At the very hot tables outside the Café de Paris in Monte Carlo last month the usual round of one-on-one speed dating meetings continued unabated.  Despite the fact that meeting participants were often bathed in sweat, with forearms sticking to the tables, meeting notes were taken and business cards exchanged.  In spite of the warm weather it all seemed like business as usual.

During the meetings in Monaco there was a sense that, despite the hopes of reinsurers, no pricing floor on premiums was going to be reached for the January, 2017 renewals. Presumably, underwriters arrived in steamy Monte Carlo hoping against hope that the diminished flow of alternative capital into the market and several noticeable loss events would begin to turn the market. This hope seemed to be unfounded and both Swiss Re and Munich Re warned that they would "walk away" from business if the price wasn't right.

Certainly we've heard these warnings from industry participants in the past but to be frank someone must be listening. According to JP Morgan, even in these dark times the "Big 4" continental reinsurers seem likely to recover their cost of capital.  JP Morgan thinks that "with normal hurricane losses three of the reinsurers we follow will at least achieve their target ROE, and comfortably exceed cost of capital of we estimate 8% for each group." Morgan excluded Munich Re because it is bearing restructuring in connection with its ERGO primary unit but included Scor, Swiss Re and Hannover Re.

Admittedly there is that caveat of "normal hurricane losses" included in the JP Morgan prediction. What's normal? Losses incurred over the last ten years or longer term historical losses?  Refraining from that debate you can be sure that for those few days when it was possible that Hurricane Matthew might strike Florida as a Cat 4 or higher reinsurers were once again faced with the possibility that the storm could be another Ft. McMurray fire-sized loss, large enough to wipe out quarterly profits but not raise rates, or whether it would be an Andrew sized loss wiping out annual profits but probably starting discussion of increased rates.

Talk about mixed feelings. It's an unenviable position to be watching a storm path when one of the outcomes is either continuation of the falling market, but erasure of quarterly profits, and another outcome is the possibility of an increase in rates but elimination of much more than a single quarter's profit.  As it turned out it was none of the above. Matthew seems to have done relatively little damage in Florida, barely scraping reinsurance limits, so the status quo will continue --but with quarterly profits intact, at least as a result of Matthew related claims. The flooding damage in North Carolina is likely to be covered, if at all, by the NFIP.

J.P. Morgan's observation is even more impressive when set in context of the current market condition. If Morgan believes that Scor, Swiss and Hannover are going to cover their cost of capital in a time of falling rates and negligible investment returns that can only mean that they are writing at an underwriting profit. And that means that they are turning down business unless they get the price they need. It's a very fine line though as we saw when the $3.6 billion insured loss from Ft. McMurray wiped out quarterly profits for several reinsurers. 

But there is more to an underwriting profit these days than just declining business as we realized in connection with the Sompo-Endurance deal. We have not been the only ones noticing that reinsurers are moving down the food chain to get closer to the risk and that they have become increasingly active in underwriting insurance.  One of Sompo's goals was to consider the "acquisition of an insurance company with strength in the insurance business in developed and emerging countries."  By acquiring Endurance, Sompo was able to do just that.

When John Charman took over Endurance in 2013 he quickly made it clear that he was going to expand the company's appetite for risk and move quickly into the insurance space. Think back to those times, it wasn't that long ago, but well before Ajit Jain's Wall Street Journal quote of last summer about Berkshire "moving down the food chain."  

Of course Berkshire had already put its money where its words would be in 2013, two years before Ajit's quote, with the creation of Berkshire Hathaway Specialty Insurance aimed at the insurance market in an effort that Warren Buffett  thinks (page 12) is on its way to being one of the world's leading P&C insurers.

At that same moment, in 2013, Charman jumped in with both feet at Endurance and said  "I am hell-bent on making sure that Endurance becomes a great global insurance and reinsurance franchise over the next three years." At the time Endurance was earning $2.5 billion in GWP and pretty much stuck to its traditional focus of reinsurance and crop insurance.

Charman made it clear that Endurance would become a fundamentally different company within the next three-to-five years in terms of scale, geographies, products and people, "and absolutely in profitability". So what happened?

Over the next three years the amount of GWP from reinsurance rose only a bit over 10%. However the amount of GWP from then existing insurance books for US financial institutions, PI and facultative when combined with new lines of business introduced by Charman, such as excess and surplus lines (E&S) casualty, US-based primary casualty and commercial property insurance, and aviation, produced an increase of 138% in GWP. Overall Endurance's GWP jumped in only three years from about $2.5 billion to about $3.25 billion an increase of about 30%.

Clearly the bulk of the increase was attributed to insurance premium. Charman and Endurance were among the first to recognize that there was value to be gained for reinsurers further down the food chain in the insurance markets.  

We've often noted that reinsurers tend to follow the same path. Every month there are more articles about the insurance market being invaded by reinsurers as they seek to replace declining premium. Artemis notes that "Specialty reinsurance was one of the first lines to suffer after reinsurers looked to replace dwindling property CAT premiums, followed by casualty and then primary insurance lines, as reinsurers sought out improved returns to boost their RoE's."

We think back to what Steve DeCarlo of Amwins might have meant at the NY InsiderScope meeting in May when he said "Capital decides distribution and always chooses its means of deployment" in terms of capacity.  There is a long list, aside from Endurance and Berkshire, of carriers augmenting their reinsurance books with insurance premiums. We've written, for example, about efforts by Everest, Arch, Nephila, to name a few, moving down that food chain (yes, that food chain  must be a busy place) to try to capture more of the original premium.  As DeCarlo notes these are conscious decisions made by reinsurer management as to how to deploy their underwriting capital.

But what we may have overlooked is that there is an additional play here in terms of adding tremendous value to those carriers who have embarked on that path. For years we've been hearing the warnings of pundits about how essential it was for reinsurers to begin to develop sources of premium originating other than from reinsurance. Those warnings generally are in connection with the triple whammy effect of declining premiums; additional capacity in the market; and negligible investment income. The thinking is that those who don't diversify in some way will eventually wither and die.

But there is another effect that we now see too.  A company that has taken these steps, and has established a multi-platform offering, becomes particularly appealing to a potential acquiror. In the case of Endurance, Sompo was clear that it had been attracted by its insurance component and in particular its US platform.

In one sense it's what Steve DeCarlo said about "capital deciding the distribution" isn't it? Sompo already owns reinsurer Canopius in London but wants to expand into insurance and is interested in obtaining an American platform. Their interest aligned with Endurance's profile and the interest was keen enough that Sompo was willing to pay a 45% premium over the undisturbed Endurance stock price.

We perhaps should have remembered DeCarlo's quote while in Monte Carlo. There were numerous comments overheard while there about the absence of M&A activity. One analyst, said "Most of the executives we met shared our surprise over the lack of M&A in 2016, with most attributing the pause to widening bid-ask spreads." 

Boiled down this means that buyers were unwilling to pay the price demanded by sellers. The potential for deals though was right in front of us. Reinsurers on their own were adjusting their appetites to capture more profitable premium. It's not surprising that Sompo would simply swallow one reinsurer that had made the adjustment to satisfy its own interest in capturing more profitable premium.

 

Of course John Charman is a well known in the risk business prompting many stories about his most recent success and what it means to him personally. Here is the  link if you're interested but you have to give credit when credit is due.  This is a big one for him.

 

We have noticed a trend that seems to be a normal outgrowth of supply and demand. As reinsurance has become less expensive its buyers seem to have begun to buy more of it. It's noticeable. According to A.M. Best the 20 largest cedents in Europe ceded 17% more in 2015 than in 2014.  An analysis from Bernstein shows that cession rates in the US grew for the first time since 2011 in 2015 from 12.9% to 13.7%. 

The two reports show that the US cession rate increased then by about 6% while one measure of the European cession rate reflected an increase of 17%.  Conventional thinking is that the soft market is enabling insurers to take advantage of low prices to cede more risk on favourable terms.  We already have seen that several large cedents have centralized their reinsurance buying strategy over the past few years both for efficiency and in preparation for better managing group wide reinsurance purchases.

Analysts have also suggested that, in addition to just simple supply and demand, there is a concern held by insurers buying more reinsurance about earnings volatility noting that "a few large losses could disproportionately affect quarterly results".  

These are among the basic reasons companies buy reinsurance. Smoothing out earnings volatility, reducing exposure, and benefiting from a good price are very valid reasons to purchase reinsurance. Of course, by ceding a portion of its exposure an insurer is also ceding part of its premium, and premium as we all know is hard to come by these days.  

In this competitive market insurers ceding risk usually are able to negotiate ceding commissions that compensate somewhat for the premium paid to the reinsurer. In the end the insurer gets the portion of the risk off its book that it doesn't want and receives a ceding commission from the reinsurer to help make up the premium it has to pay the reinsurer to lay off the risk. As we've noticed in recent issues ceding commissions have increased and this, too, is not unexpected. A buyer has more than one reinsurer option and will look for the most attractive terms.

Nothing unexpected, we thought, so far. Basic supply and demand dynamics.  Then we saw this explanation as to a possible reason why buyers are choosing to "de-risk" their revenues by accepting ceding commissions over underwriting risk. Matt Carletti at JMP Group, an industry equity analyst, observed that the increase in cession rates portends trouble ahead. He said "Generally speaking, we believe that primary insurers know more about the risks they write than their reinsurers do and when they shift to laying off more of the risk, there is usually a good reason why."

That's an interesting remark and immediately made us think of the long running underwriting discipline discussion.  We don't know of any chief underwriter at any insurance company who would say anything other than that his or her underwriters are highly disciplined and obtain the required rates for coverage or do not insure them.

There is another possible pitfall here though. The insurers laying off exposure to reinsurers in larger amounts this year than last are writing the same business that a number of the reinsurers themselves are moving down the food chain to insure. 

We're not sure what this means but to see even a hint introduced that the increase in cession business was anything more sinister than a seemingly good business decision based on the laws of supply and demand was troubling.  Hopefully, if JMP's analysis is correct, the same reinsurers which assume portions of exposure that primaries are eager to dispose of aren't picking up similar business, which may be inadequately priced via their "down the food chain" strategy.