemnity, Gen Re, etc. are going to enjoy the same high rates of return as does Berkshire.
We'll close this with one final observation. We've always thought that the popular understanding that once interest rates increase, and risk bearers can again earn better investment returns, the interest of the ILS carriers will wane. Now, we see that that understanding may not be right.
The interest rates will increase for everyone including the hedge funds backing the ILS carriers. If a traditional carrier is still not diversified, and bound to only specific LOB's, then they will still be in trouble. Their ROI will increase marginally, and they may be able to better withstand >100% loss ratios, but they will remain at a disadvantage to the model used by Buffett and the ILS carriers.