The CEO of reinsurance giant Swiss Re, Christian Mumenthaler, has questioned the robustness of the ILS business model, asking whether the understanding of underwriting risk has become decoupled from those who provide the capital to back it.
During a conference call held with analysts last week, after the reinsurance firm announced its full-year 2017 results, Swiss Re’s CEO highlighted what he called a “little doubt” about the use of alternative capital in reinsurance.
When asked about the influence of alternative capital on reinsurance pricing, Mumenthaler said, “I have to say that these price levels, when we calculated, I’m afraid there is a little aspect of what we saw in the financial crisis. A decoupling of people who understand the risk and people who take the risk.”
It’s been a while since the subject of the financial crisis has been raised in relation to ILS and it’s surprising to hear that coming from Mumenthaler, especially given his reinsurer does utilise some capital markets capacity for its Sector Re sidecar and retrocession and earns fees for structuring catastrophe bonds and other instruments capital market investors buy into.
But, we’d say that the ILS business model is no different from the reinsurance business model here, that the capital is provided by third-parties.
Without its shareholders Swiss Re would not be the underwriting power-house that it is today and it’s extremely unlikely that the individual investors holding shares in the reinsurer have a full appreciation of the risks their capital is being asked to cover. Just like the pension funds backing ILS structures are less aware of the risks than the ILS managers who underwrite them.
Mumenthaler continued, saying that because the market has been through a relatively benign period, in terms of major losses, “some of the returns look good.”
The same could be said of reinsurers here, whose results have belied the fact that many reinsurance firms are underwriting at close to break-even, in the current pricing environment, and have been for a number of years.
Questioning the ILS business model again, Mumenthaler said, “I’m not sure that everybody in this capital market value-chain is completely aware of where prices are, because in contrast to us they don’t have diversified capital and they have to completely collateralize it.”
It’s an interesting statement, given the major reinsurers wield their ability to discount heavily for the sake of diversification in some regions of the world, where pricing has been at or below expected loss at times in recent years.
In fact, some of those areas where the major reinsurers exert their diversified nature so greatly have become regions where the ILS market has been pulling back, writing much less business (look at Japanese and European catastrophe programs for example) as they find the pricing unattractive due to competition from diversified global players.
Also important here, when discussing pricing for one reinsurance business model versus another, is the question of cost-of-capital, which has a key bearing on the ability of alternative capital to underwrite concentrated peak catastrophe risks at efficient rates.
Given the institutions (such as pension funds) backing alternative capital and ILS funds see the asset class as diversifying to their portfolios, they can often participate in markets for lower returns than an incumbent could sustainably manage.
In fact, cost-of-capital alongside the expense rate of the business managing and deploying that capital are key to the ability of ILS and alternative capital to participate in the market at rates which traditional players have often bemoaned. Cost-of-capital, cost of risk (loss costs etc) and expense costs go a long way to driving an underwriters ability to lower pricing sustainably.
After all, this is the “new normal” we’ve been discussing for years, that capital, business models and soon technology, are going to make the insurance risk to capital value-chain so much more efficient that traditional players will need to embrace change (and alternative capital) to keep up.
Whether the pricing is understood by end-investors is less important than whether those end-investors have strong relationships and trust in their ILS fund managers, who after all are professional underwriting and portfolio management houses, also adept at managing third-party money.
In the same way it’s not vital for reinsurer shareholders to understand the detail behind the risks, that the likes of Swiss Re has underwritten.
It is worth noting that the average end-ILS investor, particularly the pension funds that are the source of most of the alternative capital in reinsurance, are highly sophisticated and ask a lot of very searching questions of ILS fund managers before they allocate capital to them.
In fact, we’d venture that the ILS investor base is probably much more aware of the potential risks that their managers are underwriting, than the shareholders of a major reinsurer could be.
Mumenthaler said, on the subject of pricing and investors understanding of it, that he has, “A little doubt here, whether we’re in non-sustainable territory right now.”
Others may rightly ask whether rates are sustainable in diversifying peril markets that are dominated by traditional reinsurance firms. But we’d say that question also comes down to one of risk appetite and business models, with the global diversification of the portfolio making it possible for many reinsurers to soak up cat risk from these peril regions.
Mumenthaler said that alternative capital has not been the only driver of rates, saying there has been, “From the reinsurance side and also on the primary side, a push for higher rates, which doesn’t uniquely come from this capital that is just there for the cat at the end.”
“You can clearly see that, for example, the big CorSo type players in the U.S. they all push for higher prices, and that’s independent of alternative capacity, because they know their piece of the value-chain needs higher rates,” he continued.
The question here is whether they really need higher rates, or whether their value-chain is already too expensive, some might say.
Mumenthaler doesn’t think that alternative capital will dampen rates more broadly in reinsurance, saying that, “I don’t think, no matter how long this goes, that completely unsustainable rates for the whole value-chain will be borne.”
But acknowledging the role of alternative capital, he added that, “I think prices have to go up. But it’s clear that on a medium to long-term, there is a dampening effect on this sub-line of business coming from this alternative capacity.”
The sustainability of rates and reinsurance pricing is entirely in the eye of the beholder. For a major reinsurer like Swiss Re, it may see Florida property catastrophe reinsurance and retrocession rates as too low, while an ILS fund manager may find them acceptable.
On the flip side, underwriting many layers of European windstorm risk, or Japanese earthquake risk, is less attractive for an ILS fund, where as Swiss Re can likely soak that up all day long.
As the insurance and reinsurance value-chain continues to be reimagined the drivers of pricing are likely to come under increasing scrutiny, along with the cost of various business models and their viability or sustainability, in certain areas of risk, over the long-term.
At some point, decisions will have to be made about what risk to write and what no longer meets cost-of-capital, as well as how far diversification can enable you to participate in areas where risk linked returns are no longer commensurate with a sustainable ru-rate for your business.
That goes for ILS funds or alternative capital vehicles, just as much as for reinsurers.