Ever since the news emerged back in March that global insurance and reinsurance broking power-house Aon had teamed up with Warren Buffett’s reinsurance giant Berkshire Hathaway to provide a sidecar type facility at Lloyd’s of London, the media has been awash with opinions on whether it is a positive or negative step for the market.
Some of the most forthright statements from Lloyd’s itself have been published today, as the Financial Times carries a piece on statements made by finance director at Lloyd’s Luke Savage, who clearly seems concerned about the Aon-Berkshire sidecar facility and believes it could undermine the Lloyd’s markets expertise and lead to reduced underwriting standards.
We’re not here to approve or disapprove of business models within the re/insurance market but we are here to raise ideas, in our own perhaps naive way, and make suggestions which are not being made elsewhere (you’ll notice that the media tends to avoid providing an opinion). The Aon-Berkshire sidecar facility encourages so many strong reactions in the market that we’re starting to believe that the wrong questions are being asked about it.
Interestingly the FT refers to the facility as “Warren Buffett’s investment vehicle”, which is true and puts it on a par with so many other Lloyd’s investment vehicles which help capital to access the return of the market by deploying it into the business Syndicates underwrite.
In this respect the Aon-Berkshire sidecar is not that unusual. The more unusual feature of the Aon-Berkshire sidecar, which is beginning to attract, perhaps unwanted, attention, is the fact that it does not manage the risks it allocates capacity to, rather being a passive allocator of capital to risks Aon brings to Lloyd’s.
The other factor that worries the market is the potential size of the facility. With 7.5% of all premiums Aon places at Lloyd’s being placed with Berkshire through the facility. The fact that Aon is responsible for as much as a quarter of business underwritten at Lloyd’s is perhaps the real worry here, as there is the potential for the facility to grow or for other sources of capital to want to access the market in this way.
Luke Savage is quoted by the FT as saying that the facility exploits the Lloyd’s market, risks undermining the underwriting expertise that the market prides itself on and is against the long-term interests of policyholders. He said that Berkshire Hathaway is going to be getting the return of Lloyd’s without making the investment in underwriting expertise that market participants make every day.
Savage called the facility “A tracker fund on Lloyd’s”, again an interesting statement as it is true that the facility will be large enough to broadly track the return of the market, by participating in 7.5% of the business Aon places in the market. That’s actually a very good strategy for achieving a reasonably diversified return from the re/insurance market, the strategy makes a lot of sense from Buffett and Berkshire’s point of view.
Other similar deals do exist (Willis is working on its 360 facility which could be even bigger, we understand) and so do other investment vehicles which allocate capital to Syndicates rather than to specific re/insurance contracts, so passing on the responsibility for underwriting expertise to the Syndicate underwriters. So the strategy, of broadly deploying capital into the Lloyd’s market in order to achieve a return from a diversified book of re/insurance business is not that unusual at all.
For Aon the facility makes a lot of sense, meaning it can guarantee clients 7.5% of the capacity without even thinking or working to place it. On the subject of underwriting expertise and diligence; interestingly the facility puts some of the responsibility onto Aon to ensure that Berkshire is writing a diversified book of business in the market. If Aon placed nothing but Florida wind with Berkshire’s 7.5% participation pot of cash, we’re certain Warren Buffett would not keep the facility running for long.
In fact, on the subject of underwriting diligence and whether a facility such as the Aon-Berkshire sidecar will lead to reduced standards in underwriting, there is actually no reason to believe it will.
The facility is only taking a small piece of each placement at Lloyd’s and for the business to be successfully placed the other 92.5% must be underwritten in the market by Syndicates and companies who will be using all of the usual underwriting tools at their disposal (if they so choose). The Berkshire facility then effectively follows-on to provide the last 7.5%. So a level of diligence must be applied, by Aon first in electing to take the business to the market and then by the Lloyd’s market itself, before Berkshire’s capacity comes into play.
The real issue here, however, is perhaps not one of underwriting standards. Rather it is of a market which sees large sums of capital ready to come forward and to take on re/insurance business with more of an investor-trader mentality than a traditional underwriter mentality. Berkshire Hathaway can well afford the 7.5% of Aon’s subscription business, knows that the overall book will be well-diversified (at least as diversified as the Lloyd’s market is), appreciates the return it can make it and therefore is willing to take the risk of losses.
That mentality, more of a risk investor-trader than a risk underwriter, is one which is prevalent in the insurance-linked securities marketplace and it scares the traditional re/insurance market. ILS managers have been accused of deploying capital with no thought for risk for lower returns lately, when the fact is that ILS managers (who tend to be as sophisticated as any traditional underwriter) can be willing to take on the risk for a lower return. The lower cost-of-capital is one reason, but there is also this element of trading risks rather than underwriting them which is changing the way business is done, risk is perceived and appetites are changing with this in some areas of the re/insurance market.
The Aon-Berkshire Hathaway sidecar facility at Lloyd’s is a prime example of an evolution in the re/insurance space which has now reached such a high-profile size that it is suddenly receiving a lot of attention. It’s yet another change in the dynamic of the reinsurance market, coming at a time when other changes have been pushing traditional players onto the defensive, so it’s no surprise it is receiving negative press.
Is this just another step in the evolution of the re/insurance market? Are we simply seeing capital being allocated to one market, on a fixed percentage basis, by one of the world’s largest underwriters (or asset managers) who is perfectly happy with the thought of its capacity being allocated in small chunks to each slip?
Consider this as a scenario. What if the Japanese pension fund community clubbed together and allocated 0.01% of its capital to the Lloyd’s of London re/insurance market and asked a lead broker to manage it on a subscription basis. That would be such a small percentage of Japanese pension assets but a huge amount of capacity coming into the marketplace. Wouldn’t that be good for those seeking re/insurance cover? Couldn’t it bring down costs for cedents? Is that such a bad scenario? Would it receive the same negative press?
The way the re/insurance world is moving it feels like we are going to see a lot more activities launching which will take a passive, trader’esque view of underwriting, allocating capital while relying on the natural diversification of a market or the assistance of a firm like Aon to help it manage underwriting risk.
Would the naysayers be placated if Berkshire Hathaway took a more active role on the facility itself, effectively approving each allocation of capital? It feels likely that it would not and that there would still be complaints over the access to business Berkshire would then have in the Lloyd’s market.
With all of these facilities, ILS managers, hedge fund backed reinsurers, special purpose insurers, where questions of underwriting standards have been raised, it is perhaps more accurate to ask whether we are just seeing a glimpse of the future of underwriting.
This may simply be the future, particularly for certain types of business. A source of capacity (Berkshire), someone to control its deployment (Aon and the Lloyd’s markets acceptance of business), a cost-of-capital, an appetite for risk and an ever-increasing appetite for the return of the re/insurance market. That may be all that is required in some areas of the reinsurance market in the future. The investor-trader mentality, and the willingness to continue deploying capital as long as the business is diversified, has always been prevalent in the re/insurance space but it has never been as overtly evident as it is today.
So, should the market be focusing on how facilities such as the Aon-Berkshire Hathaway sidecar arrangement can help Lloyd’s expand, bring new opportunities to the market and increase the capacity available, perhaps even reducing the costs of re/insurance? Should existing players be working out how they can work with the facility, by using it as a follow-on source of capacity? Should Berkshire Hathaway and Aon be considering how they could share some of the wealth back to the Syndicates who continue to exercise diligent underwriting standards? These are the kinds of questions we feel it is time to explore.
The re/insurance market is evolving and this sidecar facility at Lloyd’s is just another example of how capital, and capital sources, are driving that evolution. It’s time for the market to raise its head, open its eyes, glimpse this future that is emerging and start to work with it to see how this expanding interest from capital in the returns of the re/insurance market can be made to work for everyone’s benefit.
This piece aims to stimulate our readers and the market to think differently about a topic which is perhaps becoming clouded by emotion right now. As ever we’d love to hear your thoughts on the Aon-Berkshire facility in the comments below!