Capital Flows into Insurance: Are We at a Tipping Point?
A sudden rush of small, related moves within an industry could signal something bigger: an imminent tipping point, perhaps with large impacts. Recent capital flows into the property and casualty (P&C) insurance industry appear to show signs of one such shift.
Much has been written on the first chapter in this story. Institutional investors have come to value certain forms of reinsurance risk as an attractive diversifying asset class. Their hunger for truly diversifying yield led them straight to the profitable golden goose of this industry: the arcane world of property catastrophe reinsurance. This new source of capital (‘alternative capital’) killed what used to be extraordinary returns for traditional property catastrophe reinsurers.1
More recent activity across the industry begs the question, how much of the alternative capital will flow from the corners of catastrophe reinsurance to the broader insurance world? To be clear, as intrinsic value investors, we hang our record on individual stock research and not on our ability to answer such broad overarching questions. However, as analysts of the industry, we would be remiss if we did not study changing competitive dynamics that could alter both intrinsic values and risk profiles of the firms in which we invest.
Here are a few developments that have piqued our interest:
- The Lloyd’s market of London is showing increasing interest in collateralized reinsurance, a form of alternative insurance capital. When compared to catastrophe bonds, collateralized reinsurance vehicles are able to access a broader range of insurance risks. Lloyd’s predicts exponential growth in these investment vehicles and is lobbying the UK government for tax reform to help support London as the dominant market for those vehicles.2 Further, in December 2015, Lloyd’s announced plans to launch indices3 that will track insurance performance across the entire portfolio of risks that pass through Lloyd’s. The Lloyd’s market of London is no small potatoes, with a significant volume of the global specialty risks shopped through this market. Formalizing structures that index and securitize Lloyd’s business could attract meaningful amounts of institutional capital into global insurance.
- Fund managers have continued to explore insurance as an asset class. Nephila, the largest institutional fund manager in the reinsurance space, has focused on catastrophe risk for almost two decades. In the span of the last three years, however, Nephila has expanded access to the broader insurance business in multiple ways including launching their own Lloyd’s underwriting syndicate, investing in Florida homeowners insurance companies, and establishing multi-year deals with outside underwriters. In one of their more recent deals, insurance writer TRU will use capital from Nephila to underwrite its growing commercial property insurance book.4 Nephila is by no means unique in this respect. Credit Suisse Asset Management and Securis have shown similar inclinations to deploy institutional assets into broader insurance risks.
- Recent growth in ‘fronting’ companies appears to be a curious offshoot of the appetite for insurance risk. Due to regulatory constraints, most insurance business cannot be written directly by alternative capital vehicles, creating the need for fronting companies that have the appropriate licenses and ratings. State National, the largest dedicated fronting company, enjoys an exclusive relationship with Nephila and wrote almost a billion dollars in premiums in 2014 for Nephila. ClearBlue and Spinnaker are among new fronting start-up companies with a star line-up of management and investors underscoring the staying power of these vehicles in the coming years.
- While the earliest breed of hedge fund reinsurers focused solely on reinsurance, the newer forms have more ambitious mandates. XL-Catlin’s new venture with Oaktree Capital will reinsure both property and casualty risks from XL-Catlin’s own book, which is along the lines of a similar venture from ACE and Blackrock. Enstar is set to begin fundraising for a hedge fund vehicle with UBS O’Connor that will be the first to offer risks from closed books of insurance business. These are a few in a long list of recent ventures suggesting growing investor appetite for packaged insurance risk.
- The attitude of traditional players towards alternative capital is changing. We were surprised by Markel Corporation’s recent purchase of CATco, a fund manager specializing in insurance linked securities. Markel is a firm we admire both for their long track record of creating shareholder value and their no-nonsense approach to business and investing. They see alternative capital as a permanent feature in the insurance landscape and have said they fully intend to expand their current offering in this space.5 Insurance brokers as gatekeepers to specialty risks have also begun to embrace alternative capital with open arms. Broker facilities (where a broker uses its data, analytics, and reach to put together a pre-packaged portfolio of business) have become more common.6 The increasing propensity to package broad swaths of insurance risk leaves the door wide open for alternative capital. It is worth noting that the recent merger of insurance broker Willis Group with professional services firm Towers Watson brings under one roof Willis’ deep access into global insurance markets and Towers’ advisory business with access to over $2 trillion in institutional capital.
With institutional investors coming to accept insurance risks as an asset class, industry players willing to partner with these investors, and intermediaries eager to supply innovations that hasten this marriage, we have the classic markers for a tipping point. We see a period of immense opportunity, with capital use becoming more efficient and distribution more streamlined—a period where management teams who understand the particular strengths of their firms could add significant value.
Perhaps because product differentiation appears minimal, insurance markets are sometimes mistakenly considered commodity markets. In reality, insurance firms can enjoy all of the three sources of genuine competitive advantage: cost leadership, access to customers, and economies of scale. Of the three, it appears to us that access to customers should become increasingly valuable in a world where capital is a commodity and access to insurance risk becomes dear. Firms with such privileged access should be able to parlay this advantage into value-enhancing alliances with capital providers. For investors, this suggests a more flexible approach to valuing these firms, as traditional balance sheet multiples can underestimate the potential for value addition from such capital-releasing alliances.
Such periods of rapid change are also periods of heightened sensitivities—where strategic steps and missteps can have outsized effects both positive and negative. As humans, we are inclined to think in ‘gradual and proportional’ terms. When faced with potential tipping points, however, it seems wise to account for a wider and more drastic range of possible outcomes. This tone of caution informs our investment approach. Fortunately for us, across the value chain, this industry offers unusual diversity. In our search for attractively-valued franchises that can capitalize on the shifting landscape, we have gravitated toward firms that have one or more of the following features7:
- We like management teams that seem to understand the particular strengths of their firm, show willingness to expand on these strengths as opportunities emerge, and do this without losing sight of underwriting discipline.
- We prefer businesses with excess capital on the balance sheets. Excess capital might subdue today’s returns, but becomes a genuine advantage in the aftermath of a large loss event.
- We are drawn to niche franchises with advantages localized in product or geography. These would be firms that are somewhat outside the global P&C cycle and hence shielded from direct impacts of the capital glut.
- Finally, we highly value the strategic advantage the global insurance brokers enjoy. As matching global risk with capital becomes a more complex endeavor, these intermediaries have a huge opportunity to monetize the centrality of their position in the value chain.
Conversely, we are short the stock of firms that seem to be highly valued by the market despite enjoying none of the above advantages.8
Insurance is centuries old. In that time, it has met more than its fair share of change and has survived and prospered into a vibrant industry of diverse business models. However, it is worth remembering that the journey has been bumpy and the highways littered with roadkill. As we survey the early signs of change, we remain selective as we balance outsized opportunities against rising risks.
2 UK government publishes ILS legislation, The Insurance Insider, November 9, 2015
3 Lloyd’s of London plans index launch, Financial Times, December 17, 2015
4 Nephila to provide capacity to TRU MGA, The Insurance Insider, September 16, 2015
5 Markel Corp. Q3 2015 earnings call
6 In the largest of such deals, this November, insurance broker Aon announced Aon Client Treaty, an all-class facility where 20% of its Lloyd’s business will be packaged and pre-placed with certain carriers.
7 As of December 31, 2015 we owned shares in insurers XL, L, AIG, BRK.B, PRA, ESGR, IPCC, ENH, Y, NAVG and PGR and in insurance brokers WSH (now WLTW), MMC and BRO across different strategies.
8 As of December 31, 2015, we held short positions in CINF, THG, SIGI, MCY and FAF.