New Fair Use Policy: I’ve always operated under the principle that this blog is meant to enlighten others and thus, if people want to share it, they are more than welcome to do so. I assumed anyone reproducing it in a professional context would be, well, professional enough to cite it.
So, I now have a new policy. It’s pretty similar to the prior unstated policy. Anyone is welcome to share the content of this blog elsewhere, as long as they cite it. If you’re not sure if this applies to you, then it does.
For those of you who are here mainly for the insuretech pieces and are tired of me prattling on about hurricanes and such, I have bad news for you. Not only will I keep doing it, but you have badly misread the situation. See, the price of cat reinsurance is very important to the success of insuretech underwriters.
If you’re not sure why, you may want to keep reading. If you want the Cliff Notes:
– reinsurance capacity is strained
– returns on cat reinsurance will be very high
– if I write other reinsurance that is either volatile or not very profitable, I am missing out on writing more cat
– Therefore, I will sign down or non-renew other reinsurance treaties to improve my portfolio return.
If that isn’t clear enough, the “other” reinsurance they will pivot away from is likely to include startup MGAs.
The Reinsurer’s Veto
Diligent readers will recall one of my more popular posts this year was the warning to reinsurance dependent MGAs to plan for the day when cheap reinsurance was no longer available. Well, I hope they listened because they’re running out of planning time!
From that piece:
There isn’t enough reinsurance capacity in the world to support every wanna be MGA startup.
Even if there were, it assumes reinsurers will continue to be stupid and give away their capital for nothing. They won’t. Eventually, they will demand higher prices or walk away completely.
If they demand higher prices, well, that ruins the economics of a lot of business plans. The idea that you can “lock in” a fat margin at the expense of the reinsurer will disappear.
Why bring this up again? Because if you are a startup MGA dependent on cheap reinsurance, Hurricane Ian changed your business model…and you may not even be aware yet.
You may have heard how cat reinsurance pricing is on the rise, but thought it doesn’t apply to you. Sorry to be the bearer of bad news but, yeah, you got that one wrong.
See, reinsurance capital is fungible. If one line of business has high returns and another has low returns, capital will flow to where the returns are higher. Most of the time that’s not a constraint because most of the time there is more than enough capital to go around.
In other words, when there is excess capital, reinsurers will still write mediocre business alongside the premium accounts because they justify “relationships” and “we need to make Aon happy writing the crap to get the good accounts” and all sorts of other excuses to let the underwriters keep underwriting.
Shortages Cause Inflation
We are now entering a different environment. Just like the broader economy has encountered numerous supply shortages that led to higher prices, property reinsurance is experiencing a shortage that is leading to higher prices.
The last time we saw something like this was 2006. If you are a startup founder or VC investor or a younger underwriter, there is a good chance you have no idea what I am talking about. That’s unfortunate.
2006 was the last time we had a true capacity shortage. Reinsurers were already burned in 9/11 and then after back to back bad hurricane seasons in 2004 and 2005 (punctuated by Katrina), the cumulative losses led a number of markets to throw up their hands and withdraw capacity (accentuated by the S&P capital model change).
Thus, the annual negotiation between insurers and reinsurers wasn’t a poker game to see who would fold first. Instead, it was like musical chairs with way too many children and not nearly enough seats.
Buyers were less price sensitive than normal as they were more preoccupied with just finding enough capacity. In other words, there was a supply shortage.
We are now likely entering a market similar to 2006 given the cumulative cat losses in recent years mathematically reduced excess capital and the psychological impact of repeated losses has caused many reinsurers – who are supposed to understand the difference between process and outcome – to materially reduce their property appetite, if not exit completely.
In recent years, because capital is fungible, the desire to find an alternative to cat re led many reinsurers to be willing to roll the dice with startup MGAs. Today, the equation has flipped.
The Spread Beyond Cat
Those reinsurers who are still willing to write cat have more demand than they can fill. Every dollar of capital allocated to low return business prevents me from writing more high return cat.
Now, that may not always be the case (for example, there are diversification credits you don’t want to lose), but unproven MGAs tend to produce volatile underwriting results (or predictable losses!). If they write lines with cat like aspects (hello, cyber!), then they are directly competing for capital with cat.
In other words, if you are a reinsurer, you’re looking at all your volatile lines (energy, marine, political risk, aviation, terror, cyber, etc.) and evaluating whether you should still be writing those when you can write more cat instead.
This means one of two things…either reinsurers will pull capacity from MGAs or the price will have to go up significantly to not reposition the capacity to cat. Don’t be surprised to hear of cases where MGAs with XOL treaties face 100% price increases. No, I didn’t mean to say 10%. That’s an extra zero.
Even if you’re buying casualty quota share, terms will change materially and beyond just less favorable ceding commissions. Get used to hearing about things like loss caps. No, I don’t mean where you get a locked in loss ratio like you may be used to. I mean you retain any losses over a certain loss ratio.
Expect to have to retain larger individual losses too, so instead of only retaining $1M/loss, you may have to retain $5M. Do you have the capital for that?
So yeah things are going to get ugly. Is it fair that you have to pay more because of hurricane losses in Florida? Maybe not, but was it fair that you got crazy cheap reinsurance the last five years because reinsurers lowered their return hurdles due to zero interest rates and lack of liability losses?
Chicken Little?
Before I scare everyone too much, is it possible things won’t be that bad? After all, reinsurers are famous for being Chicken Little and predicting higher prices after every bad hurricane or earthquake. Usually, they’re wrong.
What’s different this time is the capacity shortage. Most of the false alarms were greed based. There was lots of capacity and reinsurers tried to bluff their way (the poker analogy) to higher pricing.
That’s not where we are right now. The music is playing with a lot fewer chairs.
Not only is traditional capital exiting, but the ILS writers have much of their capital trapped as collateral, the cat bond buyers are finding better opportunities in corporate credit, and the hedge fund bros have learned they aren’t very good at insurance and have given up.
Yes, there is a chance Ian is a much smaller loss than being bandied about (a scenario I have admitted I am sympathetic to), but we may not know that for 3-6 months. We’re 6 weeks away from negotiating Jan 1 reinsurance treaties. I don’t think the market will believe this is a $30B loss that fast.
Cyber Bully
I hinted at it above, but to drive the point home before we finish, I think the biggest risk here is with the large cyber MGAs. They are very reinsurance dependent and they bring a lot of volatility.
There really isn’t a good reason a reinsurer would want that risk over a national US property cat treaty up 40%. Maybe if the cyber is up 100%? Maybe if it comes with significant caps on volatility or much higher retentions?
Whatever the solution is it will result in much higher CRs, higher volatility, and greater capital requirements. Do the investors putting massive valuations on these companies understand that? I’m pretty sure we know the answer to that.
As for the already public insuretechs, their reliance on cheap reinsurance will also be problematic. As costs rise, so does cash burn which is already their greatest challenge. Just like how a year ago none of the analysts asked about cash burn, today none are asking about how financial results will change when cheap reinsurance goes away.
Reality Bites
If there is a theme here, it’s that startups continue to pursue unrealistic business models that investors don’t understand well enough to suss out how “sus” they are. Chasing the fad (top line growth, MGAs, reciprocals, etc.) is going to keep ending badly until investors put forth the effort to understand the pros and cons of the models they become enamored with.
If you’re a reinsurer and you’re pulling chairs away, the startup sticking you with losses is going to be the first to end up without a seat. That’s just reality and it shouldn’t come as a surprise, but I’m sure it will to some.
Unfortunately, 2023 is going to be another tough year for many insuretechs because reinsurers are going to reassert their will and too many startups didn’t plan ahead for that day.
Another provocative essay, Ian. Thanks.