Ed Noonan, CEO of Bermuda domiciled insurance, reinsurance and third-party reinsurance capital management group Validus Holdings, believes that there is some evidence of discipline waning among ILS managers operating in Florida.
In the Validus Holdings earnings conference call, held on Friday, Noonan said that his previous comment that ILS managers were behaving rationally in deploying capital at increasingly lower property catastrophe reinsurance pricing perhaps no longer holds true, particularly in Florida.
Noonan has a concern that some ILS managers are deploying capital, perhaps to meet mandates and a need to invest, at lower pricing than is perhaps sensible. Noonan highlighted the Florida property catastrophe reinsurance market as ground zero for ILS money, so the market where any aggressive appetite to deploy capital becomes most evident.
Noonan explained the recent change in Validus’ viewpoint; “In the past, we’ve said that we believe ILS managers were acting rationally and that their pricing reflected a lower cost of capital. We no longer hold that as a universal view. We see some managers with genuine expertise behaving in a rational manner consistent with their cost of capital. However, we see other managers, that have raised very large pools of money, going beyond rational economic behaviour in attempting to put money to work.”
The discussion around pricing discipline, both in the traditional reinsurance market and the ILS space, is one which will run and run. Capital providers have different risk appetites, return targets, mandates over how much capital they must deploy and perhaps most importantly different costs-of-capital.
This makes it extremely difficult to say who might be losing discipline, in terms of accepting pricing that is not commensurate with the risks, or offering terms which are to relaxed and leave it open to larger losses. Pricing that is too low for one reinsurer or ILS manager may be deemed still acceptable by an investor with a high risk appetite and a very low cost-of-capital.
When asked whether he felt we were approaching a floor in catastrophe reinsurance pricing, Noonan replied; “I’m starting to think we might be headed for the basement.”
Noonan explained; “I think the truly disruptive factor in the market right now is ILS money. I made the comment that we’ve always viewed the ILS managers as behaving rationally, I can’t honestly say that with what we’re seeing in Florida right now. I mean we have large ILS managers who are simply saying, “Whatever they quote we’ll put out multi-hundred million dollar lines at 10% less.” I think it’s not a good model. I think alternative capital is extremely valuable for the industry and I worry that now we’re getting into an over-heated phase where if your compensation is based on simply deploying capital to limit, your incentives are different.”
Noonan and Validus have clearly been watching the market closely and talking with their AlphaCat investors to understand where the appetite for risk and return lies among capital market investors. Right now they feel that the returns are becoming less attractive for their investors but that others continue to deploy new capital.
Noonan continued; “That’s frankly how markets get in trouble and get overheated. I don’t think that investors can fully appreciate that the expected loss costs that are driving valuations in the ILS space don’t line up with the expected loss costs that professional reinsurers come up with on the same account.”
Noonan singled out the cat bond market as an area where pricing is no longer commensurate with holding the risk, in his and Validus’ view; “And so, they’re starting out with a disadvantage on pricing and then coming in. What is the yield on cat bonds in the aggregate, five and a quarter percent now? I don’t think that’s actually appropriate compensation for the risk.”
More broadly, Noonan feels that outside of Florida pricing has maintained more discipline; “Regarding the market in general, I’m not as worried, I think, long-term buyers outside of Florida value the large traditional reinsurers very heavily. I think Florida companies value the traditional reinsurers very heavily. But as I said, Florida is ground zero for ILS money and it’s behaving in a way that I think is frankly ultimately bad for the ILS market.”
Noonan clarified that it is not the entire ILS market that he feels has lost its discipline, just certain players in the space; “I don’t, by the way, mean to kind of besmirch the ILS market in general or all ILS managers. As I said there are some with genuine expertise that are deploying new capital in a rational way, but frankly there are some large ones that aren’t.”
“I think at some point investors, they do have to revisit their decisions. They have watched the yield, their expected yield, decrease fairly dramatically. It was north of 9% in 2012 and now it’s barely north of 5% today,” Noonan continued.
Noonan said that the correlation argument, meaning that investors are willing to accept lower returns in order to gain the low-correlation benefits of an investment in ILS, does still hold, but at some point the return just becomes too low.
At some point, Noonan said, people will look at this space and see that they’re investing in BBB or BBB- securities at a low yield when they could be getting a higher yield in other asset classes.
Noonan noted that Validus is also taking advantage of the pricing environment, improving its retrocessional protection and increasing its aggregate cover particularly for U.S. hurricanes. Validus’ Talbot unit has, for example, purchased a multi-pillared fully-collateralized reinsurance cover from the alternative market for its direct property and onshore and construction books.
Noonan also highlighted the relaxation of terms on traditional reinsurance contracts and the inclusion of elements such as terrorism cover within renewals becoming more prevalent since January. He said that this concerns him, as reinsurers could be risking running out of catastrophe capacity should a string of terror events on aggregate erode layers.
Validus continues to push-back against practices which clearly forget the lessons that the reinsurance market has learned at great cost in the past, Noonan said.
It’s widely expected that property catastrophe reinsurance renewal rates in June, particularly for Florida, will continue to decline. The question of how much further rates can go is a difficult one to forecast. For catastrophe bonds and ILS, the evidence of some kind of floor on pricing is beginning to show. The recent pricing on the record $1.5 billion Everglades Re 2014 catastrophe bond showed a level of discipline as it priced towards the upper end, the first cat bond to do so this year.
Of course any floor will be set by the risk appetite and return requirements of the particular capital being deployed, so a floor for one ILS manager may not be as low as a floor on pricing for another.
If a floor on pricing is not found in June we should expect to see much more discussion of discipline in ILS and more questions on the rationality of capital over the coming months. The discussion should really be broader though, to encompass the expansion of terms such as the hours clause and inclusion of more non-modelled perils.
One thing is certain, if rates continue to drop and you combine pricing that is perhaps becoming too low with a much broader assumption of risk, you can begin to see that some ILS managers and traditional reinsurers will eventually be risking putting themselves and their investors at ever greater levels of exposure to the occurrence of a major catastrophe event, or series of smaller events.