Reinsurers who succeed in the current environment will be those who can adapt their ways of managing risk, says Lee Coppack.
A young German boy was given £1 by visiting English relatives and was told by his parents he could spent it as he liked provided he came back and told them what he wanted to get. In the shop was a football. In German marks, it cost the equivalent of his £1. He went home to tell his parents, but by the time he returned to the shop, the price of the football had risen by 20% and he no longer had enough money. Fortunately, his parents made up the difference.
This story was recounted on a fascinating BBC World Service programme called My Century by the boy himself, now an old man, and it was a graphic account of hyperinflation in Germany between the two world wars. He and the other people speaking remembered very clearly the ways people coped as best they could with inflation on that level. It made an impression on them, but for a child with nothing to compare it to, hyperinflation would have seemed the norm.Thus, in insurance and reinsurance, rates have always swung up and down and investment income has made up for underwriting losses (mostly). Since that is the way the business has worked, certainly for the last 30 years, we tend to assume that is the way it will continue to work. Rates which have gone way down must go way up again and investment income will cover the losses in the meantime.
It might still happen that way. But what if it does not?
We have the conjunction of low interest rates, low inflation and low rates. Low interest rates mean higher asset values for insurers, so they feel wealthy, as one of the senior executives replying to our survey (see page 66) comments. Since interest rates were high throughout the 1980s, and have only come down gradually since the mid-1990s, longer established companies should have some nice appreciation in their assets.
We can see one of the results. Property/casualty insurers in the United States last year recorded capital gains of $18.2 billion. If they had not, the 17.6% fall in net income, largely due to an underwriting loss which more than doubled the 1997 figure, would have been more severe. Once high yielding bonds have been sold or matured, they will need to be replaced. Reserves will have to be set for claims on new business, and today's fixed income securities will be lower yielding. Lower premium rates will generate less cash flow.
So the scene is set. The results of unwise underwriting decisions will make themselves apparent. Underwriting losses will erode the capital base, investment income will fall, at least in real terms, and maybe in absolute terms. Instead of the big bang, the catastrophes which will take other people out of the market and leave us to enjoy the much higher rates, we are likely to have a steady state (of deterioration) - maybe with some big bangs thrown in. Liability losses still, too, have the ability to strip out cash from the balance sheet, as the problems related to US workers' compensation pools this year have shown.
The current situation has some uncomfortable similarities with the way the market was, say, nine or 10 years ago, but some important differences make it less likely that we will see the level of insolvencies and near insolvencies we did after Hurricane Andrew. Minimum capital requirements are much higher and excess of loss aggregates are much more carefully monitored. The power of rating agencies has made it more difficult for insurers to use doubtful reinsurance security, and in any case, there has been generous capacity available from good security.
Another important feature of the market roughly 10 years ago was the growing appreciation of the real exposure from asbestos related and environmental pollution claims. Now although social inflation can outstrip the growth in funds generated to pay liability claims and some locust-like long tail liability losses are probably in gestation, none at the moment looks to have the potential of asbestos related claims. In addition, wordings have been tightened.
Absent a short period combining a major Japanese earthquake, US eastern seaboard storm and stock market collapse (not, of course impossible), it seems likely that there will be a further gradual contraction in the population of the reinsurance market, as participants put the worst lines of business into run-off or sell the better portfolios to move on to other, more attractive activities.
The stock market generally is not enthusiastic about waiting for this process to take place, as the ease with which capital was raised following Hurricane Andrew demonstrates. It prefers the big bang followed by the big reaction in pricing. The FT-Bermuda Stock Exchange (BSX) index, which is made up of the shares of 10 quoted Bermuda companies, was launched with a fanfare on 15 July 1998 at 1,000. It had fallen to around 645 by mid-August this year.
Short term stock market under-performance will affect the companies' financing options for acquisitions and executive and staff share options. Longer term the implications are more profound and, since investment returns are regularly the main source of earnings for (re)insurers, especially in periods of soft pricing, one way for companies to differentiate themselves is by superior investment performance.
Analysts currently do not attempt to value the performance of non-life companies as asset managers in more than a normalised or average way, because as Tim Dawson of Credit Suisse First Boston in London says, the actual total return generated over a period by asset class is almost impossible to ascertain.
Says Mike Smith, managing director of Bear Sterns in New York: “In the non-life sector, there is enormous uncertainty and risk on the liability side of the balance sheet, and as such insurance companies and the regulators generally do not want to double up on that risk by investing the assets in risky investments. Thus, a non-life insurer's portfolio will look rather dull, consisting of high quality government and corporate bonds, a relatively small amount of equities, and little else. I used to say that the primary requirement of an insurance company investment manager was a strong back, to carry the cash over to the Federal Reserve.”
Today, however, the choice of investments is far greater, as the chart shows, and it offers the potential for improved returns, provided they can be achieved without jeopardising security. To do that requires the (re)insurer to assess the risks to which the company is exposed across the whole of its balance sheet.George Rivaz, chief operating officer at Tempest Re in Bermuda explains: “Our second major financial risk (after catastrophe losses) is the market pricing of our investment portfolio. We evaluate our overall business risk using an integrated simulation model which looks at both asset and liability risks.”
Going a step further, the company can analyse the effect of the risks that it accepts and the different risks in combination on its allocation of capital for solvency. Those (re)insurers will be able to price at the margin because they will be able to optimise the use of their capital.
Tim Dawson points out: “Strategic asset allocation and capital management can influence returns on capital, which are the key value driver for any company, not just insurers.”
Mr Rivaz says: “Modelling has been fundamental to Tempest Re from the outset: the prospectus used to raise our initial capital included results from a portfolio simulation model. We model every risk we assume, so the whole of our underwriting performance to date is in large part a benefit of modelling.”
We are, therefore, likely to see an increasing polarisation between those companies, particularly among reinsurers, who can manage their capital dynamically, using their ability to price at the margin to gain competitive advantage, and who can optimise their investment income to generate better returns, and those who continue to work with the historical models which are the ones that they know.
Finally, if a dynamic system of modelling is integrated into operational risk management in (re)insurance, as is now the norm in financial institutions, companies will be able to trade fortuitous risks apart from the constraints of the indemnity contract. These will be next generation of reinsurers who will regard buying and selling Florida windstorm options as no more novel than soybean futures.
Lee Coppack is co-editor of Global Reinsurance. E-mail: email@example.com