Nearly all industry observers seem to agree that at long last the the ongoing decreases of insurance and reinsurance premiums rates have not only been arrested but that expectations of higher premiums are no longer wishful thinking. We (and everyone else) have been writing about this possibility for years. However one could be excused for worrying about the claim cost that will need to be paid in order to start upward rate momentum.
There have been warnings from rating agencies and analysts that the trio of destructive hurricanes, plus the earthquake in Mexico, could signal more than an "earnings event" for some carriers. Of course "more than an earnings event" means a "capital event" that would require markets to get more money into their coffers quickly.
This really shouldn't be a surprise and, frankly, hardly anyone in the industry actually does seem surprised at the prospective ripple effects of the significant CAT losses throughout the market. Years of declining premiums, coupled with paltry investment returns, combined with share buybacks and claim reserve releases have possibly left little in the cash drawer. At least such a scenario was the one that was being warned about earlier in the summer. Now we will see what actually unfolds and so far we would venture to observe things haven't spiraled into a tailspin as some of the more gloomy observers warned could be a possibility just months ago.
One observation that perhaps should not be so surprising is that there does not seem to be
agreement as to whether rates will increase or not. There does seem to be a general consensus that "loss affected" rates will experience increases but even that consensus is not firm.
We should remember that for several years now industry executives and analysts have been speculating that the pricing "floor" is in sight and that the rate of decrease in premiums was slowing --as if straining for some bit of evidence that the "turn" was near. Given the divergence of opinion as to when rates would stop their downward fall it's maybe not surprising that people are pulling their punches in announcing without reservation that rates will now rise. There remains a host of uncertainties not the least of which are what will the effects on alternative capital be and just really how great the insured loss is.
As usual, with reinsurance and insurance few things are crystal clear and why should they be? After all even as the industry relies increasingly on data to base rates upon at the end of the day the price of the coverage comes down to a negotiation between the buyer and the seller. If the buyer doesn't think an increase is justified the market can either walk away (and risk a competitor insuring the risk) or accept the buyer's price.
That may be why some observers think some reinsurers are trying to signal to buyers that the market turn has definitely occurred and that rates are going up and it's only a matter of how much. It always boils down to a conversation between two sides and oddly one factor seems to be that if both sides have read enough articles about the inevitability of premium increases then momentum for price increases builds.
It may be easier to start with what we think we now know. Without doubt the natural catastrophes of Q3 will cause very significant claim activity for reinsurers. Hurricanes Harvey, Irma and Maria (approximately
$100 billion total) plus the strong earthquakes in Mexico (
$1 billion), each occurred in the third quarter. Q4 didn't start off very well either with projected
insured losses from the California wildfires pegged at approximately $4.6 billion.
The headlines speak for themselves and here's just
one of them:
"Q3 insured losses could be costliest in history." There are a few parts to this potential claim number that are interesting. First, and not surprising, is that
Bermuda insurers and reinsurers expect to pay out at least 25% of that total, or $25 billion, to cover insured losses from Harvey, Irma and Maria. The Bermuda reinsurers after all have a pedigree as CAT carriers and despite widespread diversification this 25% share of US CAT was almost expected.
The next component which we were interested in was the effect of insured losses of this size on alternative capital. Here at last was a possible litmus test we thought of how alternative capital would react in the face of a loss of profit if not a loss of principal. We noticed this
comment from
Munich Re Syndicate Limited CUO, Dominick Hoare who said that non-traditional capital had been "severely impacted". Hoare went on to say "Much of this capital has been
destroyed or 'trapped' under their collateral arrangements. This capital will only 'reload' if modelled returns increase significantly, this will involve very material increase in rate". "Furthermore", said Hoare "there is a huge divergence amongst the modelling companies regarding the quantum of loss. Such model frailties will lead to capital requiring additional margin to cope with this uncertainty."
Somewhere in offices in
Munich, Zurich and London we are sure that executives in rated reinsurers read that comment and thought, at long last, "welcome to our world." From the perspective of the claimant trapped collateral for an ILS product is no different than a claim reserve by a rated carrier. Model uncertainty on the scale of the loss is a fact of life for insurers and reinsurers. That's one of the reasons markets are so keen to understand their underwriting data. Some markets can quickly estimate their individual projected claim losses once they know the extent of the CAT damage and where it occurred. And as far as the discussion about the willingness to stand by the client on the next renewal or the idea of abandoning the client because your capital is tied up because of a claim...well this is one of the main selling points of a rated insurer.
Another component of the $100+ billion in Q3 claims concerns the collateralized retrocession market. By some estimates US wind-exposed retro limits deployed by collateralized writers are in the range of $18bn to $20bn and some $9bn to $16bn of that amount may have been lost to claims or certainly "trapped", and unable to be withdrawn, until well after the January 1 renewals. Much of the
retro capacity appears to have been
provided by so-called CAT funds such as
Catco, Aeolus and AlphaCat.
Even though this collateralized retro is on the top end of any CAT arrangement sources say that retro has a disproportionate effect on "dictating increases in primary reinsurance and, ultimately, insurance pricing." In fact, and this was news to us too, in both 2001 and 2005 surging retro pricing was key to driving premium increases. Now with the 1/1 renewals upon us Moody's
says the "key wildcards" is the availability of retro cover which is increasingly provided by ILS vehicles.
Alternative capital is
estimated to make up around $17.5 billion of a total of $20bn-$25bn limit or about 70% of the retro market. According to
Artemis "
Retrocession is popular with third-party investors as a way to access higher returning reinsurance business as it can yield upwards of 20%." Participation in the retro market by investors has increased since 2015 as alternative capital seek collateralized instruments to chase that "yield upwards of 20%".
But like all insurance the investment comes with a risk --no matter how far up the risk chain you may be and no matter what the models say. Something can happen and that something may have happened in the Third Quarter.
Alternative capital began to make its effects felt over a decade or so ago with the introduction of CAT bonds designed to payout in the event of hurricanes and earthquakes. Since then alternative capital has developed many more sophisticated ingress routes to the insurance and reinsurance markets even beginning to penetrate the primary insurance market. The hedge fund reinsurer model is well established as are sidecar insurers funded by alternative capital that are bolted onto existing insurers and reinsurers.
In a sense these machinations are not as novel as they may seem. Historically capital, whether traditional or alternative is what supports risk underwriting. In prior years the "Names" at Lloyd's signed up to pledge their capital over an agreed to period of time to be used to underwrite risks that broadly conformed to the risk appetites of those investors. But the difference now, and one that has been noted by traditional carriers, is that most of the underwriting vehicles supported by alternative capital are not only finite in duration but are supported largely by model results that can provide reassurance to an investor that has money pledged as collateral will not only not be lost but in fact produce a satisfactory rate of return. When an investor sees the event posing the
risk of loss in terms of a "one in one hundred year event" or "one in five hundred year event" that can provide a measure of comfort as to the safety of the investment.
When a capital market investor is supporting a retro layer not only do the odds of the event occuring affect his thinking but we would think, too, that the safety offered by all the layers below him that need to be penetrated and depleted must also provide a measure of comfort. First the insurer's own retention needs to be burned. Then the initial layer of reinsurance needs to be depleted. If there are retro layers between that reinsurer's layer and the capital market backed retro layer then those layers too need to be "destroyed", to use Hoare's term, before the claim wave finally ends up with the retro cover supported by the capital market investment.
Many insulating layers and a small chance of occurrence --plus a rate of return in the neighborhood of 20%. Where do we sign up one would think? This is one of the reasons why billions in alternative capital have flowed into the reinsurance industry over the past years. It's a smart investment.
It's a smart investment though until that rare event actually occurs and all the insulating layers have been depleted. Then the bill comes due and the claim must be paid. The investment has already "left the building" and is sitting in a collateralized fund. If the cedent meets the definition of the claim trigger the funds will be paid to them. Loss of principal can occur and the alternative capital investor must revert to the capital provider whether it's a pension fund, hedge fund or financial institution and tell them that not only will there be no expected 20% return this year but that the principal might not be returned either.
According to Leadenhall Capital's Lorenzo Volpi as much as $12.5bn of that capital market supported retro total of $17.5bn could be lost or trapped as a result of the Third quarter claims.
What's worse from the perspective of the retro market is the timing of these losses. These funds are now "trapped" as it will take weeks if not months to sort through claims and determine how much is to be paid. The underwriting year ends for many of these coverages on December 31. How would you like to be the fund manager who has to go back to the capital provider after notifying them of the possible loss of the investment to ask whether they're interested in "re-loading" to take advantage of what will certainly be higher rates (and higher returns) for new coverage incepting on January 1? These will be difficult discussions which is why the capital markets are signaling loud and clear that rate increases will be needed if they are to continue fueling the expansion of capacity.
Here is the first sentence of a recent article in the Insurance Insider: "Insurance-linked securities (ILS) investors contemplating leaving the sector because of low rates may be enticed to stay by price increases expected following the recent hurricanes."
If surges in retro pricing in 2001 and 2005 were instrumental in causing premium increases in reinsurance and insurance it seems a possibility at least that the capital markets investors who comprise 70% of the retro market are going to need a similar pricing surge to continue to invest.
How big a surge? That's the big question but it's one that the traditional and alternative investors have been dancing around for years. Rated carriers may have a slightly different view of the scale of increases that can be imposed on long-standing clients.
Jed Rhoads, Markel Global Re's president and CUO summed up what seems to be the consensus view of traditional reinsurers when he
noted that "We've never had a $100bn insured loss that didn't turn the market", but then said "We have always been responsible as a reinsurance industry to our clients to
do gradual rate increases on them just as they have put gradual rate decreases on us multiple years in a row."
Rhoads' observation could no doubt be echoed in London, Bermuda, Zurich, Hannover, Munich and elsewhere. Markets don't remain in business for decades and centuries building relationships
without being "responsible." The challenge though for the capital markets is to convince investors who have signed up for short term investments with a high rate of return based on a very remote chance of losing principal, that the "responsible" path outlined by Rhoads is the one to follow.
If capital markets investors are not convinced and demand significantly higher rates to continue participating in the retro market then that amplified effect could come into play and drive rates up across the board. No matter how you slice it there is no doubt that alternative capital is facing its first big test. CAT bonds have defaulted in the past and investors have lost money but the scope of losses from the Third Quarter will provide the sector the opportunity to either demonstrate that they are in the risk insurance business for a long time or whether their involvement was simply a search for yield.
Speaking in
Baden Baden this week
Leadenhall Capital's Luca Albertini was clear that alternative capital investors "are in this space in a mature way and here to stay but they are not committed at any price. They expect an increase." If Albertini is right, and he certainly would be someone who has his finger on the pulse of ILS investors, the capital not only remains interested in the risk sector but is determined to see rate increases.
There is another clue though in a comment made by
Mike Reynolds, global CEO at JLT Re. Reynolds is looking at the cost of capital discrepancy between third party funds and publicly traded rated carriers. No doubt remembering the
birth of the big Bermuda CAT reinsurers that were quickly setup and funded in the post Hurricane Andrew era he
noted that "We are in a different world to that of the 1990s and 2000s, when we would see a string of flotations post-event. Today, and indeed this renewal season, the lion's share of any capital raising will happen via collateralized vehicles--although some of them will be owned by quoted carriers."
Thus far we have not seen any evidence of a "string of flotations" in Bermuda or anywhere else. The absence of such activity may mean that the answer to whether alternative capital intends to remain may have already been revealed but ironically, if Reynolds is right, it will be the reinsurers themselves who are setting up and owning the collateralized vehicles.
