Reinsurance: what does “normal” mean any more?

We read with interest Willis Re’s recently published “Reinsurance Market Report- Year End 2015” for its insights into trends within the industry.

Many of the themes remain the same- a continuing rise in “alternative capital (now estimated at USD 70BN); weak investment returns; the perceived need to diversify revenue sources across product lines; and the return of surplus capital to shareholders. However, there were a couple of aspects of the report that should give senior management of (re)insurers pause for thought- normalized ROE, and rising Expense Ratios.

While the headline industry ROE shown in the report for those groups that make sufficient disclosure was a respectable 10.2%, if one were to adjust that figure for beneficial prior-year reserve development (of an average 3.7%) and normalized CAT charge of 4% (vs. the 0.9% experienced), “underlying” ROE would have been 3.4%, which would certainly not be sufficient to cover any reinsurers’ cost of capital (WACC).

It seems obvious that companies should not be able perpetually to keep releasing significant levels of prior year reserves- eventually they will be exhausted because of the impact of ever-shrinking premium rates, so there will be nothing available to release. And, if they did, it might make regulators and others begin to wonder about the extent to which reserves were being managed, or somehow “smoothed”, so it does beg the question of when such beneficial developments will come to an end, or even reverse.

So far as rising Expense Ratios are concerned, the report flags that, for the same subset, between 2007 and 2015, Expense Ratios increased by an average of 4% to 33.1% (with increases weighted to the most recent years); which again, of course, is a drag on underwriting profitability and thus on ROE. The sense is that, in attempting to diversify their books of business, reinsurers have increased their focus on so-called specialty lines and had to hire more expensive underwriting talent, as well as seeking to increase expenditure on hazard modelling, and have had to deal with greater regulatory and governance costs. Obviously, if such resources enable greater volumes of more profitable business to be written, that is a good thing; but the fact that levels of premium in aggregate have not increased much in recent years because of the prevalence of soft markets makes one wonder when and how such an investment in human capital will generate adequate returns. And all this should be considered against the background of rising levels of disruption within the industry and the debate about the extent to which underwriting can be done by expert systems based upon adaptive algorithms.

Of course, investment returns also remain suppressed in the current low rate environment (with the market volatility in the first quarter of 2016, no doubt spooking many); while the increasing prevalence of “negative” interest rates and the receding probability of material rate rises from the Fed merely serve to constrain performance further.

So, a reinsurance executive’s lot is not a happy one! What we are observing in reinsurance is a very basic economic dynamic, which happens without fail in every sector: as capital becomes abundant, the availability of excess returns moves away from capital to a more scarce resource- highly-skilled labour- until capital finds a new opportunity to which to apply itself where it is not abundant. At Awbury we seek to provide carefully selected programmes (using our scalable E-CAT platform) that are not commoditized; offer attractive risk-adjusted returns on capital; and in which our interests are fully aligned with those of our partners. We are not a panacea, but we believe that we can add value to a (re)insurer’s book of business in ways that are not constrained by existing market norms, and will not be affected by the probable reversion to the mean in the NatCAT space in terms of reserving and the levels of CAT losses.

And in honour of William Shakespeare, on the 400th Anniversary of his death:

…determine on some course, More than a wild exposure to each chance That starts i’ the way before thee…” Coriolanus, Act IV, Scene I

The Awbury Team

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Brexit: this is not a drill!

So, we are finally putting finger to keyboard again to write a post about “Brexit”- the risk of the United Kingdom leaving the European Union, as a consequence of a “No” vote in the referendum being held on June 23rd.

We shall not rehearse in any detail how the fact of this event risk came to pass, other than to say that the governing Conservative Party’s internal politics are largely to blame.

At Awbury, we find it somewhat odd that the “Yes” campaign appears so dysfunctional. The “No” campaign is not much better, but it has the easier slogans and “pitch”, and seems to be gaining some traction, even if the bookmakers’ quoted odds still just about assume a “Yes” vote. Opinion polls are “within the stated margin of error”, meaning that, prima facie, the outcome is too close to call.

The comforting thought is that, as in the Scottish Referendum last year, at the last moment a sufficient majority of the “people” will see reason and vote in favour of what they know, even if they do not particularly like it, rather than opt for what would be a very uncertain outcome. After all, an independent Scotland’s fiscal position would have been severely damaged by the collapse in oil and natural gas prices.

However, can one really be certain that “reason” and “rational self-interest” will prevail? There is a demonstrable level of distrust of governing elites; and the political classes are failing to make a robust and coherent case to rebut the anti-immigration, anti-Eurocrat and nationalistic “sound bites” of the Leave campaign, with some disturbing parallels with the current populist insurgencies in the US elections campaign.

The battle lies between the simplistic and the complex; and, in a democracy, it is very dangerous to patronize those who will vote because “we” know better; and so you should trust “us”. Having to explain often means you are losing the argument in a political system that promotes the “soundbite”. One may wish for some Churchillian rhetoric that will engage people’s hearts and minds and win the argument decisively; but it is, so far, sadly lacking.

As our title states, this is not a drill. It is the real thing, and a “No” vote will have real if, as yet, uncertain consequences, for the United Kingdom, the European Union, and for the wider world. What was, until very recently, seen as hypothetical now runs the risk of becoming very real; and any business that is not planning for the aftermath of a “No” vote is in denial, because the risk is no longer “in the tail”.

The day after a “No” vote, the world will have changed; and, because there is no precedent for such an outcome, scenario and contingency planning are essential, even though the more significant consequences (other than volatility in the FX markets and a probable change in government leadership) will be in the medium- to longer-term.

At Awbury, we have been monitoring the unfolding of the campaign as part of our regular “scanning of the horizon” and threat analysis, both to understand its potential impact on our own business, and to try to estimate the same for our partners and clients. We do not pretend to have all the answers, but would welcome a call from those who wish to discuss the risk and how we can help manage the credit, economic and financial components of it.

The Awbury Team

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