Fairfax in the new world of alternative (re)insurance capital?

[WhoIsWarren]

Forgive me if this subject has already been addressed elsewhere, but I'm looking to get a sense for how Fairfax's various (re)insurance businesses are being (or will be) affected by the rise of "alternative capital".  It's the topic "du jour" in the sector generally, but I never see reference to how Fairfax will fare.

 

Prem was asked about this in a general sense at last year's AGM -- his answer was, shrug of the shoulders, capital comes and goes in the insurance industry; it's perhaps in a different form this time around, but (naive) capital will get hit and exit, paving the way for the next up-cycle.

 

This contrasts with the views of other industry insiders -- take Richard Brindle from Lancashire (because he's well-respected and followed on this board), who thinks that the alternative capital, yes could be a bit frothy in places, but it's here to stay and the traditional (re)insurers will just have to embrace and adapt to it.

 

Perhaps Prem is right and there's nothing to worry about.  But, if he's wrong, where are the pressures most likely to be felt?  Presumably it's in the reinsurance book, which accounts for c.40% of net premiums (with Odyssey Re alone making up nearly 50% of total over the last 10 years, according to Prem's 2012 letter).  But could there be knock-on implications for the direct businesses??

 

I know there are lot's of insurance buffs out there.  And Fairfax buffs.  I'd love to hear your thoughts.

 

Thanks

[obtuse_investor]

Forgive my ignorance, but can you define "alternative capital" for me (and others like me)?

 

 

[oldye]

Reinsurance side cars backed by hedge funds looking for a new place to bet.  A few years back the late Jack Byrne's White Mountain used these vehicles with horrible results for shareholders.  Another trend I've noticed are the new hedge fund run insurance co's like Green Light, Third Point Reinsurance, Sac Re etc.  lots of capital and general dearth of insurable events is why I don't currently have any investments in this sector.

 

http://www.propertycasualty360.com/2006/07/17/byrne-says-white-mountains-shareholders-protected-by-sidecar-deal

 

 

[Guest longinvestor]

Reinsurance side cars backed by hedge funds looking for a new place to bet.  A few years back the late Jack Byrne's White Mountain used these vehicles with horrible results for shareholders.  Another trend I've noticed are the new hedge fund run insurance co's like Green Light, Third Point Reinsurance, Sac Re etc.  lots of capital and general dearth of insurable events is why I don't currently have any investments in this sector.

 

http://www.propertycasualty360.com/2006/07/17/byrne-says-white-mountains-shareholders-protected-by-sidecar-deal

 

This is part of the "Hedge funds going long only" trend. Watch out, rest of the world, the 2-and-20 crowd coming to an insurance biz near you!

[Tommm50]

The hedge fund money is going into one of the most lucrative parts of the reinsurance business, property cat protection (earthquakes, floods, hurricanes, etc.). They don't have the overhead traditional reinsurers have and they can write this business at a significantly lower rate.

 

This puts tremendous pressure on any reinsurer who's major business is property cat. It puts some pressure on more diversified reinsurers (including Odyssey Re) as they have to make more money on the other parts of their portfolio, notably U.S. Casualty business and standard property business.

[Uccmal]

Francis Chou held a couple of these in the mid 2000s, pre and post hurricane seasons.  Flagstone re, and Blue Ocean re come to mind.  They were private placements.  One of them had to be completely recapped after the dual hurricane seasons. 

 

This is an inevitable part of the cycle.  A couple of good disasters will wipe them out.

[Uccmal]

Follow on to that:

 

flagstone was taken out a couple of years ago... for its book of business by the looks of it.

 

I cant find any info on Blue Ocean re. 

 

Good luck to the hedgies in businesses where they have no concept of the risk.

[Tommm50]

There are a lot of sophisticated models out there on catastrophe risk. Their fatal flaw is they're based on past experience. Global climate change is a reality. Wouldn't it be just desserts if they stepped into the punch over the next few years?

[giofranchi]

Well, I know and follow just two of them: GLRE and TPRE.

 

This is an inevitable part of the cycle.  A couple of good disasters will wipe them out.

 

GLRE practically writes no cat reinsurance… its business is mostly concentrated in high frequency transactions. Severity transactions are selectively chosen and amount to only a very small percentage of its book of business.

 

Good luck to the hedgies in businesses where they have no concept of the risk.

 

TPRE reinsurance operations are led by Mr. Berger, who has a long and very successful track-record as insurance / reinsurance underwriter.

 

I don’t know the rest of the lot… and I tend not to speak about things I don’t know… ;)

 

Gio

 

[WhoIsWarren]

Forgive my ignorance, but can you define "alternative capital" for me (and others like me)?

 

My bad, I should have given background to my question.  Let me state that I am not an insurance expert, below is my 'pidgin' understanding of the state of play.

 

"Alternative capital" is simply insurance capital provided through non-traditional vehicles, typically by non-traditional backers.  The catch-all term for these alternative sources is Insurance Linked Securities, and it includes Catastrophe Bonds, Collateralised Industry Linked Warranties (ILW), Collateralised Reinsurance and Sidecars.

 

ILS' have been around since the mid-90s, post hurricane Andrew, when it was acknowledged that the traditional (re)insurers could not be expected to have enough capital to cover the market's needs.

 

Alternative capital hit $20-25bn in 2007, and although there was some fall in the popularity of these vehicles over the following few years, capital has poured into the alternative space particularly in the last 2 years and topped c.$45bn in 2013!  This will likely grow again in size in 2014.

 

Investors in ILS' include hedge funds, sovereign wealth funds, pension funds.  The big selling point is that returns from ILS' are uncorrelated with market returns.  And with returns in other asset classes, such as regular bonds, looking slim, the promise of decent ILS returns (probably high-single digit from here) looks attractive.  This is below the return typically targeted by (re)insurance companies, though (re)insurers have the advantage of capital efficiency (alternatives are fully collateralised, reinsurers aren't).

 

All this extra capital, combined with (perhaps because of) a lack of large-scale losses, has meant huge pressure on reinsurance pricing.  During the recent 1/1 renewals, risk-adjusted pricing was mooted to be down 15-25%, even more on certain lines.  It is clear that alternative capital is having a dramatic effect here.

 

The most affected lines to date have been those whose risks are well-modelled, for example US Wind; conversely, risks like European wind (which doesn't seem to be as predictable) has not seen anything like the same level of competition from alternatives.  However, some, such as John Seo of Fermat Capital, believe this is just a matter of time.  Below is a link to an article in yesterday's FT by John Dizard, who quotes Seo:

 

http://www.ft.com/intl/cms/s/0/2cd1ba24-7479-11e3-9125-00144feabdc0.html?siteedition=intl#axzz2rgzezHSj

 

Anyway, my own guess is that there has got to be some silly alternative money chasing silly premiums, all in the name of "uncorrelated returns", so that when the next series of disasters occur, some capital will exit.  But I'm not convinced that this is entirely a cyclical phenomenon, as some posters are suggesting.

 

How this all affects Fairfax is what I'm trying to understand.

 

By the way, Seo features heavily in this Michael Lewis article on the history of modelling insurance, which I found interesting.

http://www.nytimes.com/2007/08/26/magazine/26neworleans-t.html?pagewanted=all&_r=0

 

If anyone notices that I've badly explained or completely misunderstood any of the above, please correct me!

 

Thanks

[racemize]

I wonder if the ILS market will shrink back down if rates on bonds get to normal levels?

[WhoIsWarren]

I wonder if the ILS market will shrink back down if rates on bonds get to normal levels?

 

Racemize,

 

Perhaps, yes rising rates might do it.

 

I'm not exactly sure how alternatives are structured, but as far as I know the capital in these vehicles (which is held upfront) earns a cash rate of interest, in addition to an insurance risk-premium.  So perhaps rising rates won't have much of an impact?

[mcliu]

Tons of capital chasing small returns in unfamiliar markets with potential for large losses. Hmm...  ???

[WhoIsWarren]

Tons of capital chasing small returns in unfamiliar markets with potential for large losses. Hmm...  ???

 

I agree, that's the way it looks.  But then why would someone with the industry stature and experience of Richard Brindle think that this capital is to be taken seriously??

 

These vehicles aren't been run by complete novices either.  As gio already pointed out, the 'permanent capital' guys such as TPRE and GLRE, typically hire-in teams with lots of experience.  And with the sidecars, the sponsors typically put up 10-15% of the capital at risk, so interests are at least somewhat aligned.  At what point the benefit of the fees outweigh the sponsor capital at risk, I'm not sure, but I don't think we're there yet.

 

I'm also interested to know whether anyone has an opinion as to how alternative capital may impact the direct insurance market down the line.  I believe that to date alternative capital has probably been a net positive for direct insurers, lowering their reinsurance costs.  In the future, perhaps alternative capital may find routes to market and reduce returns there too??

[A_Hamilton]

Tons of capital chasing small returns in unfamiliar markets with potential for large losses. Hmm...  ???

 

I agree, that's the way it looks.  But then why would someone with the industry stature and experience of Richard Brindle think that this capital is to be taken seriously??

 

These vehicles aren't been run by complete novices either.  As gio already pointed out, the 'permanent capital' guys such as TPRE and GLRE, typically hire-in teams with lots of experience.  And with the sidecars, the sponsors typically put up 10-15% of the capital at risk, so interests are at least somewhat aligned.  At what point the benefit of the fees outweigh the sponsor capital at risk, I'm not sure, but I don't think we're there yet.

 

I'm also interested to know whether anyone has an opinion as to how alternative capital may impact the direct insurance market down the line.  I believe that to date alternative capital has probably been a net positive for direct insurers, lowering their reinsurance costs.  In the future, perhaps alternative capital may find routes to market and reduce returns there too??

 

I'd add to this, what is the cost of capital for an endowment or pension plan? 5-8% depnding on the situation. These cat bonds are problematic in my opinion because if it were any other industry they would be treated like UBTI (after all they are effectively in the business of writing insurance), how can there be taxable competitors with this disadvantage?

[WhoIsWarren]

I'd add to this, what is the cost of capital for an endowment or pension plan? 5-8% depnding on the situation. These cat bonds are problematic in my opinion because if it were any other industry they would be treated like UBTI (after all they are effectively in the business of writing insurance), how can there be taxable competitors with this disadvantage?

 

Hi A_Hamilton, can you explain this some more?  Thanks

[A_Hamilton]

I'd add to this, what is the cost of capital for an endowment or pension plan? 5-8% depnding on the situation. These cat bonds are problematic in my opinion because if it were any other industry they would be treated like UBTI (after all they are effectively in the business of writing insurance), how can there be taxable competitors with this disadvantage?

 

Hi A_Hamilton, can you explain this some more?  Thanks

 

First, on 5-8% cost of capital. Think about a pension plan with an 8% return on plan assets assumption. If they can acheive that by owning cat bonds they'll allocate capital there. FFH has a much higher required return assumption which is one reason why so much capital will flow from pensions ane endowments into these structures.

 

Separately, on UBTI,

I don't know how other countries operate, but in the U.S. a non-profit or pension can't directly control a company. So, for instance, Harvard can't buy 100% of Kraft and operate it as a for profit entity but not pay tax because Harvard is a non-profit. If Kraft were owned by Harvard it could charge substantially less for products than other consumer food companies because they don't have to pay taxes and can still earn a decent return on capital.

 

To me, since these entities are effectively in the business of writing insurance our laws should force non-profits to pay taxes on their cat bond returns as any other taxable player would.

 

[WhoIsWarren]

Separately, on UBTI,

I don't know how other countries operate, but in the U.S. a non-profit or pension can't directly control a company. So, for instance, Harvard can't buy 100% of Kraft and operate it as a for profit entity but not pay tax because Harvard is a non-profit. If Kraft were owned by Harvard it could charge substantially less for products than other consumer food companies because they don't have to pay taxes and can still earn a decent return on capital.

 

To me, since these entities are effectively in the business of writing insurance our laws should force non-profits to pay taxes on their cat bond returns as any other taxable player would.

 

 

Ok I see what you mean.  What you suggest is very reasonable.  I don't have a good sense of how substantial these tax-exempt entities are, but I'm guessing they are a smaller part of this overall phenomenon?

 

Thanks for explaining.

[A_Hamilton]

Separately, on UBTI,

I don't know how other countries operate, but in the U.S. a non-profit or pension can't directly control a company. So, for instance, Harvard can't buy 100% of Kraft and operate it as a for profit entity but not pay tax because Harvard is a non-profit. If Kraft were owned by Harvard it could charge substantially less for products than other consumer food companies because they don't have to pay taxes and can still earn a decent return on capital.

 

To me, since these entities are effectively in the business of writing insurance our laws should force non-profits to pay taxes on their cat bond returns as any other taxable player would.

 

 

Ok I see what you mean.  What you suggest is very reasonable.  I don't have a good sense of how substantial these tax-exempt entities are, but I'm guessing they are a smaller part of this overall phenomenon?

 

Thanks for explaining.

I'd actually think they are a very big part of the cat bond market. These are high yield instruments that tend to have low correlation to junk bonds and equities. These are an ideal pitch to every pension fund and endowment.

[WhoIsWarren]

Separately, on UBTI,

I don't know how other countries operate, but in the U.S. a non-profit or pension can't directly control a company. So, for instance, Harvard can't buy 100% of Kraft and operate it as a for profit entity but not pay tax because Harvard is a non-profit. If Kraft were owned by Harvard it could charge substantially less for products than other consumer food companies because they don't have to pay taxes and can still earn a decent return on capital.

 

To me, since these entities are effectively in the business of writing insurance our laws should force non-profits to pay taxes on their cat bond returns as any other taxable player would.

 

 

Ok I see what you mean.  What you suggest is very reasonable.  I don't have a good sense of how substantial these tax-exempt entities are, but I'm guessing they are a smaller part of this overall phenomenon?

 

Thanks for explaining.

I'd actually think they are a very big part of the cat bond market. These are high yield instruments that tend to have low correlation to junk bonds and equities. These are an ideal pitch to every pension fund and endowment.

 

Interesting! Thank you A_Hamilton