Reinsurers expense management & efficiency increasingly important

As the reinsurance market becomes ever more competitive, as increasing amounts of third-party, lower-cost and ILS capital seek to access the market alongside excess-levels of traditional capital, expense management and all-round efficiency is growing in importance.

The topic of expense ratios is one which hasn’t yet been that widely discussed by reinsurance companies as they speak about the competition and threat posed by alternative reinsurance capital and insurance-linked securities (ILS) players during their analyst calls and presentations.

We’ve been suggesting since last year that a time would come where the returns on reinsurance business underwritten could soften to the point where reinsurers expense ratio, and its management, will become increasingly important and start to be discussed by the companies it affects and their shareholders.

Analysts have begun to touch on the expense ratio in recent months and that means it is now an issue that some of the industries biggest shareholders are increasingly aware of. Once that begins to happen it’s typically only so long until CEO’s and executives of reinsurers are forced to begin to consider their responses to the threat of spiraling expenses occurring at the same time as margins are becoming eroded.

XL’s CEO Mike McGavick appears to agree and feels that we’re now moving into that phase of the competitive and softening reinsurance market cycle.

We’ve reached a time where the cost of operation, compared to the capacity you wield, could become a real issue for large traditional reinsurers and the efficiency of small, nimble teams, focused on peak property catastrophe risks using third-party capital may be difficult or even impossible to compete with.

The stark difference in premiums written per employee, that we discussed in this article in July, demonstrates the dilemma that some reinsurers will face. They have come to the current softening market, where efficiency of capital and operations are vital, from a point where they are very large and some might even say sluggish.

At the same time the ILS fund managers and collateralized reinsurance players are coming from extremely lean business models and growing into this market using capacity which has a defined, often lower, return appetite, enabling them to be extremely competitive and agile. This also allows them to add complexity, in terms of broadening their underwriting scope into more complex lines, in a cost-conscious manner, ensuring they only take on so much risk that they can manage and growing expenses in a sustainable manner.

This is a real threat to large reinsurers and goes a long way towards explaining some firms moves to dramatically cut back on underwriting some risks, usually the peak catastrophe risks which are the best modelled, where returns no longer meet their balance-sheets requirements. This has resulted in moves into primary, specialty and facultative type lines of business where operating scale remains a more significant advantage and the depth of expertise is still a key differentiator.

XL Group, through CEO Mike McGavick, is the first re/insurer to address this increasing threat to their business, at least that we’ve seen address it specifically during an earnings call.

McGavick said on XL’s business at the end of Q3; “We are pleased with our progress across the segment. Our business leaders are taking the necessary actions to achieve their targets and to fight in a tough rate environment, even when that translates into maintaining discipline on pricing they are not chasing the markets down in search of top-line.”

Emphasising the fact that the market environment is increasingly challenging but it remains disciplined, McGavick said; “The tough conversations on price, terms and conditions in the reinsurance markets continue. But here too we like our disciplined approach, which means opting not to renew a line or being unwilling to follow terms defined as unacceptable for the market and for our business.”

But discipline in terms of underwriting is just one action that XL will take to continue improving and maintaining an advantage in the competitive reinsurance marketplace.

“As we’ve discussed, rate is only one lever we can pull,” McGavick said. “In this next phase of competition, we see expense management and the ability to gain leverage from the prior strategic investments we’ve made as being increasingly important.”

McGavick explained later on in the call that XL’s expense lever is going to be increasingly important as the firm moves forwards. He said that the message has been sent to XL staff, as they create their budgets, that they need to be aware in the current market that the firm needs to be particularly conscious of every dollar spent.

McGavick acknowledged that this may be seen as “straight out of the soft cycle playbook,” but added that at XL they do not see it that way.

“This could be forever, we don’t know. We have to be prepared to continue to drive towards the goals we’ve set ourselves and the expense lever becomes more important and frankly so does remixing (of the business mix) as we get into this more difficult pricing environment,” McGavick said.

This is the first real commentary on adopting a more cost-conscious approach to running an insurance and reinsurance business that we’ve seen during Q3. It’s a pragmatic approach in the current environment, perhaps essential to do all you can to become a more agile operation, but those who leave it too late to reign in spending or to use the expense lever may well regret it if their expense ratio spirals out of control in quarters to come.

As recent price declines filter through in terms of lower earned premiums, for some firms the expense ratio will come under ever greater scrutiny. An inability to control this could draw unwanted attention, putting them on the radar of those considering acquisitions. This could be another threat for the mid-tier reinsurance firms which do not have the scale or depth of expertise to change their direction to avoid the softened market.

It is also interesting to hear McGavick say that in the next phase of this competitive market environment the ability to gain leverage from prior strategic investments XL has made will be important too.

The growing input that XL’s share in insurance and reinsurance linked asset manager New Ocean Capital Management is providing as well as how XL can grow that contribution and leverage third-party capital at New Ocean for further growth across its business, is one example of investments XL has made.

Controlling expenses while maximising the return generated from new initiatives, particularly those that aid its cost-of-capital, and growth into less pressured markets, is a strategic approach from XL that makes perfect sense. It’s vital that re/insurers such as XL get to grips with their cost-of-capital and expense ratios early on.

Increasing expense ratios could also contribute to more reinsurance firms taking on higher risk investment strategies, as they attempt to offset a couple of extra percentage points of negative with a couple of percentage points of positive through adjusting their asset management strategy. This could result in more reinsurers taking on hedge fund type strategies or looking to set up hedge fund reinsurer units in partnership with an asset manager.

It’s also vital that third-party capital management is brought into the business sympathetically. Growth of third-party capital managed could actually lead to a spiralling of the expense ratio, if the capital mix changes too suddenly and third-party capital income becomes more important to the firm while it maintains a traditional organisational structure and resourcing.

The issue for traditional players is that third-party reinsurance capital management income is unlikely to completely and like-for-like replace the profit made from their balance-sheet underwriting overnight. Becoming more efficient at the same time as adjusting the business model, capital mix and direction will be a growing focus.

Whether reinsurers choose to maintain balance-sheet underwriting volumes at the current low pricing and rates, shift increasing amounts of business into third-party capital backed structures, attempt to grow into new lines and markets, or a combination of all of these, controlling expense ratios is going to be key for reinsurers across the market over the next few years.

As the reinsurance market passes through what could be a long period of adjustment, CEO’s of large reinsurance firms will be hoping that ILS managers do not grow too fast or raise considerably more capital, as on a cost per-unit-of-risk underwritten basis they may struggle to compete.