Quantifying the fear factor to end the soft market

As the soft market persists and the pain of low rates combined with historically low investment returns continues to hurt reinsurers, the big question for some time has been: what will it take to turn the market?

The problem with this question is that, unlike in previous elongated soft markets, mechanisms now exist that allow money from the capital markets to enter the industry extremely quickly. Because so much money has already poured in during recent years, it is abundantly clear there is a lot more waiting in the wings should rates show even the smallest hint of increasing.

On this basis, many believe a big catastrophe loss would not be enough move the market. Instead, only a combination of factors or something much more sinister and fundamental would be needed to effectively scare third party capital from making that investment.

Stephen Catlin, the founder of Catlin and now executive deputy chairman of XL Group, believes not only that the market will turn but also that there will be an overreaction when it does, although it will take a number of factors converging to make this happen. The longer the soft market lasts, the more pronounced it will be, he believes.

“Capital is fickle; investors can be like sheep. Re/insurance has been the flavour of the month for some time now but that will not last forever,” Catlin says. “Margins are thin and rates unsustainable. A big loss could change things or it could come down to cash flow. If cash flow turns negative, that could change things fast.

“If you have negative cash flow, reducing yields and changing investor sentiment all together we could see the market move quite suddenly.”

He compares the market to what happened in 2000/2001 when a combination of factors including inadequate reserving on casualty business meant the market was already hardening before the terrorist attacks of September 11, 2001.

“Then 9/11 happened and that was a loss the industry had not expected or considered before. There were so many classes of business correlated and people reacted,” he says. “I believe the longer this soft market lasts, the more likely it is that we will see that sort of scenario again.”

An unexpected big loss combined with the more general pressures on the industry could certainly cause a reaction, he believes. A very big cyber loss might do it, Catlin says. But he is also clear that the industry cannot continue with rates at these levels for much longer.

“We know things are not sustainable. Reserves in the industry are as thin as they have been for a long time. There is just no room for manoeuvre. People were hoping that interest rates would increase but that still looks a long way off.

“That makes the industry very attractive to investors and they have more patience as a result, but this situation cannot go on indefinitely,” he says.

THINK ONCE, THINK TWICE

Jed Rhoads, president and chief underwriting officer of Markel’s Global Reinsurance Division, agrees that it will take something significant to change the market—and he believes an insolvency would make people think twice about investing in the industry.

“Some reinsurers are perceived as too big to fail, but we’ve heard that before in the banking industry,” he says. He questions whether there is a series of events in this low interest rate environment, including concerns about foreign exchange, which could lead to change.

“This market feels similar to the early 1980s and late 1990s when we could not foresee what would actually change the market cycle before it did, and where the lack of reinsurance losses ultimately led a lack of underwriting discipline,” Rhoads says.

Charles Goldie, head of specialty lines at PartnerRe Global, agrees a big loss in itself is unlikely to be enough to turn the market because there is so much capital willing to move in. He too believes a fear factor would be enough to change the industry if the losses stemming from a big event were very different from those predicted by the risk modelling agencies.

“If a category 5 hurricane hits Miami, the risk modelling agencies predict a $100 million loss; if it comes in at $97 million, the market will not react,” he says.

“If a category 2 hurricane hits Miami with an anticipated loss of $30 million, which turns out to be close to $100 million, that is very different. The market will turn based on fear—not the size of the loss.”

NASTY SCHOCK OR PLEASANT SURPRICE?

Brian Duperreault, chief executive of Hamilton, agrees that the market will eventually change but for reasons that are, as yet, unclear.

“I have seen many big changes in this market and they have always been a surprise,” he says. “How can you predict a shock? I don’t know that this is the so-called new normal. Every time it has turned it has been for different reasons,” Duperreault adds.

“Often, as was the case with 9/11, there is an unexpected loss that also causes that fear factor. More capital withdrew than was destroyed after that loss. If something occurs that shakes the industry’s confidence, the market will harden but you cannot predict what that will be.”

Kaj Ahlmann, the managing director and global head of insurance strategy chairman of the global advisory council, insurance, at Deutsche Asset Management, also agrees that the market will turn, despite the capital waiting in the wings.

Ahlmann, previously of Employers Re, part of GE, says that little has really changed in the sense that capital will flow into the industry post-loss. As such, he believes a big loss will cause the market to harden and disagrees with those that believe current market conditions should simply be considered a “new normal” for the industry.

“This is just the calm before the storm,” he says. “There will be some dramatic event sooner or later—it will happen. The ups and downs will continue. A big loss will happen and it will shift the market, especially given the size of the exposures that exist now.”

Exposures in some regions have increased quickly in recent years, meaning that a loss could be bigger than the industry has endured before.

“The flood risk and the storm risk in the US is now enormous,” he says. “The coastal exposure has been expanding like crazy and the way the industry is assessing these exposures is not as sophisticated as it should be.”

He agrees that there is a vast amount of capital ready to enter the re/insurance markets, especially in the aftermath of a big loss. This would dampen any spike in rates but he argues that this dynamic has always been true.

“There has always been a tonne of capital out there, it is just a question of how it enters the industry, which route it takes. Is there more now? Probably, but the same has always been true in the aftermath of a big event. That doesn’t mean rates won’t harden and the cyclical nature of the industry will not return,” Ahlmann concludes.