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- Rumblings in China should alert industry
- Smoke clears on PartnerRe: RSA/Zurich next
- Alternative capital is here to stay
- Millette is back in the ILS/alternative cap arena
- Formerly "safe" LOBs may be in target zone
- CATEX in Monte Carlo
- Roger notes "short-termism" is the biggest risk
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Contact
Princeton: 609 683 0888
London: +44 (0)20-7816-2691
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The Monte Carlo meeting later this month is lining up to be particularly interesting. The news that RSA seems to have responded favorably to Zurich's acquisition terms indicates that industry consolidation isn't just limited to brokers and reinsurers. We now face the possibility of "super-sized" cedents entering the arena. And why not? Everything we've been reading discusses how cedents are raising their retentions and consolidating reinsurance purchases across whole enterprises. If you add in the trend demonstrated by reinsurers and brokers, to move as far down the premium chain as possible, to get closer to the original buyer in order to retain more premium or commission, you can see why cedents might react. It stands to reason that eventually cedents would realize that they are well positioned to benefit from these developments. The RSA-Zurich deal is a logical follow-up to the Ace-Chubb deal. Meanwhile back at the ranch --the reinsurance ranch that is --Exor indeed did win the bidding for PartnerRe and we will note some of the comments by the institutional stock managers, ISS in particular. With the exception of Validus' Ed Noonan hardly anyone was saying anything publicly about the deal until the end stage so the ISS comments are revealing. Alternative capital will have a full seat at the table in Monaco. We know this because trying to arrange meetings with the ILS carriers has been a challenge. They are planning to be very busy. We can remember only two years ago in Monte Carlo when the ILS carriers were casting about finding their footing. Welcome to the mainstream. CATEX has a full schedule of meetings beginning on Sunday morning in Monaco. We're also awaiting the release of the list of Intelligent Insurer award winners that comes out Sunday too. You may know that CATEX has won the award as Best Technology Provider each of the past two years. We have all of our fingers crossed! Roger Crombie's column is here too and, as you will read, he has become frustrated with his homeowners association board and the structure of boards in general. If you have any questions or comments about this newsletter, or CATEX and its product suite, please contact me.
Thank you very much.
Sincerely,
Stephanie A. Fucetola Senior Vice President/CATEX |
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The "Opacity" of Risk --and one big risk at that
We noticed a few things that piqued our interest over the summer. We saw the tremendous explosion at Tianjin, China which actually may result in an insurable loss of $1.5 billion. More recent reports show the insured loss could be as high as $3 billion. We noted the disparity in the size of the insured loss, when compared to other economic losses in Asia, and read that the Port of Tianjin is a region with a very high insurance penetration compared to the rest of China.
Tianjin is the 5th largest port in the world so it's likely that the value of the infrastructure far exceeds $1.7 billion. When compared to a port in the US or Europe Tianjin was still under-insured. The cause of the explosion remains unclear and the apparent lack of proper instructions, when trying to extinguish the sodium cyanide, calcium carbide and toluene diisocyanate fires with water, apparently exacerbated the losses significantly.
Then we noticed that at least in two instances large investments were made by Chinese companies in the reinsurance arena. China Minsheng Investment Corporation announced that it had purchased Sirius Re and a new Chinese reinsurer was capitalized with $1.6 billion behind it.
There were a number of stories, prompted by the damages caused by Super Typhoon Soudelor, noting the "gap" between economic losses in under-insured areas such as China and the level of insurance held. This "gap" is the sweet spot for many reinsurer, insurer and broker business plans over the coming decades.
We read a number of articles talking about the realization by ceding insurers that alternative capital is here to stay. To put it another way it seems that the "permanence" of alternative capital is now accepted by insurers and reinsurers alike. We even saw articles talking about the comfortability of alternative capital with investments over much longer time horizons than previously ever mentioned --all of this based of course on the uncorrelated nature of insurance and reinsurance risk to financial market risk.
And we read that even more capital continues to come into the market. Guy Carpenter noted that new alternative capital has been flowing in at a rate of $1 billion a month for the past 18 months and that the appetite may even continue once interest rates rise.
If the alternative capital flow is to continue unabated, and the sweet spot for the risk industry is that "gap" between under-insured areas and possible maximum economic loss totals, that means that sooner rather than later China is going to become even more important to the insurance industry.
This news is hardly a news bulletin. Lloyd's John Nelson seems to visit China often enough as do other industry leaders. However, as simple working people who maintain innocuous enough IRAs and 401ks, we've long been a little skeptical about putting our retirement savings into Chinese stocks and mutual funds. We're wondering, when we have comparatively so little to lose, if much larger players share our concerns?
Capitalism is an odd thing. It requires initiative, a certain amount of ambition and an acknowledgement that the rules exist to ensure that there are level playing fields. Entrepreneurs in countries emerging from years of totalitarian rule always seem to have the first two --initiative and ambition --but we're not so sure about the "acknowledgement of the rules" part.
We've given up counting the stories about harmful substances "mistakenly" added to pet food, fertilizer and food for human consumption pertaining to Chinese suppliers. We've also given up tracking the number of stories about faulty, not up-to-code building materials imported from China. We've even become a bit blase about stories concerning rail, road and infrastructure scandal in China which have caused the loss of life or financial harm. And, finally, we know very well that censorship of speech and media is alive and well in China.
We have a vague idea about how China works. We hear stories about booming economic success but also read stories about urban "ghost towns". We read about a growing urban middle class but also read about extreme poverty in rural areas. We can see that a sense of empowerment has reached the average Chinese person and can't help but sympathize with them when they join in spontaneous demonstrations against government inaction about issues such as environmental concerns. We know that there are controls on communication over the Internet and we've read that the government employs 100,000 citizens to monitor the other 1.4 billion people online.
We've read numerous stories about official campaigns to end corruption but we've also read stories about the "prince-lings", children of Chinese leaders, who seemingly have their fingers in many economic sectors and companies and without whose assistance corporate success in China seems to be difficult if not impossible.
In short we see a bit of a stacked deck of cards when looking at China and we wonder really about the math behind it all. How long can one small group of leaders at the top control 1.4 billion people? Eventually something will have to give, right?
But every country is different and we're not Chinese and we don't live there. So judging the situation isn't really our remit and we're hardly qualified to do so anyway. But sometimes things happen in this increasingly interconnected world we live in which brings up the realization that we are being affected by decisions made far away and by a group whose sole goal could be self-preservation.
We noticed last month when China devalued its currency. The logical result of that was overnight Chinese goods became much cheaper on the international market and foreign goods became much more expensive to buy in China. The Chinese government apparently believed that they needed to boost their domestic economy (although it's an open secret that analysts know they can't rely on the regular economic numbers released by Beijing) so one can only think that's the reason for the devaluation.
By the way, the devaluation no doubt had an impact on insurance and reinsurance premium pricing too. If you sold a policy in China denominated in renminbi you're now getting paid less.
The government's goal is a 7% annual growth rate --no matter what. Observers have wondered for a long time about the $28 trillion of Chinese debt (282% of GDP) and the fact much of that debt is linked to China's real estate market. Observers have also known about unregulated shadow banking accounts that underwrite nearly half of new lending and that the debt of many local governments is unsustainable. But so long as the economy meets that 7% target growth rate the equity, financial and lending markets remain afloat, and other problems remain masked.
The 30% plunge of the Chinese stock market this summer was due in part to a belief that the 7% target was not going to be met as well as a loss in confidence in the metrics used by the government to calculate economic growth. China is, after all, a country whose premier has said that since Gross Domestic Product is "man-made" it is therefore unreliable. No major advanced country's statistics are viewed as skeptically as China's.
We suppose that the net result of everything that we've seen over the past month about China now has us concerned too. We're concerned that the biggest, potential market for our industry is a place where the normal market rules don't seem to apply. The unelected government has limited experience in macroeconomic capitalism; the economy remains centrally managed; official statistics cannot be relied upon; much of the debt load is linked to real estate of questionable value; regulations and laws seem to be applied unevenly; freedom of speech and criticism of the government are prohibited; and per the FBI, its government funds hacking efforts designed to steal Western corporate and government secrets.
What frankly has us worried is that we just can't erase images of those euphoric flag waving mobs, armed with sledgehammers, atop the Berlin Wall in 1989. Realistically, in China, how long can one expect this imbalance to continue? How long can a population of 1.38 billion people be "managed" the way Beijing has been managing until pushback occurs. And while "pushback" could lead to increased freedom for the average Chinese what will it mean for the economy?
Not to revert to the conundrum of a philosophical discussion on definitions but supposedly, if you can even imagine a "black swan" event that means that it's already a foreseeable event and thus not a true completely unforeseen event. Even we, from our little corner of the world, are imagining potentially pivotal change in China in the future. Unless we are completely off-base in our analysis does that mean that the risk industry is pricing in the prospective cost of such a possible upheaval in China when writing policies? Does that mean that the industry is mindful of these risks when they are increasingly making China a centerpiece of their future business plans?
Readers of this missive are in the business of evaluating risk. We are assuming that the answers to our questions are a resounding "yes" in both cases. We hope so.
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Smoke clears on PartnerRe: Zurich and RSA next
Before we get to the Zurich-RSA acquisition we do want to note comments made in the final stages of the ill-fated Axis-PartnerRe merger. The two big shareholder advisory firms, Glass-Lewis and ISS both recommended that PartnerRe institutional shareholders vote against a proposed merger with Axis.
ISS in particular had some interesting words about the PartnerRe board, especially in connection with the $3.5 million cash bonus it had structured with interim CEO David Zwiener. ISS noted that the bonus would be paid only if the Axis deal came to fruition rather than any other transaction approved by the PartnerRe board.
ISS said "At the least shareholders may question how the PartnerRe board, surely advised by capable counsel, could have accidentally created such a conflict of interest for its interim CEO rather than drafting language which would reward him for executing on the transaction which offered the highest value to all shareholders."
ISS noted that the resistance of the PartnerRe board to overtures from Exor was "puzzling".
We like what Validus' Ed Noonan had to say too. "ISS and Glass Lewis got it right" said Noonan. "This is a victory for good governance. It's just a shame that the PartnerRe board let it go so far that it had to be publicly rebuked in this way. It's embarrassing for the directors."
We would only note that it was those same directors who allowed the whole thing to unfold in the first place. Mr. Noonan is being charitable. We've even seen speculation that those directors would be vulnerable to a D&O claim.
So much for M&A news in the middle of the summer, right? Not quite. Last month news came that Zurich Insurance was looking to make a bid for RSA. Almost immediately the 300 year old British insurer said that there was no substance to the reports and that there had been no discussions with Zurich.
Things changed quickly however as Zurich was forced by UK takeover laws requiring a formal expression of interest (as well, perhaps, as a little goading from RSA's Stephen Hester) into actually discussing an offer with RSA.
Surprisingly, relatively quickly, RSA agreed to recommend to its Board that it be acquired by Zurich for approximately $9 billion. The dust is still settling on this one but initial reactions are that the nearly 2 times book value offered by Zurich will nicely benefit RSA shareholders who had been told by management that they could see a return of 12% to 17% by 2017. The Zurich deal would provide them with more than 5 times that amount in 2015.
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Alternative Capital to play big role in Monaco
There was some interesting discussion about alternative capital this month too. We noted this in connection with the Monte Carlo Rendez-vous later this month. This year, it seems, the ILS players will be full fledged participants as they meet with brokers and cedents about reinsurance coverage offerings. Things have changed very quickly for them.
In its latest renewal report Guy Carpenter observed that over the 18 months leading up to the mid-year 2015 renewals some $18 billion in new capital came into the market through ILS funds, sidecars, hedge-fund backed reinsurers and collateralized vehicles. Carpenter says that, overall, of the $400 billion in capital dedicated to reinsurance globally some 16% or $66 billion is so-called alternative capital.
This is a big number and points to the broker's conclusion (and we don't dispute it) that there is a " growing embeddedness" of this capital in the reinsurance market where it's increasingly viewed as a permanent fixture. The upside to this "growing embeddedness" is that ceding companies are gaining increased confidence in it and buying additional limit and restructuring existing programs.
Oddly, though, in a study from A.M Best, primary insurers were asked whether they had felt the impact of alternative capital in their own business. 78% of them said that their business had not been affected by the growth and entry of alternative capital in reinsurance.
Hmmm. You can hear the sighs from London, Germany, Switzerland and Bermuda. Don't those cedents have any idea that the low reinsurance premiums they're now enjoying are largely due to this $66 billion influx of capital? Well, maybe the respondents took the question literally and decided that since they had no contracts (that they knew of) with any alternative capital provide the answer was "no"?
Watch this number to change though. The ILS players are as savvy as the traditional carriers and know that getting closer to the risk --by providing capital to program service providers, MGA's and fronting --is where the margins are. A year from now more and more primary carriers will have seen their business affected by alternative capital.
One such example is what Nephila is doing with State National Insurance Company. State National expects to generate $10 million to $13 million in fees from its program business fronting relationship with Nephila, State National reported $3.2 million from the Nephila relationship in Q2, 2015.
State National is admitted in all 50 US states and Nephila is able to use State's facilities to access its program services unit for property insurance risks in catastrophe zones for this year and next. State National's 50 state license gives the giant insurance linked securities and CAT risk investment manager access to business it can't reach directly.
This is about as close to the risk as you can get and you can be sure that Nephila will have options available to it when its exclusive arrangement with State National ends at the end of next year.
There's more on this though that came out this month. V.J. Dowling, a shrewd market observer, noted that the reinsurance business has changed. Dowling said that "being close to the customer is critical. Intermediaries are in that position and 'He who controls the customer wins'.", describes why it is the best possible position in the value chain.
For reinsurers? Dowling said "Who is furthest away (from the customer)? It's the reinsurers. And more money is staying with the intermediaries in the form of increased compensation and out of the hands of the re/insurers."
Dowling may be right. Look at these other points that came up this month. Underwriters in London are bitterly complaining that the influx of new capital --initially coming into the CAT market --has created something called " refugee capital" that reinsurers suddenly now have available because they've cut back on CAT reinsurance. That money is cascading down now to other lines of business especially CAT-exposed, short-tail specialty lines.
In an article in Insurance Insider one source was quoted "The capital has cascaded down from simple CAT reinsurance, with traditional reinsurers moving into non-CAT classes and then cascading from there into specialty insurance classes like US CAT-exposed property, energy, etc,"
Pricing for London specialty risk business is "carnage" says Richard Brindle and the aviation market "defies belief" said one underwriter. There is so much money available to write these risks that underwriting discipline, some say, has been abandoned and risks are being written just to book the deal. Observers point not only to the low pricing but also to broadening of terms and conditions being offered by some underwriters.
Using Dowling's analysis this trend is simply a reaction (some may term it a desperate one) by reinsurers to get closer to the risk at seemingly any price. Another Lloyd's CEO was quoted as saying "I wonder if liability and binders isn't where you see the pressure next because people are stampeding towards that. The market always moves like a herd."
This stampede may not necessarily run right off a cliff --it may run smack into a wall instead. The "facilities" that have been set up by Aon, Carpenter and Willis, to bring risks into "follow-form" mechanisms, have caused significant amounts of business to be packaged up and bypass risk-by-risk underwriting controls.
When these facilities are combined with traditional line-slips, already controlled by brokers, there are bound to be underwriters excluded. Add to the facilities and line slips the "panel-style" deals, where brokers have restricted participation to pre-agreed lists of carriers, that have proliferated in the terrorism and financial institution classes, and one begins to wonder if the "cascade" will come to a full stop in the future. Many risks and classes seem to be locked up already. Where will the refugee capital go?
Money is fungible. Reinsurer capital that had underwritten excess CAT has been partially displaced by alternative capital so it has to go somewhere. If reinsurers are trying to get closer to the risk the specialty open market is a logical enough route but options are limited. Brindle says "There's virtually no open market business left. You can't underwrite the class anymore--all you can do is write the facilities. And even if you get chosen to be one of the leaders you're in a competitive bunfight with four or five others."
Another cloud on the horizon is the fact that the more risk bearers are forced to play the role of simply a capital provider --following along powerlessly per the terms of the form without any underwriting input --they could be more likely to be replaced by alternative capital which would be only too happy to jump in place. The development of ever more sophisticated analytics offered by brokers managing these follow-form facilities may indicate that the brokers have already envisaged such a day.
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| Millette resurfaces at Hudson | Alternative Capital show of force in Monaco | If you've attended any of the ILS conferences recently you know who Michael Millette is. Millette is the former global head of structured finance at Goldman Sachs. He was a key figure in the growth of the CAT bond/ILS markets since the mid 1990s.
Millette announced his retirement from GS in February and has launched a new firm named Hudson Structured Capital Management. According to Artemis "one of Millette's goals at GS was to develop the ILS market into a more broadly diverse set of structured risks, so outside of the catastrophe risks that currently dominate the market."
More succinctly, says Artemis, Millette "always saw the potential of the ILS market as much greater than purely providing reinsurance for catastrophe risks."
We then read this from Stephen Ruoff of Tokio Millenium Re: "If you look back, in former times people invested in stocks of reinsurance companies. Then they invested money into the Bermuda operations directly. Today, the capital is coming to the risk without buying stocks or investing in companies, they want direct access to the risk."
V.J. Dowling observed that the reinsurers are trying to move closer to the risk and we've seen that in the London specialty market. Why shouldn't the ILS market want to move closer to the risk as well? Not only is more of the premium available closer to the risk but the chance to build a relationship improves too.
So if Millette is able to replicate even in a small way what he did at Goldman that will mean he will have no shortage of capital looking to underwrite risk. If Nephila is already deep into US program business with State National, moving ever closer to the risk, might Millette try to do the same?
Then we noticed this article talking about the proliferation of collateralized insurance companies in Guernsey. Guernsey, an island in the Channel nearer to France than to England has seen 45 new international reinsurers licensed there during the first half of 2015.
Artemis observed "Once again the formation of protected and incorporated cells has driven new licenses, many of which are utilized by either insurance-linked securities specialists, funds, investors or reinsurers looking to transact reinsurance contracts on a fully-collateralized basis, backed by third-party capital."
We would note that not only are "protected and incorporated cells" driving the new licenses but rated commercial insurers too have been approved.
We wondered about this. After all cells are not new; nor is the use of cells by alternative capital a new development. Then we noted some comments in a "Roundtable" report released by Insurance Insider and the picture became more clear.
Panelists were asked their opinion of "the latest version of the reinsurer, the shall we say, captive reinsurance fund that's parallel to the placements". Collectively, we read a three part response.
First there were Evan Greenberg's comments about the ACE vehicle, ABR Re, noted by Swiss Re's Keith Wolfe, in which he said Greenberg had observed ABR Re will be here for decades and it will probably be at least a decade before Ace considers writing external business on it.
Then Arch's Tim Olson mentioned Arch's association with Watford Re, a platform that has a lower operational cost than most of its competitors. Olson said "given the nature of the original business that's assumed Watford can be more competitive than just Arch Re, so it's here to stay. It's part of what we are."
Then Tokio Millenium's Stephan Ruoff, putting the discussion in context, said "As you say, it's my cession, which I use and then team up with an investment manager. Having said that the interesting part (of the "latest version of the reinsurer") is the idea to spin it off and list it in however many years. Because that means not only that I'm loading off more reinsurance, I also turn a cost center into a profit center."
Swiss Re's Wolfe interjected at that point observing that "You're fulfilling a short-term objective for private equity and ultimately building in an embedded value that you can float."
The implications of these remarks are big. By running specific cession risks, that require reinsurance, through a dedicated ILS cell company that's backed by investor capital, the reinsurer obtains the benefit of the lower premium (based on the vehicle's lower operating cost), shares in the underwriting profit (if it has part ownership of the cell vehicle) and stands to reap IPO value in the future if the cell vehicle is ever floated as an independent company.
This is hardly a far-fetched scheme. The reinsurer is going to place its ceded business where it makes most financial sense and it will "control" the flow of business into the vehicle. Why not envisage the next step and think about floating the vehicle and gain even more value from the business?
Swiss Re's Wolfe said that "75% of the risks on this planet aren't in the insurance marketplace." Based on that we would be surprised if Millette is not thinking of numerous alternative capital platforms to handle the hoped-for inflow. If eventual IPO's are a goal for these platforms this could be quite lucrative.
We would be remiss not to note that there is one other constituency that must be watching these developments very closely. The percentage of ceded business placed by the "Big Three" brokers continues to increase. It would be a surprise if they have not identified equity floats as an upside to the business they've developed, managed and continue to place.
| We're looking forward to the Monte Carlo Rendez-vous which begins on Sunday, September 13th. We will, as usual, observe the activity from our table at the Cafe de Paris.
This will be our third Rendez-vous and as we've noted in this edition we expect to see signs of the continued importance of alternative capital in the reinsurance industry.
During our first conference in 2013 the alternative capital attendees were not exactly relegated to the sidelines but they were not among the main group of players that we expect them to be later this month.
There's a reason for that too --in fact there are lots of reasons for it. Low interest rates, uncorrelated risk, operational efficiency, increased modeling accuracy, plunging premium rates, cedent independence and many other factors have combined to help bring alternative capital more into the mainstream of risk solutions than was imaginable only a few years ago.
Two important factors are also present here that have to be mentioned. First, the reinsurance industry itself began to embrace alternative capital for selected risk classes after seeing the operational savings alternative capital providers were afforded by their structures that permitted lower rate offerings than could be offered by traditional carriers.
In short the cost of capital was lower under their models than it was in their own. Reinsurers followed the money. It would be hard to think of a reinsurer that does not have a sidecar or vehicle attached to it. If the risk won't produce enough premium to write on the reinsurer's traditional paper maybe the sidecar. that has a lower cost of capital, can write it more competitively.
The second factor that's contributed to alternative capital's new role is the sheer creativity and determination of ILS carriers like Nephila. Three years ago common wisdom had begun to come around to accept that alternative capital was here to stay for lines of business like Florida wind --straight up business, easily formatted for simple price and claim processes.
While the industry was grudgingly coming around to accept the presence of alternative capital in CAT business it didn't know that Frank Majors and Barney Schauble and others were already planning a run on more traditional business like program business or even funding its own syndicate at Lloyd's.
Today, people like Paul Dassenko, CEO of Risk Transfer Underwriting, a specialist provider of solutions for legacy liabilities, with a particular focus on self-insured Workers' Compensation can say "Most of our interface with alternative capital is for the longer-tail business."
Worker's Comp long-tail business suitable for alternative capital? Yes. Per Dassenko, "The capital that's coming into the market today is much more substantial, and the commitment that they're making to resourcing the capital behind the new entrants is truly credible." He went on to say "In the 1970s and 1980s, people thought they could dabble in catastrophe business and any number of other products and they were there for the short term. We have very deeply capitalized entrants today that are trying to do something different."
It's hard not to think of the $9.5 billion Nephila as anything but a very deeply capitalized entrant. And there are other "very deeply capitalized entrants" too including Aeolus, AlphaCat, CATCo, Elementum, Fermat, Leadenhall, LGT, Stone Ridge, Securis and Twelve Capital to name but a few.
It's certain that the discussions next week in Monaco will no longer focus on whether alternative capital has a role in insurance and reinsurance going in the future but instead will discuss just how extensive that role will be. Remember, if 78% of ceding insurers don't think alternative capital has affected them yet, that means there is a huge untapped market out there for ILS carriers, CAT bonds and cell reinsurers.
Much of that untapped market can and will be reached by the brokers which is why we are particularly alert to growing relationships between alternative capital and intermediaries. That dynamic, in which brokers can hardly resist entreaties from clients for more choices, has helped contribute to this "every man for himself" trend in which each sector of the industry seems to be pushing on its own to get closer and closer to the risk.
It promises to be an interesting week in Monaco and we will be watching and listening closely.
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CATEX in Monte Carlo
From our own perspective we will be meeting with dozens of prospective clients and current clients interested in learning about CATEX software particularly our Data Vera application and Delegated Authority Management System.
CATEX can track the risk, all the way down to its most granular level, and you can be certain that we will be discussing that capability with ILS managers and underwriters alike next week. The push to "get closer to the risk" is something we've planned for and our systems facilitate that like no others can.
We will also be watching the results of the Intelligent Insurer awards survey which was completed by hundreds of industry participants.
CATEX was named the Best Technology Provider of the Year in 2013 and again in 2014. We are keeping our fingers crossed as we await the 2015 results which will be released September 13th in Monaco.
We're sure that our October CATEX Reports issue will include more than a few stories gleaned from Monte Carlo meetings. This is why we go each year. We develop software and operate systems for the reinsurance industry. We have to be on the ground listening to their concerns.
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"Short-termism" is insurance industry's biggest risk
Reporting rules leave insurers ill-prepared for swings in stocks
 Roger Crombie
Of all the pressures that insurance company management faces, short-termism poses the most serious dangers. By 'short-termism,' I mean the markets' insistence on quarterly economic reporting. The need to march to a quarterly beat set for other enterprises is an obstacle to sensible behaviour at insurance companies and certain other industries.
In a greater sense, I refer to the market's need for companies to behave in a pre-ordained economic manner, even if the efficacy of the model being operated cannot adequately be judged that way.
To cite the title of a movie, there is Big Trouble in Little China - temporarily. A stock market that has become a gaming arena is experiencing a reverse. No surprise there. At the very sight of a correction, however, the lemmings fly off the nearest cliff. The recent falls in non-Chinese equity prices across a number of wider markets are a further example of the power of short-termism, which may yet signal the onset of what history might refer to as a panda bear market.
Insurance companies' results for the third quarter of 2015 will not be available for some time, but they are likely to show investment losses, with realised losses perhaps exceeding unrealised. There remain but a few weeks before September 30, in which the markets would seem unlikely to recover their temporarily lost value. If September equity values are indeed markedly lower than was the case at the end of June, earnings will be deflated in Q3.
Absent 2015 statistics, I'll use the 2007/8 period as an example of the point I'm making. Share prices tumbled around the world. Many insurers who maintained a statistically meaningful percentage (10 percent or greater) in equities faced hefty potential losses on their portfolio.
The accounting term 'mark-to-market' means that, today, such losses would have to be reported in the quarter in which they occurred. That's a sensible accounting approach. There's no merit in carrying shares at cost if they are not at the balance sheet date worth what was paid for them. Mark-to-market enhances volatility in balance sheet reporting, but cannot be decried for that reason, since it demands the reflection of actual, rather than theoretical value. Mark-to-market volatility is most keenly felt over the short term.
As the 2007/8 downturn worked its way to being described as a full-blown recession, and teetered on the brink of becoming a depression, share prices fell and fell and fell. One reasonably conservative portfolio with which I was familiar at the time fell by 70 percent in value before the thing was over: my own. I rode the downward trend all the way, and then stayed on board as the markets recovered. My broker told me that was unusual behavior. Most of his clients sold out all the way to, as well as at, the bottom.
It became apparent that many insurers and reinsurers lacked similar fortitude, and suffered as a result. As we all know, some insurance companies are really investment vehicles that underwrite for public relations reasons. Leave the portfolio alone for long enough, and profits will accrue. Such companies do a spot of underwriting, even at a combined ratio in excess of 100 percent, to earn tax advantages. Investors may then kid themselves that they have non-correlated risks in their portfolios.
Much insurance business is long-tail. That's why, for decades, Lloyd's used a three-year reporting cycle. Then Lloyd's succumbed to the current notion that Britain should resemble the US as closely as possible in every way.
An accounting system exactly the opposite of what is required holds sway for insurance companies. Executives at the companies look mostly at the short term, driving down their own share price and furthering adverse market conditions for everyone else. Buying back one's own shares because the price is low is not a sustainable business model.
It's a sorry state of affairs, and one that will make all of us sorrier if a 2015/16 bear market does indeed set in. By Christmas, it may be that we are in the grip of pessimism unseen since 2007/8. Thanks to the dictates of short-termism, the effects on the insurance industry will be exacerbated.
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Roger Crombie is an American Society of Business Publication Editors national award winner. An English chartered accountant who lives in Eastbourne, on England's South Coast, he writes and broadcasts news and opinion in the US, UK, Bermuda and the Caribbean, in print and online. His main beat is insurance and financial services, with 30-year sidelines in music and humour. All views expressed in Roger's columns are exclusively his own. Contact Roger at [email protected].
Copyright CATEX Reports
September 3, 2015
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Validus' Ed Noonan had some strong words for Lloyd's when he said that "The excessive regulation of the market is stifling the entrepreneurialism that has been Lloyd's trademark. It's just gotten too hard to create new products within the market. These are significant challenges for Lloyd's to deal with. Otherwise it won't be long until the day Taylor Swift shows up to insure her legs and is turned away because the capital charge will be too high."...Speaking of "regulation" PacRe, the hedge fund reinsurer owned by Validus and Paulson & Co. requested that A.M. Best withdraw its rating. Noonan said that having to meet the A.M Best criteria constrained PacRe's investment strategy and that Validus can front business for PacRe so the entity can access business without a rating...Interestingly, the volatility of investments of any hedge fund vehicle, while not a problem for Validus which will cover any uncollateralized losses, did raise eyebrows at Standard & Poors. S&P highlighted the increased interest from investors in acquiring (re)insurers with strong operating cash flows, in a bid to replicate Warren Buffett's much celebrated business model. S&P said the Berkshire model is hard to replicate and is becoming "crowded trade" in a saturated market. The agency warned that "under new ownership investment strategies could be altered and potentially become more aggressive". Of course the agency could also have said " don't try this unless you have $85 billion of premium float like Berkshire does" but that would have contradicted the CreditWatch S&P put Berkshire Hathaway on after its $37.2 billion acquisition of Precision Castparts Corp. The thinking is that if Berkshire's cash outlay for Precision coincided with a series of massive insurance and reinsurance industry losses, and the enormous liabilities of some of the risks held by Berkshire ever attached, it would make cash all the more important to have (Pop quiz: Black Swan event or not? If yes then how many?)....We saw that sources said at the end of July that Amlin would be open for a sale if the buying price was in the region of $5 billion. That was at the end of July. By the end of August this was firmly a non-starter with CEO Charles Philipps firmly denying the July story and emphasizing that Amlin is not for sale. Of course it's a publicly traded company and we know how that can work out if someone truly wants to acquire you...We noticed that the new $450 million terminal at Kuala Lumpur International Airport, a new international terminal for low-cost airlines, is sinking --literally. Planes that are parked need to be secured firmly to the ground or they roll away. The CEO of AirAsia, the terminal's biggest tenant said "We should have never moved. We should have let the ground settle, fix it, and then move."...The London Market Group (LMG) is proposing a levy of 10 basis points 0.1% of GWP on each slip transacted in the London market over the next 5 years to fund a market-wide modernization strategy. The war-drums, remembering Kinnect, Blue Mountain, Project Darwin and EPS have already begun to be heard...Finally, here's a risk manager worth his or her weight in gold. Borussia Dortmund is Germany's only publicly traded football club. The team finished seventh in the league. The club's net income fell to 5.5 mn EUR from 12 mn EUR the previous year but its revenue tripled to 17 mn EUR as a result of an insurance contract which protected the team against lost revenue for not reaching the Champions League. Dortmund took out the 3 year policy in 2012 when it won its third straight German football club title in the Bundesliga tournament...
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