How New Capital is Changing P/C Industry and What To Do About It

June 17, 2014

As waves of capital reshape reinsurer’s business model, the property/casualty insurance industry needs to change although exactly how remains a matter of debate.

Reinsurers face a growing threat from the capital markets—hedge funds, pensions and others that have found innovative ways to replicate what reinsurers do. This so-called alternative capital is driving reinsurance prices lower, especially the cost of reinsuring losses from Florida hurricanes.

There are signs alternative capital will seep into other areas of property/casualty insurance and reinsurance. How reinsurers can respond was a theme during a discussion by analysts at recent Casualty Actuarial Society’s Seminar on Reinsurance in New York.

The analysts did not always agree on how to react. Alan Zimmermann, managing director of Assured Research, and Matthew C. Mosher, senior vice president of rating services for A.M. Best Company and a fellow of the Casualty Actuarial Society, believed the industry needs to move on to new opportunities.

“If you are not willing to change with society, you are going to lose your relevance,” Mosher said.

Meyer Shields, managing director at Keefe, Bruyette and Woods and a Fellow of the Casualty Actuarial Society, counseled a more modest approach, such as probing carefully to find profitable niches. “We’re not in the business of solving the world’s problems, we’re in the business of increasing the value for shareholders,” he said.

The new capital has emerged in recent years, but its start harkened back at least two decades to Hurricane Andrew, which ravaged the Miami area in 1992.

Today, Zimmermann said, Andrew doesn’t seem like it would have been so important in its day. The insured losses from the storm, $23 billion in today’s dollars, pale in comparison to some more recent events, like the $47 billion in inflation-adjusted losses from Hurricane Katrina. But Andrew’s losses were four times greater than anything that preceded it and far more than anyone predicted.

The storm shook the industry. Perhaps the biggest change it brought was a new degree of acceptance of computer modeling. The computer models made catastrophe risk, once the uber-specialty of insurers and reinsurers, easier for others to understand and price.

Zimmermann recalled the powerhouse reinsurers from those pre-Andrew days: awesome behemoths, whose size, customer base and underwriting depth made them seem like impregnable “castles surrounded by the Hudson.”

But those models have been honed, and today capital market investors rely heavily on them as they invest in the property/casualty space. The dominance of reinsurers has ebbed. “There are a lot more companies,” Zimmermann said. “Now it’s more like a mobile home park surrounded by a creek.”

As new capital flows in, the price of reinsurance falls. Panelists agreed reinsurers have generally responded well to the immediate situation, writing less business as rates shriveled. Some even practice a sort of arbitrage, writing risks then ceding them into the capital markets at a lower price.

For the long run, reinsurers have responded slowly, Zimmermann said, as have most property/casualty insurers. They are trying to insure an industrialized America that increasingly does not exist.

While approaching the challenge from slightly different angles, Zimmermann and Mosher agreed that the industry needs to embrace new risks, like cyber liability.. Zimmermann, as a company analyst, sees growth as a way for insurers to generate profits. As a rating agency analyst, Mosher sees developing new business as a better deployment of capital than underwriting current business unprofitably.

While dissenting, Shields agreed that companies need to face the changes that are happening and find ways to benefit. It can take time, he said, to find underwriters who understand new lines of business. “Capital is fungible,” Shields said. “Underwriting discipline is not.”

The analysts also discussed how the industry has benefited from a decade of low inflation. Standard reserving methods have an underlying rate of inflation built into them; low inflation has allowed companies to improve earnings by releasing reserves from older years as they have proved redundant.

Now, Mosher said, those same reserving methods have low inflation baked into them. An uptick could mean property/casualty company reserves could become inadequate.

Low inflation also means company profits grow more volatile, Shields said. Companies rely less on investment income and more on underwriting income. The investment income mainly comes from bonds, which are stable, while underwriting profits come from the business a company underwrites, which is more volatile. “That itself is a riskier model,” Shields said.

Zimmermann agreed; his 40 years as an investment expert means he recalls well the steep price increases of the 1970s. “If you haven’t lived in a world of 10 percent inflation,” he said, “you can’t realize how debilitating it is.”

That experience has taught him lessons on how investors view insurance companies. Over his career, Zimmermann has gathered earnings data on insurance markets and the stock market in general, stretching back 60 years. In that time, insurers have returned 8 percent on equity. All stocks, measured by Standard & Poor’s, have returned 13 percent.

The underwhelming returns have made property/casualty values consistently lower than the rest of the market. The new capital hasn’t made the situation easier, he said.

“You can’t be in a business with growing competition and expect your stock to do well in the long term,” he said.

Source: Casualty Actuarial Society

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