The once responsible insurance-linked securities market is showing signs of being overheated and irrational, the chief executive of the holding company for a Bermuda-based reinsurer said on Friday.
Ed Noonan, chair and CEO of Validus Holdings, which includes Validus Re in Bermuda writing reinsurance and Talbot Underwriters in London writing specialty insurance, said he expects a very competitive reinsurance market to develop for the June 1 Florida renewals, adding that some ILS managers are having a disruptive impact.
“In the past, I have said that we believed that ILS managers were acting rationally and their pricing reflected a lower cost of capital. We no longer hold that as a universal view,” he said.
“We see some managers with genuine expertise behaving in a rational manner consistent with their cost of capital. However, we see others that have raised very large pools of money going beyond rational economic behavior.”
Noonan made his remarks during an earnings conference call, after reporting that Validus had posted $162.4 million in the first-quarter, with Validus Re contributing $146.4 million of that figure.
Looking ahead to the second quarter and reinsurance market conditions looming ahead, Noonan said: “Florida is ground zero for ILS funds to deploy capital. So we expect to see a significant component of ILS money put to work.”
An analyst reminded Noonan that during the last quarter the CEO had said that property-catastrophe reinsurance pricing—particularly in Florida—was approaching a floor, with only possibly one more round of rate declines left before prices couldn’t be lowered further. “Are we now closer to the floor,” the analyst asked.
“I’m starting to think we might be headed for the basement,” Noonan responded, noting that of the two sources of competition in the Florida reinsurance market—the traditional reinsurance market and the ILS money—”the truly disruptive factor in the market right now is ILS money.”
“We have large ILS managers saying, ‘Whatever they quote, we’ll put out multi-hundred million dollar lines at 10 percent less,'” Noonan reported.
He continued: “I think alternative capital is extremely valuable for the industry, and I worry that now we’re getting into an overheated phase where if you’re compensation is based on simply deploying capital to the limit, you’re incentives are different.”
“That’s how markets get a trouble,” he said.
Referring to an average catastrophe bond yield of 5.25 percent, Noonan said, “I don’t think that’s actually appropriate compensation for the risk.”
“I don’t think investors can appreciate that expected loss costs that are driving valuations in the ILS space don’t line up with the expected loss costs that professional reinsurers come up with on the same account.”
Validus participates in the ILS market through its AlphaCat Managers operation, which was set up in 2008. According to Validus’ website, AlphaCat Managers helps investors take advantage of the ILS asset class through various funds and sidecars, accessing the market through AlphaCat Reinsurance Ltd., a provider of fully collateralized property- catastrophe reinsurance and retrocessional capacity.
During the call, Noonan conceded an analyst’s point that investment portfolio diversification benefit allows ILS managers to accept lower cat bond yields. “There is clearly diversification benefit. But we’ve gone beyond that to the point where you have fairly large capacity being deployed in a way that is leaving money on the table,” Noonan said.
“They can get more money for their product and they’re simply pushing it out the door as quickly as they can take it in. That suggests to me that the market is overheated.…
“It’s one thing to say, you’re okay giving diversification credit. But that five-and-a-quarter could easily be five-and-three-quarters or 6 percent with a bit more discipline—and you have to wonder if maybe we’re past the point of rational behavior.
Noonan was hard-pressed to speculate on exactly what might bring rationality back to the ILS market when an analyst asked if it might be a large cat event, or a series of small events that ILS investors didn’t think they’d get hit with.
“It’s probably both,” he said.
In addition, “at some point, investors do have to re-up—revisit their decisions. They have watched their expected yield decrease fairly dramatically [from] north of 9 percent in 2012 [to] barely north of 5 percent today.
“I get the logic that you want an allocation to the [catastrophe] class because it’s noncorrelating to most other capital markets instruments. [But] at a certain point, people have to look at this and say it’s a triple-B or triple-B-minus security. Why am I accepting this yield [when] I can do much better on triple-B securities elsewhere?”
During the earnings call, another analyst asked Noonan whether the market dynamic in Florida this year “feels different” than prior episodes of softness?
“No, I think we’re on a continuum. There are still good Florida accts that are attractively priced. I just think the pool’s been shrunk a bit,” Noonan said.
“The only thing that’s discordant with being on a continuum is having money just being shoveled into the market” from some of the ILS players, he said, stressing that he didn’t mean to “besmirch ILS market in general or all ILS managers.”
“There are some with expertise that are deploying capital in a rational way. But there are some large ones that aren’t,” he said.
Tossing Terror in Prop-Cat Programs
Noonan also discussed some behavior in the traditional reinsurance market that is giving him some pause—namely the inclusion of terrorism in property-catastrophe programs.
“This started at 1/1 in a small number of cases, but seems to be getting traction….
“We have nonrenewed a number of programs over this issue,” he said.
“There are some cases where we’re getting paid and we’ll provide the coverage. But some reinsurers are rapidly losing discipline on this issue.
“Frankly, this is a bad idea for the market and ultimately a bad idea for buyers of reinsurance,” Noonan opined.
“The inclusion of terrorism in cat covers means that either reinsurers will be willing to run massive terror aggregates in major cities or [they] run out of cat capacity much more quickly
For buyers of reinsurance, occurrence-based catastrophe treaties are “not the best means of purchasing protection against terrorism losses. The definition of loss doesn’t match up well with terrorism events, and so the buyer is not served well by this approach.”
“The definitions of events, and relationships between events, can and likely will prove to be murky and subject to disagreement and potential disputes if terrorism is covered in traditional catastrophe treaties.
“We will continue to push back against practices that forget lessons the market has already learned at great cost,” Noonan concluded.