The Investing Landscape for the Insurance Industry
“I’d bet against any company in the auto business getting into insurance”.
This coming from the Oracle of Omaha in response to Elon Musk’s announcement over the summer that Tesla would be launching its own insurance product. This statement is all the more interesting considering Buffett made his fortune by using insurance as a financing vehicle to acquire businesses and build the empire he manages today at Berkshire Hathaway.
His success is no secret. There are two ways that insurance companies can make money. The obvious one is by taking in more money in insurance premiums than is being paid out for claims. If this is the case, the insurer is said to have operated at an underwriting profit. The second way, which is less obvious but often far more important, is by investing the money taken in as premiums that have not yet been paid out for claims, a sum of money known as the float. Per Buffett:
“To begin with, float is money we hold but don’t own. In an insurance operation, float arises because premiums are received before losses are paid, an interval that sometimes extends over many years. During that time, the insurer invests the money … If our premiums exceed the total of our expenses and eventual losses, our insurance operation registers an underwriting profit that adds to the investment income the float produces. When such a profit is earned, we enjoy the use of free money — and, better yet, get paid for holding it.”
Source: Berkshire Hathaway 2002 shareholder letter
It is quite the competitive advantage to compete for bids using a negative cost of capital while private equity firms bid on the same companies financed by (usually) high yield loans with interest rates of 7%+ per year. Despite the growing influence of insurance technology, the idea of leveraging cost of capital as a competitive advantage through insurance-linked securities (ILS) is the topic of this post. And if capital allocation decisions and return hurdles are based on prevailing interest rates, it follows that as long as radical central bank policies are in place, safety comes with a price.
State of the Market
There was nothing new about investing premium float. Buffett’s innovation fifty years ago, with the acquisition of National Indemnity in 1967, was two-fold: 1) capitalize the balance sheet with equity funding first then debt funding and 2) invest a wider portion of the assets in publicly traded equities as compared to traditional fixed income. When interest rates stood tall, underwriting losses were the norm. Indeed, according to the Insurance Information Institute, industry-wide underwriting profit was literally 0% for a quarter century[1]. From 1979 to 2003, insurance companies made money by clipping the coupons in their high-grade bond portfolios, not by performing their core job of insuring against fires, storms and slipping and falling. Below is an industry average of the cost and profit breakdown of the P&C insurance business:
Source: Writer Estimates
Couple takeaways: 1) insurance is bloated (look at that G&A ratio); 2) the industry is highly regulated and therefore highly distributed with acquisition costs and commissions eating as much as 40 cents on every premium dollar. But extremely low interest rates have altered underwriting discipline. No longer can actuaries count on interest income to absorb underwriting losses. In 2003, two years after the Fed slashed the federal-funds rate to less than 2%, six years of underwriting profitability duly followed. From this period birthed the rapid ten year growth of capital markets-backed alternative risk transfer.
Source: GC Securities
Third Party Risk Transfer
So what is alternative capital and how does it relate to ILS? It refers to pools of capital available for the transfer of risk from an insurer to the capital markets. More and more of the global risks today are being packaged, turned into portfolios and offered to the very largest providers of capital in the world. Pensions and sovereign funds are entering the market, not themselves writing insurance but rather through buying insurance-linked securities and other event-linked bonds. The way that these work is rather simple — an investor makes a loan, which is fully collateralized, and earns a floating coupon in return. At a certain level of catastrophic loss (either through a hurricane, earthquake, or some other specified force of nature), the investor must pony up a share of principal to compensate policyholders. If no catastrophe strikes, the investor gets out with his principle and interest intact.
In terms of disruptive forces in the industry, “Insurtech” receives most of the attention. This term refers to a wide-ranging array of applications to utilize emerging technologies to distribute insurance products, analyze new risks and streamline existing operations. An AM Best Survey last year asking executives in the industry “what are the greatest threats you face today?” confirmed this consensus.
Source: AM Best. CB Insights.
Despite Insurtech’s disruptive influence, it is clear ILS has reached a scale that requires closer scrutiny. To better understand its impact on the broader market, we need to examine the perspectives of both sides of an ILS transaction — the investors and sponsors.
As it relates to investors, there are two primary motivations for ILS. First, in the current low rate environment it’s a bad time to be a saver. Pension funds have future obligations to their enrollees, and in the search for yield have allocated a greater percentage of assets to alternative investments. Reinsurance-as-an-asset class presents capital markets investors a source of uncorrelated and diversified returns. Indeed, whether or not Peloton hits their quarterly targets has no bearing on how hard the wind blows in south Florida.
Source: Bloomberg. GC Securities.
This chart shows that CAT bonds, as a proxy for reinsurance-as-an-asset class, is well diversified and uncorrelated to a portfolio of traditional fixed income and equity securities.
Second is an economics reason that can be explained using basic math. Post-Hurricane Katrina, rates for Gulf Coast and Florida hurricane exposure went up considerably. The market at the time was paying 20% rate on line (which is 20 cents for every dollar of protection) for coverage for an event that produced an insured loss in excess of $20 billion. According to catastrophe modeling companies, a $20 billion loss was a one-in-50 year event, which means that on a yearly basis the expected loss is 2%, and as a result, the mean expected return 18% — a return well above the market risk premia.
What’s in it for sponsors (insurers)? These companies get access to a lower cost source of capacity that produces consistent fee income through origination and distribution of risk. In a market environment where products are undifferentiated, margins are low, and competition is fierce, achieving scale through operating leverage and positioning the company as the low cost provider is the path forward.
But insurers over the past five years are getting squeezed on both sides of the balance sheet. Underwriting profitability is dismal.
Source: Aon Business Intelligence
And investment returns are still at all-time lows.
Source: Aon Business Intelligence
Leading to low single digit ROEs.
Source: Aon Business Intelligence
And finally, as a result, consolidation has occurred since equity investors will not accept these levels of return on a standalone publicly traded equity.
The impact of ILS is tangible. The market has rewarded those companies whose business models have adapted to growing third party capital. Take last year’s AIG purchase of reinsurer and ILS manager Validus Holdings for $5.6 billion or RenaissanceRe’s $1.5 billion purchase of Tokio Millennium.
AIG is up 33% this year.
Source: Google Finance
RNR is up 41% this year.
Source: Google Finance
This compared to the broader insurance market (SPDR S&P Insurance ETF as a proxy), which is up 21% this year.
Source: Google Finance
To help us make sense of what’s accounting for this outperformance, refer back to income statement chart at this beginning of this post. Insurance companies trade on book value (BV). As such, the focus is on return on equity (ROE). The higher the ROE, the higher the BV multiple the company will trade in the open market. The outperformance can at least partially be attributed to the utilization of alternative capital sources. On the one hand, it lowers the hurdle rate (cost of capital) for these publicly traded peers. On the other hand, it helps to magnify the returns to equity despite headwinds to both underwriting and investing profitability. Insurers cut down on distribution expenses through bypassing the expensive wholesale broker network and its related 20%+ commissions. Insurers also offset underwriting losses through fee income achieved by ceding (passing off) risk to capital markets balance sheets. Finally, insurers are better able to scale top line growth while maintaining net premium margins necessary to retain financial strength ratings with insurance regulators. This increased scale manifests itself in a larger assets to equity ratio, while keeping insurance reserves in line with net exposures. Below is the revised income statement breakdown of how an insurance company can navigate the difficult terrain that exists today to achieve double-digit ROEs.
Source: Writer Estimates
Conclusion
The explosion of new technology applications to challenge the gatekeepers in the industry, funded by the dramatic rise in venture capital for InsurTech start-ups, has taken a lot of interest among industry participants. Insurance and reinsurance applicants are still, though, fundamentally sending submissions and applications to be accepted as insureds and cedants. It is an offer of risk transfer for premium. Unless platforms that control the customer also start retaining the risk with an equal to or lower cost of capital, the incumbents are still likely to control the system. So long as the indulgent state of the debt markets extends the yield famine of the past 10 years, those who build the best capital platform can offer the best products to attract customers, with the lowest cost capital translating to lower prices for consumers. In due time, the Insurtech industry can reclaim the throne atop the Fintech hierarchy.
[1] Underwriting profitability is defined as combined ratio, which is a ratio of total all-in expenses to premiums received. A combined ratio over 100% signifies an underwriting loss.
