Writing a monthly newsletter for the reinsurance industry can seem, as Yogi Berra said, like "deja vu all over again." Each month we read a spate of articles that include comments from well-meaning observers who have strained to glean evidence that the end of the tumbling rate cycle is finally in sight. Just as certain, each month there are at least that many articles by industry observers saying that rates will continue to decrease.

Over the past few months we've begun to notice articles warning that reinsurer expenses seem to be rising. Initially this rise was ascribed mainly to M&A activity undertaken by companies as they sought to better diversify and increase their underwriting portfolios. Then we read the news that Ajit Jain has instructed Gen Re to cut expenses and noted that even travel and entertainment costs for internal meetings needed to be reviewed.

We've also noted the warnings about the use of claim reserve releases being used to boost earnings. The thinking apparently is that the reserve releases might both mask poor underwriting results and deplete reserves that should be more prudently maintained for future claims.

A review of the news from the past six weeks again produces more of the deja vu effect. The same rate "optimists" are balanced out by rate "realists"; a sharper focus has been leveled on increasing expenses; and just about everyone is warning that soon there will be no more reserves to release.  The industry remains on the knife edge of profitability. We could probably cut and paste this from prior editions of CATEX Reports.

There are new developments though and they could be important.  The first concerns what had been only speculation earlier this summer about the effects of a quantum sized CAT loss. A few months ago there was speculation that even a loss of $50 billion would possibly not stop the fall in CAT premiums but not cause a spike in rates as in previous cycles. After a month or so of mulling this over it seems now that the consensus is that even a mega-CAT won't kick-start a steep climb of rapidly rising premiums.

The next subtle change we've read has to do with claim reserve practices.  Our friend Steve Evans at Artemis notes that "Building up reserves from prior accident years and then using the funds to mitigate adverse market conditions and catastrophe losses, for example, has long been a feature of the risk transfer landscape, enabling insurance and reinsurance firms to benefit from prudent loss picking and lower-than-expected catastrophe loss years."  

Without making judgment on motives there is no denying that reinsurer Q2 results have been boosted by claim reserve releases that in some cases have meant the difference between an underwriting profit or an underwriting loss.

Some observers believe that there are precious little reserves left to release at this stage. Remember that reinsurers have been waging war against low premiums and abundant capacity for several years now. The fight has not been exclusively limited to CAT pricing. Read this quote from JLT RE: "Arguably the largest 'catastrophes' ever to befall the risk transfer business have not been the mega property-related events which feature prominently in the headlines, but the slow build-up of reserve weakness driven by aggressive pricing in longer-tail, non-catastrophe lines over extended periods of time."

If JLT is right, there already are less reserves available to offset negative underwriting results.   So if future reserve releases will be limited, we have to hope for underwriting to be profitable on its own?  Are prices sufficient after these years of aggressive competition? They might have been if we had continued to enjoy quarter after quarter of light CAT claims.

Unfortunately,  Munich Re  reports that "Losses borne by the insurance, reinsurance, and insurance-linked securities (ILS) industry increased by $8 billion to $22 billion when compared with last year, staying in line with the inflation-adjusted average for the last 10 years, but above the average of the last 30 years, of $15 billion."   Q2 losses contributed approximately $6 billion of that increase .

Much of that Q2 loss stemmed from the Alberta fire in Canada. Alex Maloney, CEO of Lancashire said "the Canadian wildfires aren't even that big a loss --it's below $5 billion, but the effect it's having on firms' returns shows us that the market is so close to the edge. You really don't need a lot more to happen before people are in the red."

Analysts warn that the diminishment of reserve amounts mean that companies will begin to lose flexibility to prudently release claim reserves. In an era when underwriting ratios are already marginal, and a loss that's not "even that big", is enough to push the market to the edge, analysts fear that carriers could be facing negative loss ratios soon enough.

This scenario could get worse. We've noted concerns in the past that some insurers are already writing certain risks below the cost of capital or below so-called technical levels.  If the "buffer" of earlier reserves is gone what would happen if claim losses actually normalized? Some believe that even a return to normal CAT loss activity could be enough to tip certain carriers into a negative underwriting ratio.  

This is like a lake that has had the water drained out of it.  We can now see everything on the bottom. There are markets that admit that they've written certain business below the required price. Those markets have decided that, when combined with the balance of their geographic exposure and diversity of business, its better to hold on to a client rather than lose them.  Given the costs of client acquisition these days it's hard to argue with that rationale.

This year, first half CAT losses actually were "normal" and a number of carriers paid the price in their Q2 results. The Canadian fire, US hailstorms and the Kumamoto earthquake caused underwriting losses at several insurers.  The concern that many have is that we're now in the middle of the Florida hurricane season and that if the industry is running this close to the edge, so much so that a return to normal CAT claim activity for even one quarter produced losses, what could happen if there is a major hurricane strike in the US?

Remember that this discussion is going on in the context of an understanding that even a major CAT claim won't send rates up sharply.   Deutsche Bank thinks even a $50 billion claim won't move the pricing parameters. If premiums don't increase after a $50 billion industry loss there is little room for recoupment of losses.

Amidst this gloomy picture we noted two stories that didn't fit this tableau.  We already noted Ajit Jain's warning to Gen Re about controlling expenses.  Apparently what Ajit is really concerned about is that he believes Gen Re is under-leveraged and could be writing more business than it is. By reducing unnecessary expenses he can generate more capital to write more business. In addition to the expense issue, he's lit out after a bonus structure that, he believes, rewards underwriters for keeping rigidly to a target combined ratio, a practice he thinks that is leaving money on the table. 

Remember, Berkshire Hathaway looks at the world a little differently than most insurers. Adhering to a targeted combined ratio is all well and good but in Gen Re's case Ajit thinks "There is room for Gen Re to absorb greater volatility without necessarily increased margins." Gen Re premium dollars are included in the fabled Berkshire "float" that generates investment income.  For Berkshire, if the policy even holds its own from an underwriting profit and loss perspective, that still leaves ample room from the investment income side for the business to be profitable. 

The second story we noted  was this article : "Insurers can break free of market challenges: Willis." The broker conducted a study of  UK non-life insurance insurers and determined that 

difficult insurance market conditions are no excuse for poor performance.  Willis conducted an analysis of financial returns of insurers which showed that those operating in similar classes of business had delivered markedly different return levels over the last five years. 

Willis concluded that "T here is of course no magic formula, but most companies should be able to make gains from re-examining approaches in core areas, including capital, investment, business mix and disposals, reinsurance and uses of technology and analytics."

From our perspective we were heartened to see that although the study was limited only to primary UK non-life carriers there are measures that can be taken to "break free" of the current environment. Willis noted that there is about a 15% spread between the highest and lowest performing companies.

You might have noted that the Willis analysis did not focus on reinsurers. Fitch Ratings did look at reinsurance when they observed that the group of 44 reinsurance companies which it tracks saw operating results suffer a "steep decline" in the first half of 2016. Fitch noted that return on average common equity decreased by 36% compared to the same period last year.

Fitch noted that reserve releases continue to be important to reinsurer results with releases contributing 7.3 points to the combined ratio.  Without the addition of the reserves Fitch said the combined ratio would have been "verging on the unprofitable" at 99.6%. The same metric for the same group of reinsurers in 2015 was 95.5%.

The ratio increased because of first half CAT losses which added 6.2 points and an increase in spending.  The expense ratio increased from 32.1% last year to 33.2% in 2016.  The increase in spending seems counter-intuitive as it comes during a time of decreasing premium levels but Fitch notes that certain reinsurers are incurring increased expenses as they expand into different lines of business including insurance in order to hopefully generate more premium.  

The increased expenses have been termed "spending your way out of a soft market" by some.  According to some, or at least Lancashire's Maloney, it's not possible to "grow your way" out of a soft market. 

As we come into the Monte Carlo meetings later this month there is a definite sense that there are no longer any margins anywhere. The industry, it seems, has made about every move it can make. It's been inundated by new capital; premiums have decreased substantially; CAT losses have been lower than usual (which means lower claim payments but eliminates justification to increase premiums); investment returns are at historic lows; analysts indicate reserves available for release are drying up; and everyone agrees that even when a mega-claim emerges it still won't be enough to dissuade new capital entrants or precipitate a steep rise in rates.

In the face of all this where does a reinsurer even begin if they want to boost their business?

Gen Re is part of the Berkshire Hathaway group. It's far from being a small player although its numbers are rolled into the Berkshire group for reporting purposes.  Estimates are that the annual premium is about $6 billion, which would safely place it as one of the ten biggest reinsurers in the world.

As part of Berkshire,  Warren Buffet's famous "premium float" directive is integral to calculations performed on Gen Re's premiums.  Some $90 billion in annual premium float is at Berkshire's disposal. We noted earlier this year that Kara Raigul replaced the retiring Tad Montross as CEO.  Last month news came that Ajit Jain and Raigul completed an initial review of Gen Re operations and had several "suggestions".

Apparently the review was contained in a five page memo written by Jain.  There were a number of laudatory comments about employees, corporate integrity and dedication but what clearly was of the most interest to Ajit was the current premium leverage at Gen Re.

Berkshire, remember, can essentially write business at a 99% loss ratio but use the premiums from that business to contribute to the $90 billion of investment float that Berkshire invests. Far be it from us to suggest that an underwriting profit is less important to Berkshire than elsewhere but when one of your main goals is to generate as much premium float as possible, and contain your exposure, you do have a slightly different view of the world than does a stand alone reinsurer.

The memo noted that one of the findings of the three month long review at Gen Re was that the bonus structure of underwriters was based on the marginal profit of the underwriting loss ratio.  Again, from a stand alone carrier this metric would make eminent sense but not if you're Berkshire.  If the bonus system incentivized underwriters to pass on risks that were not profitable enough  -- because their loss ratios would likely fall outside the bonus pool target --then that means that underwriters are passing on business that would produce an underwriting profit, albeit a profit smaller than the loss ratio needed to target for the bonus structure.  

From Jain's perspective this means that business which will in itself likely be profitable (if only slightly) was being passed on and prospective premiums which could be added to the premium float were being missed.

Keep in mind that Gen Re is a direct writer and as a result does not pay broker commissions.  This practice allows for savings but in a slack market like the present can present challenges to finding new business. Many have speculated that this is why Gen Re engaged in the capacity arrangement with Trans Re earlier this summer. Gen Re capacity is backing broker produced business but Gen Re is not incurring broker costs. 

Possibly what has Ajit most exercised is that since Gen Re does not pay brokerage the only costs it does have are internal. This means that any decrease in those internal costs, or increase in written premium, has a greater proportional impact than if Gen Re was paying brokerage or acquisition costs.

When you boil it down what we think Berkshire is trying to do is a little bit of a behavioral shift at Gen Re.  Ajit is reminding them that Berkshire has an overwhelming advantage over competitors in any market environment and in a soft market that advantage increases.  If the prospective business looks like it will produce an underwriting loss then don't write it.  But if the business looks like it will produce only a small underwriting profit than you had better think long and hard about it --even if you need to loosen terms and conditions to get it.

Berkshire wants the premium float that the business will produce to use to earn investment income. If you're an underwriter, Ajit seems to be saying, don't trouble yourself with the size of the margin of your underwriting profitability --instead focus on how much written premium you can produce --and still maintain underwriting integrity.  Written premium, generated by "sane" underwriting, is the goal of any Berkshire operated underwriting unit.  Ajit's memo called on employees to tackle the issue "intelligently" to give the carrier "a shot at making a real dent in the expense-to-premium ratio", according to reports.

The memo reportedly closed by saying: "If we can't, we will need to explore other ways to do so."  

Stay tuned.

 

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