On the couch

What do you do when everything you thought was logical and true just isn’t the case anymore? What do you do if the history books can’t guide you to the best path to take?

And what do you do when you’ve just taken $140bn of cat losses in one year and the prospect of making back that money is dim at best?

The cat events of 2017 have forced reinsurers to take a long hard look at themselves. The losses shone a harsh spotlight on the underlying profitability of reinsurance business, while the quick reload of third-party capital post-loss served as a wake-up call to the market that this non-traditional competitor is here to stay.

On the face of it, there seems to be little to be positive about for the traditional market.

You can picture a reinsurer, feeling a little bleak and weary, taking itself along to a therapist, lying on the couch with head in hands, and looking to thrash out the issues.

“What do I, as a reinsurer, do well?” it might ask. “Is what I do even of relevance or importance? Do my clients even need me anymore?”

The existential nature of these questions suggests the discussion needs to be taken right back to basics.

To start with, you might question whether reinsurance as a product is broken. Does it still have relevance for buyers, or have their needs changed beyond what the product was designed for?

Reinsurance provides buyers with efficient capital which can reduce volatility in their earnings and strengthen their capital position. And those are two desired outcomes which very rarely change for buyers, according to JLT Re’s global head of analytics David Flandro.

“You could make a strong argument that there is more value than ever in the reinsurance product, as it’s very economical in terms of its relative cost and, at the moment, less volatile than it used to be,” he explains.

“So if you are a cedant and looking at reinsurance as a competitive form of financing in comparison to debt, or certainly equity, reinsurance is an increasingly attractive form of capital.”

Indeed, despite wider industry consolidation, executives have said that demand for reinsurance is growing.

But almost every party in the (re)insurance industry is looking to expand their business, and reinsurance can help them achieve those growth targets, explains Matthew Moore, president and managing director of Liberty Specialty Markets (LSM), which houses Liberty Mutual’s reinsurance division.

“Very crudely put, 10 years ago the question the reinsurer had to ask itself is how much risk can we assume at what price, to make the desired return,” he says. “That is still true but the other question we have to ask ourselves is ‘How can we help our customers grow?’”

Historically reinsurers have not been great at asking this question, Moore continues. However, by understanding the client better and offering a range of products which might benefit the client’s needs, reinsurers can play a very valuable part in assisting with growth ambitions.

So, the therapist might ask next, if the value in reinsurance as a product still holds, how did you, the reinsurer, find yourself in this position?

The (re)insurance industry has emerged from one of the heaviest cat years on record. It brought to an end a number of years in which there were benign cat loss levels, during which time property cat rates had sunk to levels which challenged technical pricing.

The expectation was that rates would jump following the cats, but they didn’t. The JLT Re rate-on-line index showed risk-adjusted global catastrophe rates still lagged below 2016 levels after rising by 4.8 percent on average at 1 January, the first increase since 2012.

Even at 1 June – the property cat renewal date for loss-hit Floridian cedants – rates moved up by just 1.2 percent.

Overcapacity had smothered rate increases. Yes, the losses were bad, but they hadn’t been extraordinary. The loss figures per event largely came within modelled expectations. There was no surprise, no shock, to scare off the ILS funds and cause carriers to withdraw capacity to such an extent that the supply-demand imbalance tipped in reinsurers’ favour.

This situation may not have been so grave if the non-cat side of reinsurance hadn’t also conceded to the soft market in the past 10 years.

Many in the market say that non-cat business – long-tail, non-event-driven lines – for the most part is grievously under-priced. For years it had been subsidised by cat business, and profitability of non-cat was allowed to slip. But the 2017 losses exposed it all.

As one reinsurance executive tells IQ: “It’s only when you hit a bump in the road that you realise how close your head is to the top of the car.”

LSM’s Moore explains: “Reinsurers have historically been over-reliant on cat business. We are now going into 2019 planning and people are going to their shareholders and having to face facts on the under-profitability of those lines.”

He continues: “It’s a reality in corporate life that when you’re making money you can put off those very difficult decisions. I think the last 12 months have just shone a much harsher spotlight on that.”

With that in mind, reinsurers now find themselves asking again whether the traditional market cycle is broken, particularly for property cat, which has traditionally been the lifeblood of the industry.

“I do believe in the market cycle. I have been hearing the cycle is dead in various forms throughout my entire career,” says JLT Re’s Flandro. “The cycle doesn’t die, it just changes. Whereas before, cat losses really drove every line of business in the short term, things are now more nuanced and subtle.”

Although prices have moderated over the last decade, cat rates remain generally higher than for most other risks although, for certain peak risk coverages, third-party capital has for now put a ceiling on pricing, Flandro explains.

“This changes the profit model of the sector. The best reinsurers will adjust, as they have done in the past.”

Perhaps the most challenging question for our imaginary reinsurer sat on the therapist’s couch is how to ensure they are one of those top-quartile carriers.

In essence, how do you make yourself relevant in a market environment which has fundamentally changed?

All members of the (re)insurance value chain are trying to match capital to risk more quickly and at lower cost. The chain is complex and overstretched, and disintermediation to achieve both speed and cost savings is a real threat for all participating parties.

Everyone in the industry is looking at the components of the value chain and asking themselves, “Where is the residing sustainable value relating to the skills and attributes that we have?” according to Mark Hvidsten, deputy chairman of Willis Re.

“I think those towards the end of the chain are in the most vulnerable position in this evolving process,” he says.

“The ultimate capital is interested in how it might be able to access the part of insurance risk it really likes, and whether the easiest way for them to do this is through the help of reinsurers, insurers, brokers, third-party asset managers or others.”

As Willis Re president and global head of casualty Andrew Newman explains, (re)insurers have grown up in an era where capital and capital management determined who got the big spoils within the (re)insurance value chain.

“The insurance industry model worked on the 19th century principle that capital was scarce and opportunity was plentiful,” he says.

“Now in a world where there appears to be more capital on the planet than we know how to deploy – and let’s assume that is a steady state for some time – originating portfolios of appropriately risk-priced business is the greater challenge.”

A number of carriers in the industry believe the answer to this question is building scale, and with it capabilities, so they may access risk via a number of avenues. Reinsurance at these companies is merely a component, rather than the totality, of what they do.

AIG has pursued this course with its $5.6bn acquisition of Validus, as has Axa, which shelled out $15.3bn to buy XL Group.

Meanwhile, traditional reinsurers such as Swiss Re and Munich Re are also growing their insurance arms in earnest – allotting their capital to where they think the best opportunity lies in this new market.

LSM’s Moore is a proponent of the diversified, multi-capability model, and is among the many in the industry who believe that in future, the reinsurance sector will be made up of fewer, larger companies each with multiple capabilities.

The executive believes that size and the ability to assume and price risk via a number of avenues not only offers economies of scale but also creates a huge advantage when it comes to working with the large brokers.

“You can have a much more productive conversation,” he says.

The industry is also about to go through another phase where third-party capital will not only grow in volume but will also be applied much more intelligently, Moore claims. This capital will bring a multiplicity of return hurdles and different risk appetites.

Large and diversified carriers can act as a “shop front” for capital searching for risk, he explains.

“When you look at LSM Re alongside Liberty Mutual, we have a wide range of products at the moment but that will only continue to get wider,” Moore says.

This view bodes ill for the pure-play reinsurer, of which admittedly very few remain. If being a jack-of-all-trades is the way to survive in this new market normal, what can a reinsurance purist bring to the table?

“There is clear difference between diversification in term of access to risk, and diversification in terms of risk itself,” explains Emmanuel Clarke, president and CEO of pure-play reinsurer PartnerRe.

“We believe in diversification of risk itself – only 4 percent of our group net written premium is property cat, we are a leading reinsurer in many specialty lines and we have a growing life and health book.”

Clarke notes that having a number of avenues to access risk doesn’t always prove to be advantageous – those carriers which operated both insurance and reinsurance divisions actually took a double impact from the 2017 storms.

PartnerRe inevitably has a unique position in the market as a private reinsurer with a long-term investor – and more importantly, an investor which is a proponent of the pure-play model.

Nevertheless, all investors still want to make a return, and how do you generate that return when reinsurance is fundamentally a lower-margin business than before?

“I don’t necessarily think reinsurance is a low-margin business. I think everyone always thinks the grass is greener on the other side,” says Clarke.

“Part of reinsurance has been increasingly commoditised and is now a lower margin business – there is no doubt about that, but for us this is a small part of the portfolio.

“We continue to shift the business towards a less commoditised, more customised, more expertise-intensive lines where the barriers to entry are higher and the returns are better. We have determined that success for us in terms of long-term value creation relies upon diversification across many classes.”

The common theme between Moore’s and Clarke’s views is that risk selection and portfolio management are key – and this is a capability that transcends scale to a degree.

With the advent of big data, predictive modelling and machine learning, actuarial science could be set to change markedly in the years to come. Reinsurers need to stay at the bleeding edge of that, says JLT Re’s Flandro.

“Portfolio management will be critical,” he says. “Reinsurers will need to focus on their comparative, as opposed to competitive, advantage. What are they uniquely good at?”

Willis Re’s Newman believes the people who will win are the people “who have always won” – those who can source, select, price and package risk, and thereby deliver stable, consistent risk-adjusted returns.

“However, what’s changed is that originating a diversified book of business alone may not be enough; securitising it in whole or in part and introducing intelligent leverage into the balance sheet has become as important as capital management was in the (pre-securitisation) buy-and-hold era,” he explains.

“Those who can both over-promise and over-deliver, avoid outsized losses and demonstrate leading performance have nothing to fear, because when you do that, capital will find you.”

In fact, reinsurers could have an advantage here, says Willis Re’s Hvidsten, because they are closer to the mindset that those who survive will need.

“Reinsurers are more agile in portfolio management, they have already started the thought process of finding cheap financing, and they are well down the road of defining what they are – which is effectively liability managers,” he explains.

“They are actually closest to the core skill of portfolio management, which is going to be a big part of what it takes to carve out a sustainable position of value.”

So as the therapist session comes to an end, and with all of the above in mind, do reinsurers have reason to be fearful?

It’s easy to take a pessimistic view of the market, particularly when you see how much risk is in the system and the mid-single digit returns reinsurers are getting for that risk, says Moore.

“There’s a lot of old wise heads around saying you shouldn’t write cat business at under 10 percent return on equity, and I don’t dismiss that, but I think we are feeling pretty bullish [at LSM Re],” he says.

As a buyer of reinsurance in the wider Liberty group, “we know it’s not a fantastic customer experience”, the executive continues.

“I think if you as the reinsurer can be more customer-centric, you will be a lot more valuable to them,” Moore says. “So with that in mind, there is a lot to be positive about.”

This article was first published in the Autumn 2018 issue of Insider Quarterly