Excess of Loss in Reinsurance Industry May Become an Excessive Loss

Following a string of global catastrophes in 2011, many insurance executives predicted a looming hard market. At the time I was an individual investor that tracked dozens of insurance companies. I crunched the numbers, called my contacts, and came to the conclusion that purchasing reinsurers at less than 0.75X TBV was a good risk adjusted investment. About a year and a half later I had sold all my reinsurers, believing that they had achieved fair value.

Something seemed odd though. Property catastrophe reinsurance prices had not rallied that much. Granted rates improved slightly, but the increase was nowhere close to the $60 billion impact predicted by some executives. As my research continued, I began to notice all the alternative capital flooding the space, a topic little discussed by reinsurance executives at the time. Slowly the puzzle came together and I realized this capital was not fleeting.

Asset managers of all kinds were looking for an investment that was uncorrelated to the rest of the market. This had interesting ramifications. First, it meant that many primary insurers whose largest cost component was reinsurance would see earnings expand as costs dropped. Dichotomy Capital invested in, and still has investments in groups like UIHC who will see earnings increase as reinsurance drops.

On the flip side, reinsurers are being challenged, except this time it’s been partially caused by a lack of catastrophes. The typical model of reinsurance is to acquire premiums from other insurers and pay out claims when a disaster occurs. In the meantime that capital from insurers can be invested and will generate income. This is insurance 101, and has helped make Warren Buffett’s track record look much better (float acts as leverage). What if, instead of investing that capital in stocks and bonds it was held in separate accounts as cash or short term treasuries? Clearly, investment returns would drop.

Holding capital in separate accounts is not a hypothetical consideration; this is the fastest growing segment of reinsurance. This segment, collateralized reinsurance products, currently account for $50 billion of capital in the reinsurance space, and by some estimates, will reach $150 billion by 2020. As of April 2014,worldwide reinsurance capacity is USD540 billion, and I estimate that it will be around $660 billion (3% CAGR) by 2020. Therefore, more than 22% of all capital will be tied up in collateralized vehicles, limiting returns from investments. Similar to other softening markets, reinsurers will expand their product offering and chase other risks.

The impact from this is basic economics: more capital chasing less demand will result in lower rates. This is whyproperty reinsurance rates have dropped 5-20% in each of the past two years. As a reinsurer, you have one of two choices, hold your rates firm and lose business, or keep business by dropping rates and adjusting terms. While Warren Buffett has walked away from US catastrophe reinsurance, most reinsurers are following the pack and dropping rates. There is also a push to chase premium that is long-tail in nature and far out of the comfort zone for many insurers.

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