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Alleghany Discussion of P&C Insurance Market


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The Alleghany annual is out:

http://www.alleghany.com/files/doc_financials/2014/Q4/2014-Annual-Letter_v002_m1ed53.pdf

 

Their discussion of the global P&C market is a must read for anyone invested in insurance companies.

 

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Early in my career as a security analyst following the property and casualty industry, an insurance executive at the time explained the business to me as follows: “The property and casualty business is a simple business: prices follow loss costs with a lag, usually about two to three years.” Over the past two years, the property and casualty industry has experienced low levels of natural catastrophe losses and casualty claims have generally emerged at lower-than-expected levels. The result has been that reserves established in prior periods have proven to be more than what is needed, resulting in “favorable reserve development” in the current period.

 

We do not know – and never know with any degree of certainty – what the future trend in claims will be. Accordingly, at Alleghany we try to use conservative assumptions, trending past loss emergence even if the “loss curve” is flattening.

 

At the writing of this letter, we are focused on the potential significant issues surrounding “deflategate.” Deflategate, of course, is our “term of art” which describes the deflationary pressures that seem to be the dominant force on a macro-level right now. If you had to pick a business that will hold its value in a deflationary environment, a property and casualty company would be high on the list. On the left side of the balance sheet you have, for the most part, high quality bonds. As interest rates fall, the value of these bonds increases. At the same time, if economic conditions are deflationary, the ultimate liabilities of a property and casualty business should shrink. The net effect of the two is a leveraged increase in equity. And although prices ultimately fall, they tend to lag the actual trend in loss costs. In a deflationary environment, property and casualty companies should hold their value.

 

It should be no surprise that insurance and reinsurance prices, after increasing for the past several years, have stopped increasing and in some cases – large property exposures in particular – have begun to decrease. Among our insurance and reinsurance subsidiaries, price decreases are most pronounced in the global property catastrophe reinsurance business, and to a lesser extent, the U.S. primary property business. Casualty rates as of this writing are more or less stable, with the exception of California workers’ compensation and some specialty casualty lines, where rates continue to increase -- primarily because they have been deficient in the aggregate relative to loss costs.

 

While mild deflation is positive for the net asset value of the property and casualty industry, it is negative for prospective returns. Our industry is being challenged by the extremely low nominal interest rate environment, both in terms of direct and indirect effects. Because a large portion of the industry’s economic return comes from investment returns generated on capital and float, lower nominal interest rates result in lower industry returns. With hindsight, one might even conclude that the industry for many years enjoyed “excess returns” because embedded portfolio returns were significantly above a declining rate of inflation. These are the direct effects. Indirect effects include increased and new competition from so-called “alternative capital” providers, including pension funds, hedge funds, and the like. According to Guy Carpenter, approximately 18% of global reinsurance catastrophe limits are now provided by alternative capital. Following six years of an appreciating stock market, the industry itself is flush with capital, resulting in excess industry capacity.

 

Faced with these environmental challenges, the industry is consolidating. In order to generate reasonable returns, companies must be as efficient as possible, avoid underwriting mistakes, and add value where possible through the investment function. A company that is successful on all three of these items will still likely generate lower nominal returns, but real returns can remain attractive.

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Isn't this a function of lower returns on capital in general fostered by an extra loose monetary policy?

If capital is made abundant, loose and cheap, isn't it to be anticipated that expected forward rates of return go down as that capital works its way through the system competing for the available opportunity set?

I do not think the P&C industry is unique in this perspective. Inflated stock markets make forward rates of return low, and this is worse yet if your view of economic growth is mediocre for the next 10yrs. Deflationary pressures are real an certainly won't add to growth projections going forward.

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Isn't this a function of lower returns on capital in general fostered by an extra loose monetary policy?

If capital is made abundant, loose and cheap, isn't it to be anticipated that expected forward rates of return go down as that capital works its way through the system competing for the available opportunity set?

I do not think the P&C industry is unique in this perspective. Inflated stock markets make forward rates of return low, and this is worse yet if your view of economic growth is mediocre for the next 10yrs. Deflationary pressures are real an certainly won't add to growth projections going forward.

 

If we call all QE-like actions at $5T (which many think has no effect on money-supply and only increases liquidity). If both are true then we must consider liquidity, which is an extremely interesting topic (tough to find good papers on, too), and certainly increases prices, ceteris paribus. If we are going to claim QE-like actions made capital "abundant, loose, and cheap" then we should compare it to the total US Net Wealth of ~$80T [1]. This is an increase of just 6.25%.  We should really use Total US assets or global assets though. Off the top of my head, consumer mortgage debt is ~$20-30T, Govn't debt is $15T (not to open this box), and consumer debt is ~$15T. So total US assets is probably around $120T - $150T. Thus, QE only increases total US assets by 3.3% - 4.2% (spread over an unknown number of years at unknown weights). Maybe I'm drinking the koolaid but this is why I don't think we are or will see inflation due to QE.

 

Sounds more like we are pulling growth forward and deflation may be difficult to avoid?

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Isn't this a function of lower returns on capital in general fostered by an extra loose monetary policy?

If capital is made abundant, loose and cheap, isn't it to be anticipated that expected forward rates of return go down as that capital works its way through the system competing for the available opportunity set?

I do not think the P&C industry is unique in this perspective. Inflated stock markets make forward rates of return low, and this is worse yet if your view of economic growth is mediocre for the next 10yrs. Deflationary pressures are real an certainly won't add to growth projections going forward.

 

If we call all QE-like actions at $5T (which many think has no effect on money-supply and only increases liquidity). If both are true then we must consider liquidity, which is an extremely interesting topic (tough to find good papers on, too), and certainly increases prices, ceteris paribus. If we are going to claim QE-like actions made capital "abundant, loose, and cheap" then we should compare it to the total US Net Wealth of ~$80T [1]. This is an increase of just 6.25%.  We should really use Total US assets or global assets though. Off the top of my head, consumer mortgage debt is ~$20-30T, Govn't debt is $15T (not to open this box), and consumer debt is ~$15T. So total US assets is probably around $120T - $150T. Thus, QE only increases total US assets by 3.3% - 4.2% (spread over an unknown number of years at unknown weights). Maybe I'm drinking the koolaid but this is why I don't think we are or will see inflation due to QE.

 

Sounds more like we are pulling growth forward and deflation may be difficult to avoid?

 

I think you're drinking the koolaid ;)

 

I'd compare base money before to base money now to get an idea of how much money *could* be created by fractional reserve banking if loan demand took off.  Then, ask yourself whether the Fed would go about destroying all the base money it has created (which is easy enough to do) if inflation took off.  That would be my framework for considering inflation. 

 

That's leaving aside the fact that we do have huge inflation today - it's just in assets, not commodities.

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Isn't this a function of lower returns on capital in general fostered by an extra loose monetary policy?

If capital is made abundant, loose and cheap, isn't it to be anticipated that expected forward rates of return go down as that capital works its way through the system competing for the available opportunity set?

I do not think the P&C industry is unique in this perspective. Inflated stock markets make forward rates of return low, and this is worse yet if your view of economic growth is mediocre for the next 10yrs. Deflationary pressures are real an certainly won't add to growth projections going forward.

 

If we call all QE-like actions at $5T (which many think has no effect on money-supply and only increases liquidity). If both are true then we must consider liquidity, which is an extremely interesting topic (tough to find good papers on, too), and certainly increases prices, ceteris paribus. If we are going to claim QE-like actions made capital "abundant, loose, and cheap" then we should compare it to the total US Net Wealth of ~$80T [1]. This is an increase of just 6.25%.  We should really use Total US assets or global assets though. Off the top of my head, consumer mortgage debt is ~$20-30T, Govn't debt is $15T (not to open this box), and consumer debt is ~$15T. So total US assets is probably around $120T - $150T. Thus, QE only increases total US assets by 3.3% - 4.2% (spread over an unknown number of years at unknown weights). Maybe I'm drinking the koolaid but this is why I don't think we are or will see inflation due to QE.

 

Sounds more like we are pulling growth forward and deflation may be difficult to avoid?

 

I think you're drinking the koolaid ;)

 

I'd compare base money before to base money now to get an idea of how much money *could* be created by fractional reserve banking if loan demand took off.  Then, ask yourself whether the Fed would go about destroying all the base money it has created (which is easy enough to do) if inflation took off.  That would be my framework for considering inflation. 

 

That's leaving aside the fact that we do have huge inflation today - it's just in assets, not commodities.

 

But the "inflation" in assets (at least for stocks) is due to earnings growth. "Inflation" for bonds/UST is due to lower rates. There are many asset classes that are lower now than they were 3-5 years ago that you are not considering. Money supply has been flat since QE was implemented. I really don't understand why there "has" to be inflation (now or down the line).

 

The biggest issue with your fractional reserve example is the multipliers (which I think you're after). I'd imagine the error range is factors larger than the actual estimated 'true value' range. I mean do you honestly think $5T over 5 years is enough to marketably change the value of our dollar (cumulative real GDP in that time is $75T - $80T - that doesn't include re-sales!). This is ignoring the fact that QE of $5T is the amount of money that "could" be lent out. There were deposit increases at the Fed that total a fraction of $5T, allowing the Fed and commercial banks to gain $5T in assets (fractional reserve banking - it's not as scary as it sounds). It's not like $5T is the increase in deposits and $50T "could" be lent out (assume 10% reserves which isn't real-life).

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