There are several strands of news in the press reports this month that struck our attention. The first is that although the hoped for rate increases following the HIM wind losses never quite materialized there is agreement that at least the decline in rates has ended. In most cases, especially in loss-affected accounts modest increases have been realized.  The overall consensus seems to be that finally there is, as Chubb's Evan Greenberg wrote, a period " where rates move in a meaningful and positive direction over time."  

Greenberg qualified his remarks when he added that the gradual premium growth may not be "in all classes and territories." He continued " That would be logical but it may be my mistake."

Most would agree that premium rates do not function as unpredictably as say, for example,  the weather. There is a certain measure of awareness and knowledge that participants in an insurance or reinsurance transaction have concerning them. Continuing his comments about slowly rising rates Greenberg said "How far, how much and whether it will be enough to achieve adequacy--I don't know. Rationally, it should move."

Chubb, as an insurer that ultimately will be required to pay a claim in the event of a loss, obviously has a keen interest in ensuring that rates are adequate. Others in the insurance value chain may not be so committed, a conclusion we drew from remarks by US insurer RLI president and COO Craig Kliethermes who said that "some level of sanity has returned to the CAT market, but there are still a number of MGA's willing to write business below our pricing floor." He continued "We still see irrational behavior in several places where MGAs have been given the pen, or standard markets are trying to gain a foothold in the specialty place."

These observations lead to our second strand namely the "trying to gain a foothold" idea. In a broad sense what we've seen so far this year, with AIG's acquisition of Validus Re and the expected acquisition of XL by Axa, is being interpreted by Willis Re as a " dynamic change in reinsurance mergers and acquisitions with large primary carriers re-entering the reinsurance market, having largely abandoned the sector in the 1990s and early 2000s."

In its latest 1st View report Willis commented that "Many major non-life primary companies with large personal line and small medium enterprises portfolios are facing the greatest disruption from new distribution models."  This is an ongoing theme related to the explosion in "insure-tech" technology that, as Swiss Re chairman Walter Kielholz said this month of household and auto insurance " Customers will hardly ask anymore which company the policy is from. They will not care about that."

The Willis report identified non-life primary companies as being under pressure as well saying they "are facing profitability challenges and an inability to differentiate their results from general investment markets."

Apparently, according to Willis Re, one solution for these primary insurers to these threats is that " buying large transparent, well-managed reinsurance companies with synergies in some areas of their existing portfolio is proving attractive."

Somehow we've seen this movie before we thought.  Willis did note that big insurers had exited the reinsurance market at the turn of the century because poor exposure management had led to earnings volatility and sometimes large losses resulted in capital strains.  The change now, according to Willis is "that access to diversified sources of risk, allied with greater confidence that historic technical issues are now better managed through advanced risk quantification techniques, is sufficiently enticing for large primary companies looking for growth."

Presumably, already possessing the primary underwriting knowledge of a risk, combined with the advances in modeling technology, primary insurer management is confident enough to believe that integrating a reinsurance operation into its value chain would make sense.

In addition to the increased confidence primary insurer managers may have about their ability to operate reinsurers, Willis noted of reinsurers that "Away from the headline property catastrophe renewals, many other classes managed uncontentious renewals and despite limited movement in original rating levels, underlying exposure growth has fed through into modest increased reinsurance premium volumes for reinsurers." Translation: the reinsurance sector should be growing.

We couldn't help but think of Pat Ryan's description that the goal of insurers is to create " diversified multiple capital platforms" and realize that's what was happening here. 

The third strand we noted this month is that the debate, for any reasonable person, about alternative capital as a valid player in the risk underwriting sector is over.  There may still be holdouts who will frame the discussion in terms of "traditional capital" vs "ILS and CAT Bond capital", who will raise the long-term relationship related benefits to buyers of traditional capital, but the volume of alternative capital that continues to come into the reinsurance market makes it hard to argue that the landscape has changed permanently.

According to Aon Benfield alternative capital in the global reinsurance market increased by 10% in 2017 to comprise a total of $89 billion of the global reinsurer market capital total of $605 billion at the end of 2017.  Traditional capital increased by just 2% year on year to end 2017 at a total of $516 billion.

Aon Benfield noted the effect of this continued flow of capital saying "The willingness of investors to reload mitigated upward pressure on retrocession pricing at the January renewals. Established sidecars were renewed and several new vehicles were formed, as traditional reinsurers looked to grow their business positions, while controlling next exposures."

In a declaratory statement about the future of alternative capital the broker said "We expect to see further growth in the alternative capital market during 2018. Passing the test posed by the 2017 catastrophe events has dispelled any remaining doubts about the sector's permanency, boosting the confidence and acceptance of both investors and the broader marketplace."

That last comment from Aon Benfield isn't surprising. More capital coming into the market means more choice for buyers of coverage.  The negative effect that inflows of new capital may have on the upward trending of rates should, per this narrative, be more than made up by new exposures coming into the market for the first time.  In any event the alternative capital tidal wave is one that most people long ago decided to ride rather than stand in its way.

One traditional insurer that has chosen to ride the wave is Chubb and that insurer is about as "traditional" as one can envision.  Chubb's so called "total-return vehicle" ABR Re, which was set up in 2015 by Ace and BlackRock, the investment fund manager.  Ace, of course, later acquired Chubb and Chubb now owns an 11% stake in ABR while BlackRock owns a 9.9% share. 

We've written about ABR Re in the past. The reinsurer provides reinsurance and retrocession only to Chubb and is capitalized by Chubb, BlackRock and third party investors who comprise the 80% ownership portion not held directly by Chubb and BlackRock.  Chubb provides the risks and BlackRock handles the investment management strategy. The ABR Re capital is at a lower cost than the traditional capital generated by Chubb so the insurer is able to cede risk, or portions thereof, to ABR and collect underwriting fees and ceding commissions in the process. And of course Chubb's 11% ownership stake would see it receive a share of any profits generated by ABR Re.  

In theory, the concept driving the creation of ABR was compelling, and, as usual when Chubb and Evan Greenberg are concerned, the execution has proven to be even more compelling. In 2017 the amount of premium Chubb ceded to ABR  increased by 19% from 2016 up to $342 million. Benefits for Chubb include " helping it avoid paying commissions to third-party reinsurers, retaining as much of the premium as it can and leveraging the appetite of institutional investors to source a growing chunk of its reinsurance premiums."

There is another big benefit too and that pertains to claims. By the end of 2017 Chubb reported that ABR Re holds $365 million in reinsurance recoverable on losses and loss expenses for Chubb and it is an amount not on Chubb's balance sheet. This is an increase of about 150% from the amount at the close of 2016.  These claims are presumably part of the 2017 CAT losses and as Artemis  noted "The increase will be down to the losses of 2017, showing that ABR Re and its investors have been paying their share of Chubb's major catastrophe losses from last year."

No doubt this is business that Chubb likely would have ceded anyway, to some reinsurer, had they not had the ABR Re option available. However the control that Chubb will maintain over the claim process, and any renewal evaluations, ensure that business ceded to ABR will be viewed in the most favorable light possible in the future.

In a real way what Chubb has managed to do in a microcosm is to create a scenario where a primary insurer has a relationship with a reinsurer to provide the complementary fit that Willis Re identified as a major incentive motivating current primary insurer interest in reinsurers. Certainly the captive nature of ABR Re, in that it only accepts risks from Chubb, is not similar but the benefits to Chubb's balance sheet, and the revenue provided by Chubb's placements to ABR would be in an enviable situation for any primary insurer to be in. 

The final strand we noted was in connection with the observation by Willis Re about intensified interest in reinsurers as an acquisition target. Information included in the XL Catlin proxy statement (beginning at page 21) that was released earlier this month indicated that there were no fewer than seven parties interested in acquiring XL. Press reports speculate that in addition to Axa, others such as Allianz, The Hartford and Swiss Re may have been interested.  

All that actually is known is that it was Axa that made the offer to XL that was accepted unanimously by the XL board. The section in the proxy statement about the contacts XL CEO Mike McGavick was having with potentially interested parties is interesting reading. All we actually thought we "knew", and now we realize that we didn't "know", was gleaned from a narrative that appeared in early March soon after the Axa-XL deal was announced. 

That story, published in the Insurance Insider on March 5th described XL's CEO McGavick as almost indifferent to the prospect of a sale as he said " We weren't looking to sell but Thomas (Buberl, Axa's CEO) came forward with a very compelling proposition indeed."  

The story noted that, according to McGavick, talks between Axa and XL started on November 15th when the two executives came together to discuss where they thought the industry was going.  The meeting apparently went well as McGavick reported that "It was one of those strange meetings where you're finishing each other's sentences."

Until the proxy was released on April 16th this is all we knew.  In fact, in last month's CATEX Reports we observed that in light of this apparent casual exchange, which led to the $15.3 billion offer, we were surprised that the XL board was as receptive as it was in so quickly and unanimously endorsing the offer.  In fact, the offer did not quite come out of the blue so to speak and, according to the proxy, Axa was the third prospective acquirer XL had spoken to in 2017. 

Of course McGavick had kept the XL board apprised of his every move and the board was well aware of all ongoing discussions he was having with prospective acquirers.  However, naively, we had the mental image of a nearly casual "catch-up" type of meeting between the XL CEO and the Axa CEO that ultimately led to the idea of a more strategic fit.  That may have been what happened but by the time Buberl came to the meeting he certainly was aware that XL was in play. Of course, the meeting could have gone terribly. Instead of being one of those "strange meetings" where the parties are completing each other's sentences the two could have ended up disliking each other and resolved to end future contact.

There is a great deal of speculation as to whether Axa agreed to an excessive price to obtain XL. We won't delve into that. Buberl is adamantly defending the price he offered and no doubt, unsaid, part of his motivation was to ensure that Axa's great European competitor, Allianz, did not end up acquiring XL. It's speculated that Allianz was one of the seven prospective suitors and may have been the company that offered McGavick a non-binding oral indication of interest for a cash amount in the area of $50 a share.   Axa was the only other known offeror and Buberl offered $57.60 a share.

The deal is an all-cash purchase and Axa expects to pay for the acquisition with cash on hand, subordinated debt and, subject to market conditions, proceeds from the planned IPO of its US business, Axa Equitable Holdings. Just in case though Axa has arranged a bridge loan facility that can now provide up to $8.54 billion it can call upon to consummate the XL deal. 

If for some reason XL changes its mind about the Axa purchase and does not proceed with it then Axa would be in line to receive a break-up fee of up to $499 million from XL. 

The XL-Axa narrative is certainly exciting to read and it seems to confirm Willis Re's notion that the reinsurance sector is in play as an M&A target.  The reports that The Hartford, Allianz and Swiss Re might have been in the mix are more than interesting as an acquisition by any of the three would have been a blockbuster deal too.

We did note that in the inevitable recaps that reporters do of the prospective payouts executives of acquired companies receive one interesting name.  Stephen Catlin, the founder of the eponymous Catlin Insurance that XL acquired only in 2015, still retains a significant amount of XL stock.  By some reports Catlin will end up receiving over $18 million for his XL stock. If you track this sort of metric you will learn that Mike McGavick could end up with over $150 million in stock sales, vested options and equity awards.

The headline earlier this month said it all --"CAT events send 80% of Lloyd's syndicates into the red." Overall Lloyd's indicated that it incurred roughly $6.3 billion in net claims from major 2017 catastrophes.  That's a big number but when compared to the $144 billion in 2017 insured disaster losses compiled by Swiss Re it comes to a little over 4%.  

Lloyd's writes a lot of business other than CAT coverage or lines that could be affected by natural disasters but that $6.3 billion was enough to tip 80% of the syndicates into an underwriting loss for 2017. The CAT claims are reported to have comprised 17 points of the combined ratio of 115.6%.  Parsing the numbers further Lloyd's accident-year ex-CAT loss ratio jumped by 5.6% to 58.9%. This deterioration is said to be due to claims inflation, lower deductibles and weakening of pricing and terms and conditions.

In a normal cycle, or a cycle without the alternative capital option ever-present, the increase in CAT claims would perhaps signal that a time of rate increases lay ahead. Not so this time reports indicate. A quote from an Insider article says "A sampling of annual reports from Lloyd's carriers shows executives wondering what it will take to stimulate a general price hardening, especially since a historic CAT year failed to get the job done." 

You can probably guess what's next. The article and others went on to lament the fact that despite the historic CAT losses some underwriters are thought to be getting "away with extremely poor underwriting performance over a long period of time", a theme picked up by Lloyd's performance director Jon Hancock who noted that there was "a lot more to be done" on the part of managing agents to improve underwriting profitability.  

There are several interesting quotes from practitioners about underwriters (not named) who the observers believe to be lacking discipline. Overall though, in addition to the large claim losses, there is another drumbeat we've heard before and that concerns the expense involved in doing business at Lloyd's.  Even Hancock admitted that it was "too difficult and too cumbersome" to do business at Lloyd's.

To be fair there was news that " The Lloyd's market took 39.5 percent of premiums to deliver the product in 2017, down from 40.6 percent" so in one sense the direction is at last positive but as Adam McNestrie notes it's difficult to justify executive compensation incentive bonuses at Lloyd's when the market is in the red.

The cost of doing business at Lloyd's is a perennial topic and one which the Corporation of Lloyd's is well aware. The Corporation has implemented a staff reduction program but still saw its average headcount rise by 2.9% to 1,157 employees. The Corporation's expense levels were 307 mn GBP (or approximately $442 million) last year which although 1 million GBP less than 2016, still represents a 35% increase from 2014 levels.

Lloyd's is aware of this criticism as noted. The steps Lloyd's is taking to address these high expense levels include an IT modernization program, consideration of possible changes in regulatory burdens and increased R&D into new products. It's not wise to bet against a 332 year old institution but the Romanovs, Hapsburgs and Ottomans probably thought the same thing and they had been around even longer. 

It was against this backdrop --the ongoing complaining about the Lloyd's expense cost, compounded with a substantially increased level of natural CAT claims --that we read the article about Lloyd's looking to bring in ILS capital as soon as next year to back the Central Fund. 

The Central Fund is the much vaunted (appropriately so) third link in Lloyd's Chain of Security providing backstop funding for business underwritten at Lloyd's. The Central Fund is approximately $4.1 billion in size and is the final link in the chain that would be attached, after syndicate assets and member's funds, are exhausted. The Central Fund is composed of cash, securities and subordinated debt instruments.

The idea to access the ILS market to assist in insuring the Central Fund is probably a good one.  As John Parry, the Lloyd's CFO, said a "diversity of capital providers" is a good thing. Last year the UK government enacted legislation that allowed ILS risk transfer vehicles to be domiciled in the UK and as Parry said "ILS is here now. It is part of the insurance industry now. Is that another source of capital that Lloyd's can deploy to take risk?"

At the end of 2018, Parry said, Lloyd's would begin to assess the most cost-effective ways for the Central Fund to access capital. It is speculated that Lloyd's is looking to augment the Central Fund by some 1 billion GBP which would indeed be of interest to ILS players. Losses infrequently reach the Central Fund, for example, even the significant  Q3 CAT losses "had  zero impact on the Central Fund."

Of course the newly enacted ILS framework will not only touch upon the Central Fund, should Lloyd's determine it to be a viable path. More importantly if the use of ILS grows among syndicates at Lloyd's then that could well mean that the "price attached to risk will likely remain depressed, as lower-cost capital finds increasingly efficient ways to enter the market."

This fear isn't just speculation. Hilary Weaver, the Chief Risk Officer at Lloyd's, warned that "The new UK ILS regulation will, if anything, increase the already abundant supply of insurance capital. This is likely to mean that prices remain low for many risks, so that we need to remain vigilant to ensure that the prices charged for them are proportionate to the risk."

Oh, yes. Ms. Weaver also noted that " We expect this price pressure to result in a continued effort to cut costs."  She may be understating it a bit.  If ILS capital comes into Lloyd's in a big way --beyond Nephila, Securis and Credit Suisse who are already there--it could well mean that Weaver's concerns about prices remaining low will become real.  The expense ratio could become more pronounced in the future.

There were three noteworthy items coming out of Swiss Re from their bastion on Mythenquai in Zurich. The first was a warning that risk bearers must be prepared for the possibility of more frequent multiple-disaster years in the future.  The reinsurer observed that the run of disasters comprising the three 2017 hurricanes was not as rare as had been assumed and noted that there have been "five years in the past one hundred in which at least four Category 4 or 5 hurricanes occurred in the North Atlantic."

More ominously Swiss Re said data indicates that hurricanes cluster when certain conditions align such as increased ocean temperature and atmospheric humidity. With temperatures predicted to rise due to climate change this means that more storm clustering is likely. 

The report from Swiss Re's Sigma said "Hurricane clustering has emerged as an important variable to consider in assessing future loss potential scenarios."  As if on cue researchers from North Carolina State University released a study predicting a 2018 Atlantic hurricane season significantly above long-term average levels of activity with as many as 18 named storms and hurricanes predicted for this year.  

Then we read this article titled "Swiss Re chair predicts sharing economy will halve premiums."  We mentioned this article earlier in this newsletter but it deserves more attention.

Swiss Re chairman Walter Kielholz thinks that the advent of self-driving cars will result in global insurance premiums decreasing by 50% as more people move away from car ownership. Kielholz said that in the future people won't own a vehicle but will just "press a button" to have a self-driving car arrive at their door.  He went on "It may well be that car dealers will disappear. But the insurers will also feel the change hard. Half of the premium volume goes to the auto business, and that will be largely eliminated."

We've heard this before. Ascot Re's John Berger mentioned it at an Insurance Insider conference last month and went on to note that the increased implementation of robots in the workplace would have a similar impact on Workers Compensation insurance.

For Kielholz the evolving market will mean that the company has to move closer to the risk. He said "Today we are the last link in a chain of mediation services. We cannot just wait and hope for better times, we have to make sure that we always have access to risk."

We've read about how Willis Re has observed that primary insurers are likely to continue to try to penetrate the reinsurance sector. Kielholz's comments might indicate that the reverse is at least a possibility.

Then, in an earnings call, Swiss Re CEO Christian Mumenthaler was discussing, among other things, the proposed investment in the reinsurer by the Japanese tech giant SoftBank. The discussions are ongoing and the maximum size of the SoftBank stake in Swiss Re would be 10%. Mumenthaler noted that one of the attractions of the technology giant is that it has full access to growing Asian markets and a client base of about 800 million customers. 

Hypothetically, if Swiss Re can obtain access to 800 million prospective customers others can also move in that direction. Growth markets in Asia have long been a target of the global risk industry.

Swiss Re expects that the insurance and reinsurance industry is going to experience growth in the coming years.  Swiss Re expects overall market growth of 5% across the next five years based on expected reinsurance premium growth per annum. For high growth markets (like where the bulk of those 800 million SoftBank customers live) Swiss Re expects reinsurance market growth of 8% across the next five years.

Swiss Re sees a complete picture. Certain risks may wither away as technology and social changes make them obsolete. Yet, in their place, undoubtedly, a host of additional insurance needs will arise. From Swiss Re's perspective they believe their tech strategy offers them a competitive advantage to anticipate changes in the insurance value chain and secure access to new risk pools. If the deal with SoftBank goes through it will indeed present a formidable combination.