It’s all in the price…?

It is probably a truism by now that P&C (re)insurers’ portfolios of Invested Assets (comprised mainly of Fixed Income securities) have suffered from relatively meagre returns because of some ten years of post-GFC interest rate suppression by the major global central banks.

So the fact that the Federal Reserve has gradually raised its benchmark rate (and is expected to continue to do so) and that 10-year US Treasuries now yield around 3% is often considered a precursor to higher portfolio NII, which is a good thing.

However, it is not as simple as that.

As Stuart Shipperlee of ratings-advisory firm Litmus Analysis recently pointed out, for reinsurers in particular, and especially for those with significant casualty books, expected investment returns on reserves are already built into reinsurance pricing models- and the brokers and their clients know that.

Therefore, if the reinsurance market is competitive and functioning as such, a dollar of premium booked which can be invested (and which is expected to provide a higher yield) becomes more valuable, leading to more competition for that dollar.

Of course, if reinsurers were operating in a generally hardening market, one might argue that they could be less aggressive on investment return assumptions and achieve better desired pricing. Unfortunately, and to state the obvious, that is not really happening except in particular loss-affected lines (and even then not to the necessary extent). The effectiveness of CAT pricing models has also gradually improved over time, so the risks of significant under-pricing should be receding. Unfortunately, that does not of itself lead to the ability to improve underwriting margins- only a truly “hard” market like 1992/1993 can do that.

So, as reinsurers approach the important 1/1 renewal season, one is beginning to hear the now-old refrain that the industry needs higher rates on line and to maintain “discipline” in the face of a broker market that has been used for years to shaving a little off the price every year. This is coupled with a hope that, if investment returns elsewhere begin to “normalize”, perhaps peak-ILS will eventually happen, and the industry’s chronic over-capacity for available business will gradually abate. This seems more hope than likely experience in the absence of some other radical catalyst. Capital will flow to where it perceives that sound non-correlated returns may be obtained- and the ILS market is one of them.

Furthermore, and somewhat ironically, a rising rate environment is likely to drive up reinsurers’ own cost of capital, as investors seek higher returns in that sector. This may give some impetus to a firmer holding of the line on necessary rate increases, but still only creates a “zero sum outcome.”

What reinsurers really need are premium revenues that are non-commoditized and offer strong, non-correlated returns when compared with CAT lines. Some think they have found that in covering “cyber” risks. However, given the inherent difficulties in modelling and setting boundaries to both the nature and the quantum of the constantly-mutating threats, we suspect that some are likely to be suddenly and severely disabused of that expectation.

At Awbury, our focus on underwriting bespoke, value-added credit, economic and financial risks readily provides a more attractive risk/reward scenario, which has generated significant returns for our partners since inception 7 years ago- a situation which we believe is both sustainable and scalable through careful risk selection across a wide range of opportunities.

One should always look well beyond the price and simple rate on line, and instead focus on the long-term risks and value of any (re)insurance business line. That is something we do every day.

Call us.

The Awbury Team

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CRE Can be Really Expensive for Lenders (and Investors)…

As we enter what may well be the late stages of the current economic cycle (with uncertainty exacerbated by looming trade wars and Brexit), we read with interest a recent report entitled somewhat provocatively “The CRE Lending Black Hole”, published by the UK’s Property Industry Alliance Debt Group.

The thesis of this document is that (in the context of the UK), if Commercial Real Estate (CRE) lenders (and investors for that matter) properly analyzed the complete “through the cycle” realised profitability of their CRE lending, they would begin to comprehend that, as the title suggests, it has recently been something of a “black hole”; because all the profits they believed they would make and had booked were negated (and more) by the losses from subsequent write-downs and write-offs. It is important to note that the particular period on which the report focused was 1992-2008; for which the authors calculated that write-offs (GBP 19.3BN) exceeded gross profits (GBP 7BN) by almost 200%- and this ignores losses from equity real estate investments.

We are sure that there will be those who quibble with the numbers and challenge the methodologies used (which are carefully explained). However, the difference between supposed profit and realized loss is simply too great to be dismissed. Furthermore, the authors argue that latent losses were potentially much greater at the bottom of the cycle, with lenders being “rescued” from even worse write-offs by being able to “hang on” and wait for values to recover as the economic recovery took hold. Nevertheless, it needs to be pointed out that the particular time period documented encompassed what was the worst downturn in several generations, and so was something of an “outlier”.

So, why did all this happen? What behaviours were major contributory factors? Could it happen again? Is this just a UK phenomenon?

To the first point, the report makes it clear that the 1992-2008 cycle was a more extreme version of previous ones; which, anecdotally, tend to result in a “crash” roughly mid-way through the second decade of expansion. While not participants, some of the Awbury Team have been around long enough to remember the crash of 1974- not as bad, but one that left scars and caused a secondary banking crisis. As in many other areas of the financial industry, it does seem that memories fade, and those still around, who do remember can seem like Cassandras, and too easily ignored.

In terms of behaviour, as the infamous Chuck Prince quote from 2007 makes clear, no-one likes to leave the party while everyone else is still dancing. Internal and external pressures from peers and competitors mean that one needs significant fortitude to decide that actually now would be a very good time to leave, just as it seems that everything is building to the peak. In fact, one should have left some time before. In addition, each sophisticated lending organization is convinced that its policies and procedures, coupled with the quality of its risk management and governance mean that it will be able to “get out” before it is too late. They are almost invariably wrong.

Since the Great Financial Crisis, the amount and quality of capital held by traditional CRE lenders has increased significantly, regulators are more vigilant, and such key metrics as Loan to Value Ratios (LTVs) more conservative. However, there are signs that valuations are stretched in a number of sectors, while the retrenchment of banks has led to much CRE lending now being undertaken by non-bank actors, which are less transparent to the markets. While many, if not most, are experienced and use much less overall leverage, nevertheless, the concern has to be that there are pockets of vulnerability that could trigger a down-cycle.

As the report makes clear, all its data are from the UK. However, one only has to look at experience in the US, Spain, Sweden, Japan- one could go on- to realize that the experience in the UK is hardly unique.

As students of financial history, the Awbury Team believes that a critical component of managing risk successfully is avoiding succumbing to “market groupthink”; being willing to take a contrarian view and, if necessary, walk away from transactions where, no matter how tempting the economics may be, the risk/reward ratio is skewed to the downside, with too many things having to go right. Avoidance of loss and ruin is essential.

Investors may not fully appreciate the losses that can offset profits in CRE; and outcomes measured depend upon the timeframes chosen. Trying to time a market is inherently dangerous (and not just in CRE!). Investors and lenders need to model for the fact that cycles turn; and that, to avoid being forced to liquidate in a hostile environment, one must maintain sufficient flexibility and robust liquidity until markets recover.

The report, while seeking to prove a point, does still provide a salutary example of why “this time round” it is rarely different; and that behaviours need to change if the inherent CRE “boom to bust” cycle is ever to be broken.

The Awbury Team

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Integration is a good thing…until it isn’t…

Much is made these days of the risk of “cyber-attacks” on individuals, businesses and governments, with cyber insurance being one of the few growth areas in the (re)insurance industry. This is as it should be, because even the disclosed events (and the majority are likely not disclosed) show how damaging such attacks can be.

Of particular concern are systems and networks which provide essential services, such as power grids, or air traffic control systems. Yet there are also under-appreciated risks in industries in which there is clear competition, with no obvious monopoly characteristics; one example being the oil and gas business.

Earlier in the year Marsh published a Briefing entitled “Could Energy Industry Dynamics Be Creating an Impending Cyber Storm?”- a headline which should have been guaranteed to catch attention. Not surprisingly, the article highlighted the fact that 76% of executives surveyed believed that Business Interruption (BI) would be the most dangerous cyber loss scenario. Of course, one of the issues the (re)insurance market faces is how to categorize a particular event and which particular policy(ies) should answer- the so-called “hidden cyber” dilemma. Conversely, risk managers may find out that the coverage they thought they had is not there, or capped at much lower levels than expected. Causation and attribution may not always be self-evident in, say, the failure in a well-head pump.

That aside, a key issue that remains to be tested is the extent to which unexpected links and dependencies may show up as the result of a cyber-attack. One targeted at a particular O&G business may have a broad impact because of the fact that, for example, cost-cutting as a result of the 2014-2016 industry downturn has led to supply chains becoming more integrated, with fewer alternative suppliers and greater standardization. Might disruption that flowed from an attack on one oil major’s operations cascade through its supply chain and through that into the operations of other producers? At what point might the digital equivalents of firebreaks stem the attack? Do they even exist?

The benefits of closer and more extensive integration are significant, so it is highly unlikely that the threat of a cyber-attack will reverse that process. However, the ever-expanding “Internet of Things” (IoT) means that more and more components of a business’ critical infrastructure are inter-connected, such that the potential consequences of an effective cyber-attack also increase in magnitude.

Paradoxically, all this means that effective risk management may well need to re-consider the creation of redundancies in systems (compare how civil aircraft are designed) and supply chains in order not to suffer a catastrophic business failure- in essence “buying insurance” that the failure of one link or supplier can be contained, isolated and addressed. It is all very well seeking to be the most efficient and low-cost producer, but that should not come at the expense of potentially embedding the risk of ruin within the overall systems architecture.

Awbury does not write cyber-risk (and has no intention of doing so). However, one has to look beyond obvious first-order effects; and we believe that it is essential that we continue to study and learn more about the threats to otherwise robust and high-quality businesses, let alone to those with less capacity to withstand material disruption to their operations.

The Awbury Team

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