There is an unusual strand in the discourse of late that has begun to pop up. It's called "de-leveraging". If a risk is de-leveraged it means that the insurer no longer needs to maintain a reserve to pay a possible claim. That's not a bad outcome if you are a risk bearer but that's the financial definition of de-leveraging. It also has another meaning though in practice which could well mean the severing of responsibilities that an underwriter would have for risks insured because the obligations to pay any resulting claim has been kicked far down the lane.
There are a number of examples for this type of de-leveraging. Perhaps, because we live in New Jersey, we can't help but be reminded of the infamous Joint Underwriting Association (JUA), which at one time in the late 1980s, provided car insurance to 53% of all NJ drivers. This meant that the voluntary auto insurance market insured less than half of the state's drivers.
The JUA was funded not by insurers but by the premiums paid by any
The JUA had no underwriters even though it was the largest auto insurer in New Jersey. Underwriters from the voluntary market insurers would kick policy applications out to the JUA if they were not to their liking.
Worse yet was the fact that the claim process was administered not by insurers but by data companies who processed the claims and mailed the checks out.
Between the absence of any underwriting or claims infrastructure the JUA was one of the original "virtual" insurance companies. It didn't even need to make money so long as the surcharges and premiums kept coming in and the cash flow covered claims. As a result the JUA ran up a debt of some $3 billion.
There are two lessons to be learned here. The first and most obvious is that if the money needed to pay claims is too remote from the underwriting operation there is a sharp decrease in underwriting standards. If you know you are going to pass the risk to a third party, and not be responsible for the claim, you could do the underwriting blindfolded.
The second lesson pertains to what is sometimes referred to as the "Valu-Jet" effect. Here's how this one goes. When ValuJet flight 592 crashed in the Florida Everglades on May 11, 1996 killing all 110 persons on board a number of interesting things emerged in the investigation of the crash.
Like most discount airlines at the time, ValuJet did not own any hangars or spare parts inventories. The measures the airline took to hold down costs were aggressive to say the least. Pilots had to pay for their own training and were only paid after completing flights. The company outsourced many functions that other airlines handled themselves.
For example it subcontracted aircraft maintenance to companies who in turn subcontracted the work to other companies. Whenever delays were caused by mechanics ValuJet cut the pay of the mechanics working on that plane.
The deadly crash of Flight 592 was caused by an on board fire triggered by partially full chemical oxygen generators that were illegally stowed in the cargo hold. ValuJet banned the transport of such cargo but the NTSB investigation would reveal a pattern of errors and sloppiness exhibited by temporary employees of subcontractors who either were unaware of the prohibition or didn't bother to check the manifest. Even worse, the generators were loaded onto the plane without their safety caps in place..
There were other serious safety incidents as well which eventually led to the FAA grounding the airline in 1996.
You should be able to get a sense of where this is going to go in terms of reinsurance but before we get there let's go back to the first lesson learned from the NJJUA --the one about ensuring the distance between underwriter and claim is close enough to maintain the correlation between claim loss and proper premium setting.
There was an interesting conference sponsored by the Bermuda Monetary Authority in Bermuda on December 4th. XL's CEO Mike McGavick started talking about things that reminded us of the NJJUA and ValuJet.
McGavick was talking about the possibility that alternative capital (over $44 billion of it thus far in 2014) could ultimately contribute to instability in the system. He likened the potential risk to reinsurance to the sub-prime mortgage boom that led to bank collapses and triggered the economic crisis. He said "in essence this is the story of the real estate crisis and that is the risk here because the risk is being removed from those who took the risk."
Lloyd's Chairman John Nelson was present too and he didn't blink either. Nelson said (he is after all a banker and is well aware of de-leveraging) Nelson said, "It's going to be a continuous challenge that as the alternative capital market develops the temptation to detach the risk from the capital becomes ever greater and there will be kinds of securities where the returns look really alluring, but if we do that we will destabilize the whole thing exactly as happened in sub-prime mortgages."
Both statements were startling. We are, after all, in a world now where pools of money contract with underwriting teams to write risks. Those underwriters in turn contract with modelers to estimate risk of loss. In some instances management of claim activity is also contracted to claim specialists and the process chugs along almost as a virtual insurer.
McGavick said "The advantage of the integrated model is you're betting with your own money. That changes how you feel about it."
We know that McGavick is agnostic in terms of where his underwriting capital originates but we think his statement could have been made by any number of people including Hannover Re's Ulrich Wallin, Swiss Re's Michel Lies, Munich Re's Nikolaus von Bomhard and SCOR's Denis Kessler. If a risk bearer is an integrated entity, where underwriting, modeling, claims and management are all eating at the same table you can better avoid the JUA and ValuJet scenario because it is your money at risk.
Also present at the Bermuda conference was Nephila's Frank Majors, who, one could argue, is one of the largest providers of alternative capital to the reinsurance industry. Frank Majors is a very smart guy and he certainly knows to step off the tracks if a train is coming. When asked what he thought about this whole de-leveraging discussion he told the truth and said that alternative capital "is taking a risk off levered balance sheets and on to unlevered balance sheets".
Majors went on to say that "the effect of the alternative capital is actually to de-leverage the industry significantly and that in this stage of (its) development it is very different from the mortgage securitization which was a process of adding leverage."
Frank's response was 100% accurate. We think he could have gone on to say that alternative capital has allowed these very sophisticated and savvy risk bearers to access capital far less expensively than ever before and that while yes, abuses can happen (eating too much ice cream will kill you too), there is a certain amount of prudence one would attribute to a risk bearer that would lead one to assume that it will run its operation properly. Just because it is getting capital cheaper doesn't mean it will throw everything it ever learned out the window.
Keep in mind, we think that Frank Majors could have gone on and said something like that --it is the basic operating premise of all these ILS carriers, isn't it? Here's what he did say:
"This development of alternative capital does have the possibility for concern, or abuse, or misuse, or being taken too far into the future. Right now, I'd like to make the point that the effect of the alternative capital is actually to de-leverage the industry significantly. So it's very different right now, in this stage of development, very different from the mortgage securitization which was a process of adding leverage. If you have access to deeper pools of capital, that should add stability, unless it's abused in some way."
Keep in mind that by its actions Nephila is the antithesis of the virtual insurer. Remember that it has staked a syndicate at Lloyd's and is reported to have purchased stakes in three Florida insurers. Frank is doing exactly what he has said he would always do and as he notes the alternative capital market is different right now from the MBS market of 8 or 10 years ago. But as he has recognized, there is a potential for abuse there.
Nephila has always played on the right side of the tracks (to use our railroad metaphor) but it would be interesting to learn their views about so-called "ValuJet insurers", or those playing on the wrong side of the tracks.