The Battlefield

July 16, 2014| By Tad Montross | L/H General Industry, P/C General Industry | English

Earlier this year I wrote a short piece entitled "The Playing Field." Little did I know it would soon become a battlefield. One broker describing the June 1st CAT renewals in Florida called it a knife fight. Alternative capital, Insurance-linked Securities and CAT bonds are all the rage. Pension funds and hedge funds are joining the private equity firms, which have been jumping in and out of the reinsurance business for a decade.

The short-time horizon (two to three years) of these investors is in stark contrast to the duration of the liabilities of a reinsurance company where, even on a CAT cover, the payments stretch out more than three years - and on liability covers they can pay out over decades.

One broker is touting "the lowest risk margins in a generation"1  for reinsurance, insisting that the shifting dynamics are creating opportunities for "reinsurance-supported growth."2  And companies are "in the early stages of incorporating lower risk margin reinsurance into their capital management plans."3  Predicting that these rate levels are "sustainable over time"4  is a very dangerous prediction. We've seen this movie before - it was called Unicover.

Unicover was a pool of life insurers that wrote Workers' Comp in the late 1990s. Participants thought they were writing a carve-out policy, when in fact the only thing that was carved out was the premium. Unicover became a large reinsurance pool of Workers' Comp. They were essentially selling dollar bills for 50 cents. Putting the inevitable disputes aside, many companies were able to improve their net results with this cheap reinsurance but some companies built the cheap reinsurance into their gross pricing. When the Unicover pool ceased doing business, these companies couldn't get their gross pricing back to where it needed to be, and several companies failed. It was a good lesson in using cheap reinsurance opportunistically versus strategically. Any company that assumes this cheap alternative capital is permanent is taking a huge risk.

The same brokerage firm said "hedge fund-backed reinsurers seeking stable underwriting risks to complement sophisticated investment strategies will offer reinsurance terms attractive to classes that are not heavily reinsured today."5  The firm suggested that "auto and healthcare carriers are likely to lock in profits and become more capital-efficient."6  We've also seen this movie before; it was called Risk Capital Re, which went out of business after just a few of years in business. Writing reinsurance with the sole purpose of investing the float is backwards. Underwriting is the sustainable competitive advantage of any reinsurance or insurance enterprise that will be around to pay its claims for decades.

The hedge funds are getting into the reinsurance business because they can put $1 billion offshore and get the tax-free buildup; for them, reinsurance is a sideshow. They tout their competitive advantage as passing along the greater investment returns in terms of higher discount rates in their reinsurance pricing. This model is not sustainable. Higher asset returns compensate for greater investment risk and crediting the asset returns in the liability pricing is thus double counting. Liabilities should be discounted at the risk-free rate.

In the short-term there will be some opportunistic reinsurance purchases available given these strategies, but it would be dangerous to assume these are sustainable and much less sensible to build a long-term capital management and pricing strategy based on them.

Everyone is searching for yield. Central bankers have been suppressing interest rates since 2009. It is a massive experiment that will no doubt have unexpected and unintended consequences. The recent surge of interest in CAT bonds is likely one of them. Throw in benign CAT experience in the last couple of years, and ignore the extreme weather events we have experienced, and you have all the ingredients for a frothy market.

My advice is to ignore anyone that tells you this is the new normal. It probably isn't. It is a short-term opportunity to buy some cheap reinsurance. Why do I think it is a short-term phenomenon? Financial theory is being twisted. You often hear that pension funds have a competitive advantage in pricing CAT risk because they have a lower cost of capital. Pensions don't have capital; they invest other people's money. They are simply willing to accept lower returns for CAT risk - risk margins on CAT bonds are down 30% in the past year.7  I wonder how the Pension Benefit Guarantee Corp. feels about pensions investing in bonds where 100% of the principal is at risk.

Insurance-linked Securities are also being sold as a non-correlated asset class. Bankers cite 15 years of CAT bonds being in the market and their performance against other asset classes for that period, but the real correlation question is, What happens after the $200 billion insured CAT loss? I'll bet the correlations are closer to one.

There are a lot of reinsurance options today. That's good, but they are all not the same. It is important to think about both the short- and long-term implications of your reinsurance strategy. Reinsurance doesn't need to be a battlefield where there is a winner and a loser. It can be a partnership where both parties prosper over time from better underwriting and disciplined risk-taking.

End Notes
  1. AonBenfield, "Reinsurance Market Outlook - June and July 2014 Update."
  2. AonBenfield, "Reinsurance Market Outlook - June and July 2014 Update."
  3. AonBenfield, "Reinsurance Market Outlook - June and July 2014 Update."
  4. AonBenfield, "Reinsurance Market Outlook - June and July 2014 Update."
  5. AonBenfield, "Reinsurance Market Outlook - June and July 2014 Update."
  6. AonBenfield, "Reinsurance Market Outlook - June and July 2014 Update."
  7. Willis Re, "1st View - 1 July 2014."


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