Insight and Intelligence on the London & International Insurance Markets

25 February 2018

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Window shopping

Mark Geoghegan 6 September 2016

You know the high-end boutiques in very expensive neighbourhoods?

I'm referring to the sort of luxury brand shops that never display the price of their goods in the window, but prefer a seductive minimalist exhibition of their wares.

You only find out how much something costs if you are brave enough to go in and ask.

The cost of capital is a little like that - for it is something that is possible to estimate but impossible to know truly until you start making enquiries.

At the moment we are so flush with capital that its theoretical cost is of very little interest to us. We don't need it so what it costs is of little relevance.

We are like a small landlord who has owned a property for many years. We bought the house for almost nothing a decade ago and its capital value has appreciated enormously.

By rights we should revalue our asset and see what returns today's rent produces against the higher value. Then we should see if we would still make a profit if we had to reacquire the house at today's prices and with today's mortgage rates.

But of course we never do this, happy in our false accounting and ecstatic that our little asset is merrily providing us with a source of "free" income as it has paid its way many times over.

As an industry we last recapitalised in 2005 and that money's been paid back many times over.

S&P has produced an excellent report that we briefly summarise on page 9. In it the agency shows that as a sector reinsurers are barely earning their theoretical keep and the outlook is for them to do progressively worse in the next couple of years.

In more rational times this might be an important factor. At present it isn't because we aren't living in rational times.

In today's topsy-turvy zero and negative interest rate world any prospective return will set pulses racing, even if it is theoretically questionable.

In the current environment, as long as our returns compare favourably to other investments, we will continue to attract support.

And today's global cost of capital is probably still falling faster than anyone can measure it.

At various periods our industry has failed to make enough to cover its theoretical cost of capital. It looks like we are about to start another.

But until things change we will stand outside the window of the capital shop and marvel at the shiny objects inside.

In time we may pluck up the courage to open the door and make discreet enquiries, but there really is no hurry - what we have on will do the job perfectly well for now.

This article was published as part of issue September 2016/1

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