The capital markets as a wholesale risk trading market: Millette, Hudson Structured

The entry of the capital markets into reinsurance through the catastrophe bond instrument was a sign of the global capital markets becoming a wholesale risk trading market, according to Michael Millette, Managing Partner of Hudson Structured Capital Management Ltd.

Speaking on a panel in Bermuda yesterday, at the ILS Bermuda Convergence 2018 conference, Millette discussed his vision of an insurance and reinsurance market characterised by fewer, leaner and lighter companies, backed up by a functioning global market for trading in insurance risk.

Millette, who’s specialist insurance and reinsurance investment firm invests across the spectrum of opportunities in the space, explained what his thesis of fewer, leaner and lighter means.

“On the primary side of the industry, that means fewer companies,” he explained.

On leaner he said this meant much lower expenses, citing VJ Dowling’s theory that insurance and reinsurance firms should be aiming to operate at a 21% total expense ratio.

He continued, “Lighter, meaning that the traditional model of an insurer, which isn’t that traditional because Lloyd’s was different in the old days, but the post-war insurer is a company that originates risk that becomes this risk warehouse, that holds the risk to ultimate.

“What a traditional insurer looks like from a risk perspective is the end of one of the Indiana Jones movies. There are risks back there that will come back out again and bite you decades later, and the company will hold them all and hold capital against them.”

Speaking of the Hudson Structured vision, Millette said, “We think that’s over.”

So fewer companies we are already seeing through the mergers & acquisitions activity in the marketplace and there is a clear trend towards fewer, much larger and more broadly diversified risk originators.

Leaner is also a focus right now, although we’ve yet to see significant strides being made in getting the expense ratio down towards the 21% level. In fact, many reinsurance firms are trying to spend their way out of the challenging position they are in, resulting in higher expenses.

Lighter, in Millette’s thesis, means companies getting risk off their balance-sheets, so not holding to ultimate in the traditional post-war way.

This is where the insurance-linked investment markets and insurance-linked securities (ILS) come in.

Millette went on to discuss the capital markets role in an insurance market where there are fewer, leaner and lighter companies.

“We think that the cat bond market reflects the onset of the capital markets as a wholesale risk trading market, but an even more leading indicator of that is the emergence of the legacy casualty carriers,” he explained.

Millette’s firm invests in a wide range of insurance and reinsurance linked opportunities, including looking at markets like the legacy space, where pensions and other institutional grade investors have been backing large portfolios of longer-tailed risks.

While many consider this very different to the ILS market or cat bonds, it is a similar model of the cost-of-capital of institutional investors being put to work in backing large pools of risk, while the investors benefit from the insurance-linked and relatively uncorrelated returns that they seek.

Millette said that he sees this broadening of the capital markets more direct role in reinsurance as boiling down to one word.

“It leads to one critical word, season,” he explained. “Our thought model is that what primary insurance companies will do is deploy powerful brands and powerful tech and they will change the consumer experience, which is important as the consumer experience of our industry is not good.”

“What season means,” he continued, “is they’ll book risks and season them. Season means you let the risk sit for a few years on your balance-sheet, the stochastic cone narrows. Then that’s the time to move it.”

This thinking aligns well with the vision of an insurance and reinsurance market where value is key and participants have to work out how best to monetise the value they can bring to the market chain.

For these mid to longer tailed risks having a servicer who can season the portfolio can make it attractive to the capital markets, as the investors know the risks have been analysed, forward-looking claims rates assessed and then the risks can be transferred into a wholesale capital market for trading in insurance risk.

The panel session Millette was participating in was looking at how to drive further ILS market growth, with a view towards $300 billion.

This vision of the capital markets as a wholesale risk trading market, aided by the transfer of seasoned risks delivered by fewer, leaner and lighter re/insurance companies is certainly one way to get there. While casualty and longer-tailed risk isn’t for everyone right now, add the right amount of seasoning and it can become much more palatable.