Fair-Weather Friends or Raining on Your Parade

Ask any thoughtful reinsurance underwriter about 2014 renewals and you will get (in their confidence or after their requisite 4th cocktail) a side-to-side shaking of the head….an iconic Japanese-like sucking-in of air through their teeth, marked with the appearance of archetypical and decidedly pessimistic worry lines on their forehead. You will hear grumbles about prices dropping like a Guinness&vindaloo in the wee hours of the AM, excess capital, new entrants, pension funds,  f*cking hedge funds, even before you hear them whinge "…you know our leverage - you can do the math on what THAT will do to returns….". It is, without a doubt, a buyer's market.

Yet, at the same time as the bias of earnings revisions for next year are mostly negative, with, in many cases FY14 below this year, you've got the reinsurance sector stocks on a veritable tear as if they had portfolios loaded with beta, despite most having highly-constrained risky asset or FX exposure on their investment side, with the exception of the ubiquitous credit hemorrhoid that flares up from time to time, and the odd moderate duration land mine.  And it seems like every large multi-strat hedge fund has started a reinsurance company or reinsurance strategy - whether for tax dodging  roll-up and deferral for diversification, and to secure additional "permanent" reasonably stable capital - on top of the numerous reinsurance companies themselves offering non-equity and alternative investors multiple new points of direct access - both through a fund structures or sidecars. Greenlight, DE Shaw, Third Point, AQR, Blackstone, are all having a go at their own show - reminiscent of the last big business opportunity which all the smart guys in the room stumbled over themselves to get a piece of - the CDO market. And we know how THAT one turned our for investors.

Even for a long-time bull upon reinsurance as I am, I must admit to being worried. There is no doubt that there  is  was a shortage of capital to reinsure peak risks (GOM Wind & CA Quake), partly as a result of co's desire to diversify underwriting portfolios, reduce volatility, as well as the biting of more stringent capital rules, and a increase in insurable values coincidental to the financial crisis. That was then. Now, all has been forgiven, as a dearth of yield, and money to deploy lures the punters back, along with increasing allocations by pension funds desperate for yield and continued evolution in collateralized markets easing access for, well, everyone wanting a few extra bp's. Cowboys, neophytes, quick-buck artists are ubiquitous alongside the bona-fide investors whose intention (the one pitched to trustees) is to ride out the complete cycle. And the result is, as David Byrne used to sing "…Same as it ever was", with falling prices and an as yet unwitnessed, but predictable outcome.

Yes, the soft market has arrived, and if your job is to underwrite risk, then that is what you do, what you must do, and, like the ticking of a clock, what you will do. And almost all will do it irrespective of the pressure upon rates,  whether or not storms are getting more severe, because heaven forbid you return it, or lose market share or customers (or bonus!). Together this leads to more-than-a-creep in implied leverage as fence-swingers, the ignorant, or charlatans target rates of return with little regard to the risk required to attain it.  This is to the [immediate] benefit of everyone involved - brokers, underwriters, newly-minted fund managers, alternative risk-transfer professionals, the modeling community - everyone …. except the veritable principals…the owners of capital. The dutiful participate, and the more thoughtful whinge as they do so with a sense of forboding, but few to none leave the party, whatever their doubts. And as prices tumble, the loss required to put numbers in the red gets proportionally smaller. Sound familiar?

Reinsurers' stocks are were cheap.  They suffered setbacks, were way-south-of-book, and investors were slow to let go of their distrust - in fear of potential credit and duration risk in their investment portfolios resulting from potential euro contagion. But that was then. Now, with investors having already-piled-in, the stocks (club Bermuda in particular) - continue to set new highs while next FY earnings are at best, flat to fading. This is ironic from a behavioral point of view, for while investors are merciless with diminished expectations in every other sector, torpedoing the slightest revenue or earnings miss, or smallest negative change in forward expectation, there has remained an amazing tolerance when it comes to reinsurers that - to-date - has made them immune to pervasive scrutiny. It is a veritable love-fest and one might suggest, blinding them to the dark side of what they are placing upon the pedestal. Yes, some have yield. And others are contemplating buybacks and sport undemanding multiples on THIS PAST year's almost-banked earnings. But markets, as fickle, discounting machines are ignoring not just the diminishing forward expectations for the coming year, but it would seem, the increasing leverage it will take to reach these marks. Such a situation will make the arrival of the unforeseen or catastrophic that much more painful when IT does come (and make no mistake it eventually will). However, it seems at the moment, that only curmudgeons can conjure images of the perfect storm (no pun intended): large underwriting hits, combined with a market dislocation that widens credit spreads and heaps losses on duration. I'm not predicting such a perfect storm. No one can do that except the Supreme Deity herself. But what one can predict is that, now, today, such a hit will hurt investors more than it has in recent memory, and as a result, one should be questioning whether one (who is an investor - NOT the one blithely riding a traders' option) is still being sufficiently-compensated to bear the risk with the same aplomb as several years ago.

When formerly good trades become overly crowded and go bad,  the majority lose more money than they ever made. When the price is right, one is, over time, compensated for taking risks. In a very soft market, with a serious loss event(s) the damage can be, and often is, terminal. With so many new entrants and so much new capital combined with a rapidly-softening market, it is increasing-likely many will, unluckily, though not unsurprisingly, lose more than they ever made.