No rose-tinted glasses: Alleghany's readiness for the hard market

Cracks are beginning to appear in the industry’s reserves and, especially if this issue comes to a head at the same time as other capital-depleting challenges, has the potential to cause the re/insurance to reset its rates and mindset practically overnight, triggering a hard market.

That is the view of Weston Hicks, the president of Alleghany, which owns multiple re/insurance businesses including reinsurer TransRe, wholesale insurer RSUI Group, speciality lines player CapSpecialty and Pacific Compensation Insurance Company, a workers’ compensation insurer.

Hicks explains that if worries about under-reserving were to coincide with either a big catastrophe event or a severe crash in the stock market, there could be a rapid change in an industry that has now been grappling with soft rates in most lines of business for almost a decade.

Hicks discussed these themes in his annual letter to shareholders, in which he warned that these cracks in reserves and adequate pricing will “become more visible and more significant in 2017 as stress levels in the industry continue to rise”.

“You don’t have to imagine too hard to see how there could be a financial reset,” he says. “We have a stock market trading on high expectations and we have not had a very big cat event for several years. If equity values or credit spreads were to crash—and some believe we are overdue a recession—balance sheets would weaken and you start to get that fear factor.

“Equally, other parts of the industry—namely, alternative capital—are untested in the aftermath of a big loss. Their commitment in such a scenario is also unproven. There is the potential for them to contest claims and maybe not renew their commitment to the sector. All these things would lead rates to harden quickly.”

He also notes that, unlike many other players, Alleghany has not been returning capital to shareholders in recent years, preferring to build up a healthy supply of liquid capital, precisely in anticipation of such a scenario.

“We have $1 billion that we are ready to use when rates are right or for other relevant opportunities,” Hicks says.

The dangers of hindsight
On the subject of reserving levels in the industry Hicks, who, before Alleghany, worked as an analyst at Moody’s, as a securities analyst on Wall Street, and as CFO at Chubb, says the main problem is that the industry’s reserves are based on historic trends, which can be incorrect.

“I have seen a few cycles in this industry and what strikes me when I reflect on that is that companies tend to base their expectations on the last five years. If you have been through a good experience, the reserves reflect that, which is fine unless that experience then changes.

“If you look at the results for the fourth quarter of 2016, you are starting to see a few companies run into trouble on this front and having to boost reserves. Nothing serious has happened yet but I do think we are seeing the start of the end of the down cycle. They may have thought they reserved conservatively but that loss assumption cannot always be made to current business, especially if rates have been falling.”

He also notes that many companies have been releasing reserves in recent years, a phenomenon that has helped businesses boost their results during a tough period of soft rates and a challenging investment environment.

While he is keen to stress that he does not believe any company would have done this specifically to boost results, he does suggest that it can be easy to view the industry “through rose-tinted glasses”. “They are examining those reserves based on historic information, and the insurance industry is definitely a business that is based on surprises,” he adds.

While a potential reserving issue is not likely to be enough to trigger a rapid correction in the industry, Hicks says that if it were combined with a second shock, the adjustment could be more sudden and severe. While the stock market is arguably overdue an adjustment, Hicks also has some interesting views on what would happen in the event of a big catastrophe loss in the present climate.

“Much of the world’s global risk distribution system that used to be based purely on insurance and reinsurance is now underpinned by so-called alternative capital,” Hicks says. “The big question is how a pension fund would react, say, when they have invested $100 million and now they have zero. First, would there be any dispute on that claim? And second, would they reinstate and put another $100 million in?”

He stresses that if there were any suggestion the loss was outside their expectations—or those of the risk models used—that could cause fear in some parts of the industry and an unwillingness to reinvest.

He also notes that a big catastrophe event is also a very scary and unsettling experience and that when looking back on large events, it is easy to forget the real uncertainty around them as they happened, and in the aftermath.

“A one-in-100-year event is a big scary thing. There are usually lives lost and, even with the most sophisticated models in the world, you end up sitting in a room trying to make sense of losses and how bad things are, and many people freeze,” Hicks says.

“It is human nature that when there is panic and uncertainty, everyone heads for the hills. If there were clearly material losses emerging in both the traditional and alternative capital sector, there is little guarantee that many investors would remain committed.”

Separating men from boys
Hicks acknowledges that there are important nuances between the different types of alternative capital at work in the market. He notes that investors in catastrophe bonds, for instance, will also be influenced by wider movements in credit spreads, while investors in sidecars and management funds usually have closer connections to more traditional reinsurers.

In the case of the latter, he says, it is more a question of investor psychology and a potentially human reaction in the aftermath of a big loss. But whatever their reaction, he believes a big loss would inevitably lead to a period of uncertainty and dislocation during which rates would harden and many cedants would again see traditional players as the safest haven.

“It is hard to image that if a loss were big enough the traditional industry would not be capital-constrained as well, so rates would harden. But cedants would also remember the value of trust and long-term relationships and the willingness of reinsurers to trade forward. Capital may well pour back in eventually but a period of dislocation is almost inevitable.”

Hicks makes the point that it is easy to underestimate just how difficult the market can get in the aftermath of a big loss, especially one where there is uncertainty around the scope of claims and whether they are within the expectations of risk models.

He notes that in the aftermath of Hurricane Katrina, for example, RSUI Group found it very difficult to complete its usual annual reinsurance placement, to the extent Alleghany raised money by issuing preferred stock and used it to form a captive specifically to reinsure this line of business. It has kept the captive, precisely for use in such emergencies.

The other advantage of working with traditional players is that they are closer to the original risk, meaning there is no potential dislocation between the originator of a risk (usually the underwriter) and the capital provider that ends up covering it.

Where this alignment of interests becomes disrupted, Hicks says, there can be a real risk of disputes and other problems. He uses the analogy of what went wrong in the mortgage-backed securities markets, which was one of the catalysts of the last financial crisis, where there was a big gap between those assessing the risk of individual mortgages and those packaging and selling the risks to investors—who were also incentivised based on short-term sales rather than the long-term performance of those assets.

“Alternative capital is, in my view, more reliable where it is aligned with proven risk-takers who have been around long enough to have seen big catastrophic losses and live in that world of the 2 percent probability. That is what true reinsurance executives do,” he says.
“The real danger comes when investors are seen as supplying free money and they do not consider the true risks. A cat bond investor may like the risks because it offers diversification but they must consider the risks. A free lunch in the financial markets tends to lead to bad outcomes and a bubble is very difficult to spot in advance.”

In his letter to shareholders, Hicks said: “Faced with unattractive returns on traditional fixed income investments, these investors have turned to catastrophe risk as a diversifying return source. While highly successful to date, these new risk transfer vehicles have not been tested by ‘the big one’,” he pointed out.

“Will investors in these vehicles ‘re-up’ after a significant, permanent capital loss due to a major loss event? Or have the models created a monster?”

He added: “The industry has demonstrated time and time again that ‘giving someone the pen’ without tight controls and/or an alignment of interests is a bad idea.”

He says good reinsurers also price the risks in such a way to ensure they have the balance sheet and profits to absorb and earn through any big losses. A 15 percent return on cat risks, for example, can often allow a company to break even after even a very big loss. If the return is only 6 percent, however, capacity will be depleted faster making the market even more challenging in the aftermath of a big loss.

Venturing outside risk transfer
Against this landscape, where good returns have been tough to come by for some time, many reinsurers, unable to identify profitable opportunities, have been returning money to shareholders. In contrast Alleghany, although it has completed significant repurchases of stock in the past, has not done so in recent years.

Hicks explains that the first reason for this is that its share price has remained at a healthy level in recent years and there would be little upside from buying back shares. But he also believes that its $1 billion in relatively liquid investments gives the company the flexibility to take advantage of good opportunities when they arise.

This could be in the form of hardening rates, if his prediction around how the market could turn comes true. But the company has also become a busy investor in other type of companies in recent years, via Alleghany Capital, its strategic investment arm.

It now owns majority stakes in several companies completely unconnected to the world of risk transfer—an oil exploration company, a manufacturer of precision machine tools, a manufacturer of trailers, a technical service provider focused on the global pharmaceutical and biotechnology industries, and a toy and consumer electronics company.

Hicks explains that Alleghany Capital differs from venture capital firms in that it looks to work with what are often family-owned businesses long term, not seeking rapid growth or an exit strategy in the way venture capital or private equity will.

While he acknowledges that moving into industries outside Alleghany’s expertise around risk transfer is risky, he says that such a portfolio, which now represents some 8 percent of the company’s capital, also offers much-needed diversification and protection from the cyclical nature of risk transfer.

“There is a risk moving into industries we do not understand, but the return on capital in some of these sectors is higher than insurance or reinsurance at present and that offers us great strategic benefits,” he says.

“This is an alternative outlet for our capital and it gives us choices and uncorrelated returns. The profits on these can also be used to offset the losses for tax purposes.”

He says he expects this portfolio to continue to grow. Alleghany Capital is actively seeking suitable investments—the ideal being a family-owned business where there may be an issue with succession planning. Alleghany Capital can offer long-term stability for such a business and is keen that the management retains a share of the company, keeping “skin in the game”.

“We are looking for a substantial increase in this side of the business but you have to kiss a lot of frogs to meet the odd prince,” he adds.

Asked whether his view on the dynamic of the re/insurance business resembles that of Warren Buffett, who coined the term ‘float’ referring to the idea that re/insurers are an efficient way of generating cash that can then be invested to generate substantial returns (thus de-emphasising the importance of underwriting profits) Hicks notes that Alleghany is very different because the majority of its investments remain very conservative, as stipulated by US state regulators. Buffett’s Berkshire Hathaway is structured in such a way that it is much less affected by these constraints.

Alleghany Capital will only ever be a minority part of the total portfolio and Hicks reiterates the company’s major strength: being a long-term trusted partner and capital provider operating within traditional re/insurance structures.

“The landscape is clearly changing and I have no issue with that. We also utilise alternative capital and I believe that is here to stay. But that does not mean there will not be big periods of dislocation and especially during those the long-term values and expertise of traditional players will come to the fore,” he says.

“The alternative markets will retain an important role in global risk transfer, but a deep relationship with a high quality, experienced reinsurer should also always remain a major part of the formula.”