Fermat Capital Management’s John Seo explains to Artemis why the “great reload” of 2018 sounded the final death knell of the traditional reinsurance cycle.
Given the replenishment of ILS capital in the aftermath of last year’s catastrophes, the reinsurance industry should accept the traditional cycle is dead and that disruption has occurred, thinks John Seo, managing principal of Fermat Capital Management.
“I’m hearing people using the phrase that 2018 is ‘the year of the great reload’,” he says. “Of course the traditional hard soft market cycle is over. It’s not that you can’t have an event so large that it doesn’t impact the market. We all understand that.”
“But I don’t think anybody doubts that if 2017 had occurred in the absence of the ILS market it would have been a completely different story in 2018,” he told Artemis. “You would have had a traditional hard market scenario.”
“And as I’ve been saying for over ten years now, when it comes to capital markets, high yields are actually a siren call to capital.”
For traditional reinsurers, this means that the old model of recouping losses in the hard market that followed a major catastrophe are over. “That is why 2018 is so important,” explained Seo. “That was the last thing the industry was holding on to.”
ILS investors have not been scared off by $144 billion of insured catastrophe losses in 2017 (with Hurricanes Harvey, Irma and Maria accounting for $92 billion, according to Swiss Re sigma).
“The industry thought investors would run for the hills, that they would sue everybody and everything on their way out as they burnt all their bridges, and that the market would harden tremendously and it would be back to ‘the good old days’,” he said. “And of course that did not happen.
“Significant losses were handed out to investors. And we did see some investment funds that were down 99%,” he added. “That fund was able to re-raise every dollar, and then some. Why? Because when they raised money for that fund they told investors that the risk exposure to Florida was 110% of the NAV of the fund. They made it very clear that you could lose everything.”
“So because investors know they could lose everything, it just means that they are going to allocate less than they would otherwise.”
Unlike the credit markets there is no stigma attached to losing all of your investment in the ILS markets, according to Seo. And in some instances, a total loss is preferable to investors.
“It’s inefficient actually take a partial loss,” Seo explained, likening the approach to that of investors in the structured finance and derivatives market of the early to mid-90s. “Because then you have a security that is actually partially impaired and the remaining value is locked up and illiquid and will trade at a severe discount.”
“It’s cleaner to set up a contract where actually, if I’m wrong and I know I might be, then I just lose everything.”
Seo says it is clear that disruption of the traditional reinsurance market has occurred. He draws an analogy with the AT&T breakup over 30 years ago. “AT&T had developed a high-low pricing model whereby cheap local calls were subsidised by expensive long distance packages.”
“Those excess profits from long distance calls (which is a good analogy for catastrophe reinsurance rates) were used to subsidise everything else,” explained Seo. “It wasn’t break-even. AT&T was the most profitable company in the world at the time. It was a monster.
“But eventually society itself and regulator said ‘enough is enough’ and they let MCI sell long-distance service at a cheaper rate. And that was enough for AT&T to accept they needed to restructure and change everything.”
This is what the reinsurance industry is going to have to do, if it hasn’t already started, concluded Seo. “Catastrophe reinsurance was that one shining jewel that paid a ridiculous amount of money, and paid even more ridiculously after an event. And in a sense, society, regulators and the rating agencies – the de facto regulators – have said enough is enough.”