<p>A recent article suggested that at the end of Q2 2022, the total "dry powder" AUM available for investment by Private Equity has surpassed (according to Pitchbook) $1.2 trillion. </p><p>So, is so much powder dry? </p><p>A typical response that I have heard from PE firms is that "we do not want to try catching a flying knife." This implies that global economic times are both volatile and uncertain. That rising interest rates are raising the investment bar, and most firms have chosen respite versus deploying capital. </p><p>So, while PE and other investors are open for business, their selection of investments has trended towards safer harbors and more certain returns. Investing in the global re/insurance industry could very well be that safe harbor. </p><h2><span style="font-size: 14pt;">Re/insurance Market Returns </span></h2><p>Re/Insurers premium and terms and interest rates rarely align. </p><ul><li style="list-style-type: none;"><ul><li>It is normal to anticipate that higher interest rate environments will see lower premium rates charged to policyholders. This is because Re/Insurers' balance sheets rely more on investment income and the asset side of the balance sheet in high-interest rate periods. The Re/Insurance term for this is cashflow underwriting and soft (bear) market conditions.</li><li>Whereas, to anticipate that lower interest rate environments will see higher premium rates charged to policyholders. This is because Re/Insurers' balance sheets rely more on the risk or liability side of the balance sheet in low-interest rate periods. The Re/Insurance term for this is disciplined underwriting and hard (bull) market conditions.</li></ul></li></ul><p> </p><h2><span style="font-size: 14pt;">Re/insurance Market Perfect Storm </span></h2><p>So, what happens when terms restrict, re/insurance capacity becomes scarce? </p><p>Both re/insurance rates rise more than social inflation and interest rates rise? </p><p>In the author's opinion, we call this a re/insurance market perfect storm and an unprecedented event. It sounds like a perfect space for Investors to invest in an industry that is counter-cyclical to global economic conditions. Where returns can be more than investor benchmark returns, yet that investment has not happened with any substance and is unlikely to happen. The reason for that is the track record and investment performance.</p><p><strong>Re/insurance Investment </strong></p><p>Simply speaking, the re/insurance market returns over the last 20 years are not acceptable. An uptick has driven it in natural catastrophe frequency and severity losses in combination with systematic under-pricing of non-catastrophe exposed classes of P&C re/insurance. </p><p>It has further been exacerbated by bloated operating ratios and asset/investment side volatility. If you invested in Insurance-Linked Securities (popular with pension funds as an alternative investment asset), you would be more than likely to have lost on your investment six years running. </p><p>If you backed public market re/insurance stocks, you are looking at stock valuations below book value. If you invested in legacy/runoff businesses, then the impact of social inflation on long-tail liabilities may be detrimental to the invested asset.</p><p>All these outcomes have led to investors seeking safety within re/insurance. Investors have sought non-risk-taking/capital-light businesses to invest in. Most of the re/insurance investment has recently been in brokers, managing general agents (MGAs), program managers, and program carriers. </p><p>Investors have targeted EBITDA earning businesses and have engaged in M&A with multiples of more than 15x EBITDA. Investors are attracted to the fee income and working with management to expand the top line while improving operating margin ratios. </p><p>It makes perfect sense as hard (bull) market conditions will drive premium growth, which in turn drives high fee and commission income. Yet there is a potentially fatal flaw to this assumption. </p><p><strong>Shortfall in Re/insurance Capital</strong> </p><p>Capital light (brokers, MGAs, program managers and carriers) require Insurer and Reinsurer counterparts to execute trades and conduct re/insurance business. If those markets or their capacity are unavailable, then all business assumptions about capital-light business growth go out the window. </p><p>Re/Insurance broking firm, Aon, has identified that the shortfall in re/insurance capital available to provide policyholders may have fallen by $90 billion. </p><p>The impact of this shortfall will result in the hardest market conditions that this author has seen for decades. There will be a wide-scale shortfall of capacity available for policyholders from insurers, for insurers from reinsurers and from reinsurers from retrocessionaire's (reinsurers who reinsure reinsurers). </p><p>The impact will be more net line underwriting by insurers and reinsurers. The impact will be felt most on catastrophe-exposed classes of P&C. While less impactful on non-catastrophe-exposed classes. The good housekeeping process that all re/insurers are presently conducting will also see price increases continue (prices have risen unabated since Q4 2019) for those classes. </p><p>Sounds like an ideal investment opportunity?</p><p>The answer to this question is yes, but the re/insurance market must reinvent itself and its investment strategies to secure access to that $1.2 trillion of dry private equity powder. Older investment (Bermuda rated, Lloyd's of London, Sidecars & ILS) strategies must solve the issues that have been detrimental to the investment returns of these strategies.</p><ul><li style="list-style-type: none;"><ul><li>Bermuda AM Best Rated Carriers-Must solve capital inefficiencies and the ability to access affordable and outperforming talent pipelines.</li><li>Lloyds of London-Must eliminate the "you must earn your stripes" attitude for new entrants. Allow the scale to succeed and the efficiency to run their managing agency from inception.</li><li>Sidecars must bring more alignment with investors and present to those investors a message of risk and upside sharing versus fee income-motivated outsourcing of peak risk.</li><li>ILS must stop being one trick (volatile catastrophe risk only) pony and find a working solution for trapping capital.</li></ul></li></ul><p style="padding-left: 40px;"> </p><p>The re/insurance market is ripe for investment. It is time for innovative ideas to help the market close its capacity shortfalls. Innovative ideas that are capital efficient, less volatile and more investor aligned. The industry simply must provide investors with what it requires so that investment can be across all sectors (broker, MGA, insurer, reinsurer & retrocessionaire) of re/insurance.</p><p> </p><p><span style="font-size: 10pt;"><em>This article was contributed by our expert <a href="https://www.linkedin.com/in/peter-m-3a0b59a/" target="_blank" rel="noopener">Peter Mills</a></em></span></p><p> </p><h3><span style="font-size: 18pt;">Frequently Asked Questions Answered by Peter Mills</span></h3><h2><span style="font-size: 12pt;">1. How big is the global reinsurance market?</span></h2><p><span style="font-size: 12pt;">The global reinsurance market size was $435.09 billion in 2021 at a compound annual growth rate (CAGR) of 8.1%. The market is expected to reach $555.99 billion in 2025 at a CAGR of 6%.</span></p><h2><span style="font-size: 12pt;">2. How is reinsurance profitable?</span></h2><p><span style="font-size: 12pt;">The Return On Equity (ROE) of the global reinsurance industry generally declined between 2013 and 2020, albeit with some fluctuation. The highest return on equity of the global reinsurance industry was recorded at the beginning of the time period under observation, when it stood at 13 percent. </span></p><p><span style="font-size: 12pt;">After a sharp decline in 2017 when the ROE of the insurance industry worldwide was only 0.1 percent, it proceeded to increase sharply in 2019, reaching over nine percent that year. In 2020, the return on equity of the global reinsurance industry dropped again, to 2.5 percent.<br /> <br />The ROE for the time period under observation was underperforming. It is attributable to an uptick in global natural catastrophe events and the systemic under-pricing of non-catastrophe exposed classes of business. The reinsurance industry has been making pricing and terms corrections since Q4 2019 in an attempt to rectify the underperformance. </span></p><p><span style="font-size: 12pt;">It is expected that the substantial pricing increases being achieved in 2022 and 2023 plus the restriction of policy terms and conditions will put reinsurance on a path of outperforming ROE returns. </span></p><h2><span style="font-size: 12pt;">3. What are the reforms in the reinsurance sector?</span></h2><p><span style="font-size: 12pt;">The key reforms centre around technology. AI/Machine learning technology is being implemented by the reinsurance industry to improve business efficiencies and decision making. It is widely expected that tech advances will make in roads into the role of the agent/broker in insurance and reinsurance transactions. It presents an opportunity to disintermediate the agent/broker and provide greater margin for returns for the provider of insurance and reinsurance policies. </span></p><h2><span style="font-size: 12pt;">4. What are the key challenges facing the insurance industry in today's marketplace?</span></h2><p><span style="font-size: 12pt;">The key challenges facing re/insurance in today’s marketplace and adaptability. It is adapting to changing social and political environment. Understanding the potential impact and taking remediated measures to ensure fair treatment of the policyholder and an acceptable return for investors. </span></p><p><span style="font-size: 12pt;">The reinsurance industry is further challenged by global warming and the impact (e.g. increase in frequency and severity of natural catastrophe events) of environmental change on the reinsurance industry.<br /></span></p><p> </p>
KR Expert - Peter Mills
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