Make hay while the sun shines

Everyone keeps asking what has happened to the good old underwriting cycle and when the market will finally turn. But it steadfastly refuses to budge, despite the pathetic state of investment returns and a series of pretty sizeable catastrophes in recent times. Interviews with leading primary insurers and the reinsurers are full of talk of disciplined and technical underwriting, commitment to loss control and engineering with favoured clients and selective growth in more attractive markets, mainly outside of Europe and the US.hideWhat we are not hearing is talk of rocketing combined ratios, reserve buckets running dry and the need for huge price increases as one would have expected at this point in the cycle (if it still exists). While risk and insurance managers across Europe are enjoying this surprisingly long and benign period and should continue to do so there is understandably still a great deal of uncertainty and concern about the future. Risk managers are expected to provide the board with certainty in an increasingly uncertain world. It is clear from our recently completed Global Risk Frontiers survey that risk management is in vogue and risk managers are 'enjoying' more airtime with the board than ever before. This is positive news from a professional perspective of course. But it also carries a certain level of danger. Nobody wants to be forced to shuffle apologetically to the board and tell them that the cost of their insurance has just doubled unexpectedly. So where can the answers be found? One historically reliable and forward-looking source is veteran London and international insurance equity analyst Chris Hitchings of US-based specialist investment bank KBW. Mr Hitchings has analysed the workings of the insurance and reinsurance market for a long time now and has never been described as a shrinking violet. He recently published a couple of notes on the state of the London and international specialty and reinsurance market and likely trends that are worth taking a look at. So what did he have to say? In its simplest form Mr Hitchings said that he expects a reserving trauma in the primary insurance market over the next year or so. This would normally lead to a need for rapid and substantial price increases to compensate for the lost padding provided by the reserves that was needed to keep investors happy. This assumes that the reinsurance market follows the same direction. It may not because it has loads of capital that is hungry for premium to feed upon. If that is the case then it can shore up the primary market by taking on more of its risk at a relatively cheap rate. If that is the case then the soft market could continue for the rest of the average insurance and reinsurance buyer's working life and so obviate the need for any embarrassingly apologetic board meetings. The bad news for the primary corporate insurance buyer is that Mr Hitchings believes that, while the international specialty and reinsurance market is undoubtedly currently awash with capital, the signs are increasingly that a traditional cyclical correction is on the way. The current high level of capital in the market, not least provided directly by the return hungry capital markets via Insurance Linked Securities (ILS), will potentially stave this correction off until 2016. But the evidence is building that the correction will come and so primary buyers better start softening up their bosses sooner rather than later, Mr Hitchings' analysis suggests. For now though the news from the reinsurance market is good for the primary buyer. The US catastrophe renewals remain the bellwether of the overall market and Mr Hitchings noted that market hopes of continuing discipline in reinsurance pricing took a big knock in May with news that a major Florida contract had renewed 30% down. This was undoubtedly driven by the continued flood of capital into the ILS market. "Florida is always a difficult risk set but, even if -30% is not the norm, the June and July US cat treaty renewal season looks likely to be uncomfortable [for the underwriters]," stated Mr Hitchings. "Absent a serious nat cat event, we see ILS-sourced capacity as (at best) an increasingly de-stabilising influence on reinsurance pricing for some time," he added. Another talking point in the market of late was the news that Warren Buffet's Berkshire Hathaway made moves to grab a share of the surplus lines market, one through a specialist company and another through a quota share of Aon's Lloyd's-placed book. "Given our hopes of an upturn in surplus lines volumes over 2014-16, we think this is sensible but it does mean that the (we hope) expanded market will have another powerful competitor," commented the analyst. More generally Mr Hitchings said that the P&C cyclical downturn of 2004-13 is an 'odd' one. He pointed out that prices have fallen substantially in the primary segment while returns have remained reasonable, mostly thanks to big reserve releases, falling inflationary expectations and the very high levels from which price reductions started in 2003. This is not too surprising but for the analyst the odd development is that prices have been gently rising in the US for over a year now without any of the usual signs of underwriting or reserve trauma that historically accompany such pricing upturns. "We have suggested that this looks like a 'Goldilocks' cycle (prices are 'just right', neither too high, nor too low)," wrote the analyst. Mr Hitchings said, however, that the specialty P&C and reinsurance segment, where pricing has hardly fallen at all since 2003 and returns have remained very strong, is even odder. He pointed out that this state of affairs is in 'marked contrast' to the previous cyclical downturn (1994-99), in which capacity 'ingress' to the reinsurance industry was the main driver of the soft market that culminated in the huge losses of 2000-01. "The discipline of the reinsurance and specialty market has been attributed to a number of factors, including industry consolidation, painful memories of the mistakes made previously, more intense capital monitoring by management and rating agencies, better catastrophe modelling and more proactive capacity management such as in Lloyd's," pointed out Mr Hitchings. "Behind this historically unprecedented outbreak of good sense may be that, with most quoted reinsurers and specialty insurers trading at modest premiums or discounts to book value over this period (in contrast to the substantial premiums at which they traded in the mid-1990s), there has been little incentive to pursue growth and much to return excess capital to shareholders," he explained. The big question that faces buyers of both corporate insurance capacity and reinsurance capacity is: What is the outlook? Mr Hitchings reckons that the primary industry is in a conventional cyclical trough and 'reserve trauma' will emerge over the next year or so. He noted, for example, that US industry paid/incurred ratios reached 1999 highs in 2011. For the specialty/reinsurance industry, the analyst is less certain and sees two scenarios. The first more optimistic scenario sees the unusually mild downturn evolve into a moderate upturn. This would be sparked by the primary industry's traumas feeding through to reinsurers and lead to a prompt retrenchment and risk reduction by primaries and, thus, profitable growth opportunities for specialty insurers and reinsurers, said Mr Hitchings. The second more pessimistic scenario envisages an elongated cyclical peak of 2003-12, a kind of 'phoney downturn', that eventually prompts capital ingress, rising competition and, thus, evolves into a proper cyclical downturn. The analyst suggests that this could occur from 2013-16 and would lead to the eventual 'frightening' losses and, then, a proper cyclical upturn. The bad news for buyers is that developments over the past few months has strengthened the belief among the KBW team that the pessimistic scenario is more likely.

Make hay while the sun shines

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