Capital Ideas

Capital Ideas

When people talk about the changes in the industry on the street level, their reasoning and their arguments are easily verifiable through experience and easy analysis, whether it’s technology or disintermediation or some other current topic.

The real changes however are coming at the top of the food chain. New money sources are changing the expectations and the outlook for insurance itself. The Casualty and Actuarial society sounded off on this, stating that “reinsurers and the entire property/casualty industry need to evolve as waves of capital reshape their business model.”

Read that again, please.

According to the society, reinsurers face a growing threat from the capital markets— hedge funds, pensions and others that have found new ways to do what reinsurers do. Socalled “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.

The analysts did not always agree on how to react to the trend. 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. 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: “They were 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.” 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 it 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.

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. If they are right, the latest Actuary joke may be on the industry.