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Themes of 2017 and 2018

There are six complexly interlinked themes that can be used to tell the reinsurance sector's stories as we look back to 2017 and into 2018.

You can draw the lines in different places. Each touches the others; they almost all blur together. But together the six sum up the state of play and point the way for the development of the industry in 2018.

The Low Yield Butterfly Effect has changed the sector forever. By successfully reloading in the wake of $70bn-$80bn of cat losses from Harvey, Irma and Maria (HIM), insurance-linked securities (ILS) investors have choked off post-loss pricing, ushering in a stable-to-firming market where steep rate rises had been hoped for.

In doing so, they have strengthened the thesis that a broad-based hard market will never again be seen in property reinsurance, with the top of the cycle decapitated.

Key themes

High-teen returns on equity from property cat business look truly extinct and the end to the cross-subsidy from cat calls into question the viability of pricing in a range of other lines. The expected incursions by ILS into other areas also query the sense of writing business on a traditional balance sheet, beyond whatever is required to ensure alignment.

That said, 2018 could still be a year of upheaval for the ILS market, as the first real test of performance prompts a series of mandate moves that leave the scope for there to be losers from HIM, even as the sector emerges stronger.

Legacy moment

The challenge to the traditional live P&C space - which has at least avoided another two years of a grinding soft market - is strengthening the case for diversification. Along with anaemic returns on investable assets, charges against reserving risk under Solvency II and mounting fears of reserve deficiencies, this has created a "legacy moment".

The smartest private equity players in the sector are in (Stone Point with Enstar; Apollo with Catalina; Aquiline with Armour). And with the oil tanker of reputation finally just about turned on legacy, live players are coming too (Arch-Premia; Validus-Armour; Axa-R&Q; Allianz). More will follow inside the year. The low return money is there too, with Armour raising a second fund alongside Credit Suisse Asset Management.

If carriers decide that they are no longer specialists in some part of the P&C market, but managers of risk, then it makes sense to run the gamut from P&C insurance to reinsurance to retro to legacy to mortgage - allocating that risk intelligently between your own balance sheet, your reinsurers and a range of third-party capital partners with different risk appetites.

Distribution

Distribution has been evolving for some time, particularly within the London market, as the analytics arms race between the brokers has combined with the soft market and the inefficiencies of the placement process to foster facilitisation.

The brokers continued to build these edifices through 2017, even as they faced a carrier backlash led by Chubb CEO Evan Greenberg. And with most follow-form facilities still topping out at 20 percent, they have significant runway to keep going through the next 12 months.

A significant counter-current emerged during the year with the Financial Conduct Authority (FCA) taking an interest in alleged anti-competitive behaviour in the aviation market, with the probe ultimately taken over by the European Commission.

This took place in parallel with an FCA review into the wholesale insurance sector that is causing nervousness within the upper echelons of the brokers, and which puts a potential dampener upon strategic carrier relationships and panel-style deals in 2018.

Beazley has just minted an effective beta fund, giving a home to a revolutionary idea that has been in the air for a while in London. Via the new syndicate Beazley will bring together facilitised risk underwritten at a portfolio level with low return money that comes largely from ILS funds. It will continue to seek Alpha for its own investors and benefit from the fee income generated and, most likely, enhanced broker relationships.

The three-year accounting structure within Lloyd's and the way in which syndicates are capitalised is (as chance would have it) exactly what the 325-year-old market needs to turn itself into the primary entry point for ILS money within the commercial insurance market. If funds and managing agents wake up to the idea, its impact will be far more wide-reaching than that of the now operational London ILS framework - it could make London the de facto home of ILS.

Expense management

It also intersects with the next theme - an over-expensed market - in that Beazley Beta will take advantage of the cost arbitrage available from streamlining the underwriting process.

Lloyd's and the London market have a particular problem, with expense ratios running in the 40s. This is thanks not only to broker revenue harvesting, but to the growth in binders business in the US and - increasingly - the MGA gold rush in London.

Entrepreneurs frustrated by the sentinels at the Lloyd's gates and the high regulatory hurdles, and spurred on by fee-hungry incubators and private equity houses eyeing leveraged buyout opportunities, set up a profusion of new London MGAs in 2017 - each aspiring to follow the success of Dual, Pioneer and CFC.

The Target Operating Model in London continued to move forward by building an electronic trading capability, despite less than total buy-in, and making progress on delegated authority work. Modernisers will continue to fight the Luddites who refuse to change and the despairers who insist it is too late through 2018.

A proper move on expenses both in London and more broadly has been on the horizon for two or three years, but few executives have had the appetite or ruthlessness to execute to date. They have relied instead on natural wastage and incremental measures, checked in some cases by conservative regulators. The wave may finally break on expense control in 2018.

The expense issue ties together both concerns about an over-extended value chain and processing inefficiency, with InsurTech set, presumably, to transform both in one way or another.

Ex-Willis Re CEO John Cavanagh will be among those looking to concertina the value chain in 2018, along with Beat Capital mastermind Tom Milligan.

Aquiline's Jeff Greenberg, who has raised $190mn for an InsurTech fund off the back of his $490mn Simply Business coup, told one of our conferences this year that the smarter money may focus on taking out pain points for existing players in the space.

Most, if not almost all, of the money spent on InsurTech will be wasted; but a small proportion of it is likely to lay the groundwork for the transformation of the industry - although that transformation will not come in 2018.

More M&A

Carrier M&A has been on hiatus, and the scope for development on cat losses in H1 is likely to discourage it again, with the perceived unreliability of Chinese money another negative. High valuations, which render private equity houses virtual spectators, will also discourage deals.

However, all else being equal, it would make sense for a fragmented sector to consolidate, particularly given the challenges posed by depressed rates, expense issues and broker power.

Companies with lower return hurdles and significant scale will continue to have a major advantage, with the Canadian pension funds seemingly bullish on the sector, and others likely to follow CPPIB's Ascot buy with a direct balance sheet play.

The Japanese big three continue to throw off significant sums of capital that are undeployable in their domestic market, and will be back with offers at sector-leading multiples as soon as they can digest the last deal and find a new one. Other carriers with a cornerstone presence in a domestic market may look to the global specialty space too, following the Japanese and Canada's Intact, which bought OneBeacon.

There are still sellers in the space, albeit most of them reluctant. WR Berkley has flirted with a deal; Navigators is a perennial of bankers' books. The London-listed players - Lancashire in particular - are all acquirable in scale, but would constitute premium deals. Everyone in Bermuda from RenRe downwards could conceivably be taken private, or go in a synergies-heavy deal.

Serial acquirers like Fairfax and Markel will continue to look for transactions.

IPOs may make a comeback. In the turmoil after HIM, Watford Re did not make its planned IPO filing, but it seems likely this will happen in 2018. Hamilton will be coming up the same track, although its leadership change may delay that development. Richard Brindle's Fidelis, having transitioned towards a traditional model from a total return play, is probably further off as it continues its buildout.

AIG and AmTrust

Two company-specific stories that garnered the headlines in 2017 will continue to do in 2018, with AIG and AmTrust probably the sector's two most-watched names, and both still seemingly in the middle acts of their dramas.

AIG will be a true test of whether a talented executive team - led by Brian Duperreault, Peter Zaffino and Tom Bolt - can transform the fortunes of a fallen giant that has been plagued now for years with weak underwriting and a toxic casualty back book.

To do so, they will have to reverse the talent drain within the organisation and the demoralisation that came with Peter Hancock's attempts to fight off the break-up hawks through short-term financial engineering.

AmTrust has been a source of special scepticism within the upper echelons of the industry for years as it led the sector on both growth and returns, making its earlier investors huge amounts of money in the process.

Many deemed it too good to be true and it has since been hit with reported regulatory investigations, reserve charges, auditor changes and capital constraints, prompting divestitures and fundraises.

Investor sentiment is low, but with a reinforced balance sheet, higher loss picks and a big four auditor, AmTrust is arguably a sounder business than it was before its missteps, even if its reported results are less attractive.

Regardless, 2018 will be another fascinating year for AmTrust watchers as the turnaround efforts of Barry Zyskind and the management team are put to the test.

There isn't much here about the market - about pricing. Well, in 2018 the market will be the market. Long-range forecasting on rates is about as good as it is for hurricanes.

At present the reinsurance sector is on a stable to modestly positive trajectory, with the primary US market looking to be on a similar path and some pockets of hardness in the London market.

Nevertheless, the market is broadly in equilibrium. That equilibrium could be disturbed - realistically, only to drive pricing higher - by another year of elevated loss activity, an asset shock and deteriorating reserving trends, or a combination of all three.

The third is coming to one degree or another. Your guess on the other two will be as good as ours.

 

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