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Does Bermuda have a future?

Almost a year ago, many in the reinsurance market were confidently predicting 2018 would see the start of a broad market correction in reinsurance pricing.

Speaking on the company’s Q3 2017 earnings call, Axis president and CEO Albert Benchimol said he expected “meaningful price increases in the property and property cat reinsurance renewals coming up

at 1 January”.

Meanwhile, Everest Re president and CEO Dom Addesso said on the firm’s third quarter conference call that he believed the 2017 cats would “lead to a general market firming across all lines and territories”.

He also predicted “well-rated capacity will be in demand, and this will drive better rates, terms and conditions across the spectrum”.

Though there has been some improvement, it is fair to say the market has been disappointed with the level of overall pricing response. What we have seen has been a confirmation of what textbook economics would have predicted. Lower barriers to entry and an abundance of capital on the sidelines have reduced the likelihood of a capacity shortage in property catastrophe reinsurance.

At 1 January, US property rates for loss-hit cat accounts were up by 10-20 percent, while loss-free cat pricing renewed between flat and 5 percent up, according to JLT Re.

Despite predictions of this being the start of a broader hardening, pricing momentum waned as the year progressed, with just a 1.2 percent average increase at the mid-year renewals, according to the broker.

After a year with more than $100bn of cat losses, this brings the industry’s through-the-cycle earnings power into razor-sharp focus. It might be reasonable to ask investors to look past your heavy cat years, but it’s a harder sell to get them to look past your lacklustre peak earnings.

This was neatly summed up by Everest Re’s reinsurance CEO John Doucette. “A key lesson so far in 2018 that is already well known, but perhaps underappreciated, is that reinsurers cannot rely on hard markets to offset subpar results in non-loss years,” he observed on the firm’s Q1 conference call.

To understand the market’s disappointment, some historical context is useful. Though the circa 10 percent price increase in 2018 was actually similar to the last “hardening” market in 2012, it is important to remember it is not just about the change in pricing but also the absolute value of pricing adequacy.

Industry pricing remains more than 25 percent below its previous peak – and substantially below prior troughs in 2005, 2008 and 2011 (see chart above).

This tallies with comments by then Arch COO Marc Grandisson on the firm’s Q4 2017 conference call. “To get back to historical returns we would want from a property cat perspective, precisely because of the volatility around it… about 30 percent increase,” he said.

“And now where we are, we probably gained anywhere between 5 percent to 10 percent. So we would still need not an insignificant amount of rate increases.”

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There are two factors worth keeping in mind when considering the lack of pricing response in 2018. The first is the trailing loss experience in cat-exposed lines, particularly wind-exposed regions in the US.

Unlike recent large loss years this century, the 2017 events came after a long stretch of benign cat losses for coastal property in the US (in 2011, large losses were largely driven by international and earthquake risks).

This was a point raised by Alleghany CEO Weston Hicks in his Q3 2017 letter to shareholders shortly after the impact of hurricanes Harvey, Irma, and Maria.

“What is surprising is not how active 2017 was, but rather how benign the period from 2007 to 2016 was – there were no major hurricanes making landfall in the US during this time period,” he explained.

“In fact, in 13 of the 16 prior decades ending in 2010, at least one Category 3 or worse hurricane made landfall in the US every two years, on average. By contrast, the 10-year period from 2007 to 2016 was a period in which only five hurricanes, none of them major, made landfall in the US.”

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Between 2004 and 2017, there were three high loss years that subsequently generated increases in property cat pricing and ultimately returns: 2005, 2008 and 2011. These high-loss years were fuelled by some of the most active hurricane seasons in history, with storms hitting the US mainland in peak exposure areas for Bermudians (2005 and 2008), as well as a spate of international cat events in 2011 including earthquakes in New Zealand and Japan, flooding in Thailand and record tornado losses in the US.

The returns generated in years following these events were substantially higher a decade or so ago than in recent peak earnings years (see 15-year timeline chart). The heavy 2005 cat year was followed by a highly profitable year, with the simple average operating return on equity (RoE) for the (re)insurers in our composite reaching 20.3 percent. Note, there is some “survivorship bias” in this sample by focusing only on reinsurers to have continued as going-concern independent companies, but the results are still illustrative.

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However, this peak earnings phenomenon appears to have broken down following loss events in 2011 and 2017, with operating returns for the group barely scraping into double digits. Of course, 2012 operating results were suppressed by Superstorm Sandy losses. But this does not negate the point as the 2013 peak remained subdued relative to prior years.

The volatility of returns across loss-free and loss-heavy years makes it hard to speak to the true underlying earnings power of reinsurance business.

If anything, the average results observed across the cycle are probably overstated due to a heavy bias in the data sample to have a cluster of outcomes around the modal value (essentially loss-free years) but a heavy skew of potential but low-probability outcomes with very large losses. Put more simply, we have plenty of data on what a good year looks like but less on what a truly bad year looks like, which makes it challenging to estimate what true expected earnings are as an external analyst.

But with peak years barely reaching double digits, it is a fairly safe assumption to peg industry earnings power in the single digits.

“The returns on capital, return on equity of the industry, in general, as you all know, has been in the mid-single-digit for a period of time,” estimated Everest Re’s Addesso. “And therefore, these types of events [in 2017] are unsustainable, with mid-single-digit RoEs in times of low to no cat activity.”

A second and well-discussed factor is the growing role of alternative capital in reinsurance markets. Though alternative capital had been a factor in the market for more than a decade prior to 2011, that segment of the market grew around 60 percent following 2011 losses (see alternative capital growth rate chart).

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Essentially, with 2017 losses, we now have two consecutive data points on the market’s response to large losses and weak trailing returns. And what we have learned is capital destruction is – on its own – not enough to create conditions of scarcity for capacity.

The easy flow of new money into the alternative capital space has prevented this, unlike in prior years where a market re-load involved slow-moving equity raises and new company formations.

“The reloading of some alternative capital, in addition to competition from traditional players, had a muting impact on 1 January renewals, highlighting that alternative capital has become an enduring reality,” explained Everest’s Doucette.

Future of Bermuda

Considering all the above, we see three feasible avenues regarding the future of the Bermudian (re)insurer.

First, existing capital needs to be put to work in a smarter way, using multiple platforms and increasing access to business without needing to use extra capital.

This strategy is best evidenced by RenaissanceRe, one of the best performing reinsurers on the island.

“Long ago, we recognised that changes to our market are more secular than cyclical, due to the increasing efficiency of the reinsurance marketplace.

“Consequently, we built a business model that can compete as long as prices remain above expected loss,” said president and CEO Kevin O’Donnell on the carrier’s Q2 2018 conference call.

“Of course, better pricing makes things easier. But to succeed in this market requires not just great underwriting, but increasingly great portfolio construction. It also requires having great partners and the ability to deploy all forms of capital,” the executive concluded.

This can be seen in the firm’s expansion into casualty reinsurance with the acquisition of Platinum and growth in non-correlated lines like mortgage reinsurance.

The carrier’s ratio of net premiums written to tangible equity rose from 35.6 percent in 2012 to 49.9 percent in 2017, demonstrating that this growth has been achieved by using capital more efficiently.

Second, as the island has been diversifying into new lines of business it has also been reducing existing exposure to large catastrophe losses and earnings volatility.

Theoretically over time this should translate into a lower cost of equity.

Over the past five years, Bermudians have been changing their portfolio mix away from property cat due to market conditions shrinking risk-adjusted returns. Arch and Axis have both reduced their property cat exposure on a net premiums written basis over the past five years.

In the case of Everest Re, Axis and RenRe, their property cat portfolios grew in the period but disclosure is unavailable on a net basis. However, the trio significantly reduced their retention at group level, which is an indicator of increased use of third-party capital, as mentioned above.

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The decrease in net property cat exposures was also evidenced by the lower probable maximum losses (PML) in peak risk areas recorded by the companies. Every Bermudian with PML disclosures showed a reduction in its peak 1-in-250-year PML relative to equity over the 2013-2017 period, with Everest Re the only exception as its ratio remained flat. 

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Last year’s hurricanes also prompted increased use of reinsurance and retro in loss-affected risk areas.

For example, Axis’ 1-in-100-year Southeast US hurricane PML fell by 20 percent year

on year to have a 10.4 percent impact on the carrier’s equity base at the end of 2017. In 2013, the same metric stood at 17.1 percent.

Commenting on the cat reinsurance book on the Q4 2017 conference call, CEO Benchimol said the company’s exposure was being taken down overall.

“Let’s be honest. Where the world is right now, with the alternative markets driving the price for cat, cat is no longer offering insurers strong double-digit returns. And so we have to make sure that we allocate our capital appropriately for the risk and returns that are provided by the cat business,” he explained.

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The third, and perhaps most speculated path for reinsurers on the island, is M&A. Over the past few years, Bermudian (re)insurers have been acquisition targets for global insurers looking to diversify. This year’s flurry of deals fuelled market scepticism over an independent future of the small-to-medium sized Bermudian (re)insurer given secular changes described above.

This trend is likely to continue as reinsurers continue to struggle with high expenses versus lean competitors with low fixed costs at alternative capital asset managers.

Essentially, the extra cost of underwriting and transaction expenses at traditional reinsurers is not showing enough outperformance relative to more passive strategies to justify the costs.

Moreover, earnings volatility and a trend towards a preference for diversified and stable earnings (versus lumpy but higher returns) gives global insurers a cost of capital advantage that allows them to add companies like Bermudians at a relatively low return on investment and as an income-diversifying play.

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