Panic in Bermuda: When Your Business Turns into an “Interesting New Asset Class”

All else equal, we prefer to invest in strong franchises in stable industries. However, even within industries undergoing turmoil, understanding the differing prospects of individual firms can present us with attractive investment opportunities, both long and short.

The traditional reinsurance industry is currently facing declining premiums and profits as a result of new entrants and overcapacity. Several years of attractive pricing and limited losses from natural catastrophes have resulted in a growing capital base for reinsurance companies.  In addition, these “fat years” have attracted capital from institutional investors such as pension funds into investment vehicles that compete directly with traditional forms of reinsurance. The result has been predictable – falling prices, margins, and returns. The impact has been especially pronounced in the highly profitable property catastrophe reinsurance segment of the market. History tells us that cyclical overcapacity is self-healing; the healing process, however, can take a very long time. We think this is especially true of reinsurance markets today as the new forms of capital are cheap and patient, while some of the traditional players seem unwilling and/or unable to shrink.

Reinsurance contract renewals in mid-year 2013 marked something of a “tipping point” with a flood of alternative capital entering the fray. Conditions have worsened since that time with the deterioration in pricing apparent in second quarter 2014 results.  Rates declined again at the June renewals. Some management teams noted weakening in terms and conditions, and several companies began to shift their mix away from property catastrophe business. An insurance executive recently observed that reinsurance has become “an interesting new asset class”[1], implying that this is more than just a cyclical downturn.

Some argue that these new forms of institutional capital are fickle, driven by investor reach for yield in a low interest rate environment. They argue that this capital will retreat at the first instance of a large catastrophic event that serves to highlight the financial, legal, and operational risks in these investments or when rising interest rates reduce the relative attractiveness of this asset class.

We disagree.  Alternative capital flowing into reinsurance appears to be simply a sub-theme in the secular trend of global investors increasing their allocation to alternative asset classes. In a recent study, McKinsey & Co. noted[2] that allocations to alternative asset classes have continued to increase despite returns from these classes broadly lagging relevant benchmarks since the financial crisis. Perhaps this is best explained as a gradual change in investor expectations with alternatives no longer viewed as a mechanism to boost portfolio returns, but as tools in designing specific portfolio outcomes. Insurance-linked securities (ILS), with their lack of correlation to financial markets, fit well into this view. Catastrophic events can have severe financial implications for property owners and their insurers, but such events are unconnected to the prevailing mood in financial markets. This disconnect means that these securities, which are linked to natural events and fully backed by risk-free collateral, offer truly uncorrelated returns with low credit and counterparty risk. That should be attractive to any institutional portfolio manager who remembers living through the credit crunch that followed the Lehman collapse.

It is true that alternative forms of reinsurance are yet to be tested by a large catastrophic event. Mother Nature has been relatively kind to us in recent years. In fact, we have had no major peak zone Florida hurricanes in years, leaving this model untested. However, the quality of investors backing some of these funds leads us to believe that in the aftermath of a large event, there is likely to be more rather than less capital flowing into this market. The recent strategic investment of KKR in Nephila Capital, the leading ILS fund manager, was just one example of a sophisticated long-term manager with access to global capital supporting an ILS venture. Finally, at only 20% of total reinsurance capital[3], alternatives could have a long runway of growth that will likely overwhelm any growth in reinsurance demand that comes from the “price effect” of falling prices.

The challenge, for the traditional property catastrophe reinsurers, is best phrased as a cost of capital mismatch: the cost of the newer institutional capital is lower than the cost of capital from traditional firms. Faced with this mismatch, the traditional reinsurers have begun reducing their return hurdles for writing new business. As this continues, with investment returns already challenged by the low yield environment, it is hard to see how most of the publically traded property catastrophe reinsurers will continue to meet their cost of capital in the coming years.

Even as return expectations come down, we fear that risks might be rising. The trend of falling renewal prices has received significant press. Two other trends, which have received less attention, should be equally worrying to investors. The first is the broadening of the terms and conditions within reinsurance contracts, meaning that reinsurers are willing to take on more risk per unit of premium. The second is the increasing use of a second layer of reinsurance (retrocessions) whereby reinsurers lay off part of their risk to other reinsurers. If there is a mega catastrophic event, this daisy chaining of retrocessions increases the likelihood that the entire system is impacted by one weak-link reinsurer which is unable to pay. For outside investors like us, these two trends in combination make it harder to ascertain the actual level of risk a reinsurer is taking and to evaluate if the published reserves are adequate.

Given this uncertainty, we pay heed to Prem Watsa’s observation[4] that the reinsurance business is particularly leveraged to a “few good men and women at the top.” Accordingly, we pay close attention to what the leaders of these firms say and do. Most CEOs in Bermuda have come around to acknowledging that several lean years lie ahead of us in the catastrophe reinsurance business. However, their responses differ depending on their firms’ unique mix of businesses and on their individual motivations. Two contrasting examples are worth highlighting.

Firms with the bulk of their business in property catastrophe reinsurance (particularly excess of loss reinsurance) face the toughest challenge and the most difficult decisions. RenaissanceRe Holdings Ltd. (RNR), a Bermuda-based reinsurer that is the leader in the property catastrophe space, is one such firm. Management has been responding defensively: reducing gross premiums by letting go of unprofitable business, purchasing retrocession at attractive prices to improve their net risk profile, generating fee income as a manager of alternative capital, growing into other niche lines such as specialty reinsurance, and repurchasing shares as RNR’s business shrinks. However, given the significant change in its operating environment, RNR will likely be challenged in its ability to maintain margins and returns on equity. As volumes and prices depress revenues, we believe a portion of RNR’s operating expense will stay stable pressuring the margin. RNR has historically had limited success in insurance lines outside property catastrophe, and growth in these lines will come at substantially lower margins and somewhat lower returns on equity than the company has traditionally enjoyed in its core business. Given these prospects, RNR’s market price at over 1.2 times tangible book value seems excessively optimistic to us.

In contrast, Endurance Specialty Holdings Ltd. (ENH), another Bermuda-based reinsurer, has a much more diversified book of business across multiple lines within Insurance and Reinsurance.  For such a firm, when faced with limited barriers to new entry in the property catastrophe line, the best approach is to revamp its business mix toward lines where it enjoys some competitive advantage and then push aggressively to become the most efficient and lowest cost player in those lines. This is exactly the path that John Charman has been pursuing since becoming CEO – aggressively de-emphasizing the property catastrophe reinsurance business, while growing specialty insurance operations. In the process, he has attracted enormous underwriting talent to Endurance and eliminated numerous redundant positions. This speed of change is not without its risks. However, Mr. Charman’s remarkable track record as an underwriter and manager, and his significant personal investment in the company, gives us comfort in his ability and intentions to effect this transformation. Endurance’s recent attempt to acquire Aspen Insurance Holdings Ltd. would have given it much needed scale and helped accelerate this transformation. Hence, we were disappointed when this proved unsuccessful. However, the price discipline shown by Endurance throughout this process illustrated that management is focused not on size but on growth in intrinsic value per share. This growth in value is unlikely to play out in a linear fashion. Despite its recent increase, the ENH share price appears to convey a pessimistic view of its prospects.

With too much capital chasing too few opportunities, the reinsurance industry is facing an existential threat that seems more permanent than cyclical. There are many unknowable factors at play, not the least of which is the potential impact from a huge natural disaster. Trying to predict the industry’s exact path in the coming years seems futile. Instead, we focus on a more useful question - “Who is likely to survive and thrive under a broad range of outcomes for the industry?” In our opinion, the firms with the best prospects will have expertise in diverse lines and geographies and still be nimble enough to aggressively alter the mix of their portfolio. These companies would attract the strongest underwriting talent, strive for operating cost advantages, and above all, refuse to compromise on underwriting quality. Firms who are unable or hesitant to make these changes seem destined to struggle.

The views expressed are those of the research analyst as of September 2014, are subject to change, and may differ from the views of other research analysts, portfolio managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice. DIAMOND HILL® is a registered trademark of Diamond Hill Investment Group, Inc.

© 2014 Diamond Hill Capital Management, Inc. All Rights Reserved.

[1] Stephen Hearn, Deputy CEO Willis Group Holding PLC on Willis’ 2Q14 investor call

[2] The Trillion-Dollar Convergence: Capturing the Next Wave of Growth in Alternative Investments, McKinsey & Co. Aug 2014

[3] The Aon Benfield Aggregate Study estimated alternative capital at $59bn (~20% of total) as of June 30, 2014

[4] CEO of Fairfax Financial Holdings Limited in his 2013 Annual Letter to Shareholders, 

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