This Cat Market Cycle Is Not Like The Others

Reinsurance prices were up ~50% at January 1. While most observers would tell you my hurricane is responsible, I think that’s a myth. What we are now experiencing is a market hardening unlike previous cycles, except one. It is acting like the oil market of last year.

What do I mean by that? Most people attribute last year’s oil spike to events in Ukraine. While that certainly played a role, oil prices were rising before the war and rose by more than just the amount implied by Russian oil disruptions.

Why? Two reasons. First, oil stocks had suffered in recent years as investors frowned upon production growth so managements responded by limiting new capacity and focusing on free cash flow.

Second, ESG investors refused to own oil stocks regardless of the fundamentals driving down valuations further and starving producers of access to capital even if they sought to grow.

The result of this was a reduction in supply below long term demand which meant any shock to the system (like Ukraine) would send prices spiking. Managements had little incentive to add capacity because it meant making long term commitments when they have little long term demand visibility.

Similarly, cat reinsurers had performed poorly in recent years due to higher than expected losses. Many investors abandoned the sector which hurt valuations and raised the cost of capital. In response, many diversified reinsurers cut back their property growth with some even exiting altogether.

The ILS investors who poured in over the prior ten years, not unlike the oil investors who poured in to support the fracking boom, ended up disappointed in their results and lost their appetite.

Many of those who lost faith blamed climate change for higher cat losses which created more uncertainty about future prospects and thus made it more difficult to commit new capital.

This set up a similar backdrop where supply had been reduced too far relative to long term demand and any upset to the system could produce a large mismatch with much higher prices.

Thus, the irony is that the long term pessimism creates the short term optimism, because of the lack of participants willing to take advantage of the boom times compared to historic market turns.

History Lessons

Before I continue the story, let me interrupt with a reminder of how the prior three hard cat markets occurred and why this one is so different.

1993

The 1993 cat market was in response to the losses from Hurricane Andrew. The industry realized it didn’t understand its exposure to catastrophe risk and thus cut back exposure out of fear.

This led to the development of cat models which eventually became the market underwriting standard and created companies like Ren Re. This was a pure fear driven market turn.

2002

The 2002 hard cat market was in response to 9/11. Like in 1993, this time the market realized it didn’t understand terror risk and there was a major capacity crisis.

Many of us now forget the widespread fear that these attacks would recur which meant you couldn’t write airlines or office tower or even malls. A CEO writing too much cat was betting the company that 9/11 was a one-off event. So, again, this was a fear driven market.

2006

The 2006 turn was in response to Hurricane Katrina and its sisters, Rita and Wilma. There was concern that we were in a more active phase of the hurricane cycle (which proved terribly wrong – maybe a harbinger of today’s predictions about climate driven losses?) along with the psychological impact of large losses in 2001, 2004, and again in 2005.

This time the fear was at the rating agencies. They had seen the cat models repeatedly be too low for major events and demanded companies hold more capital for cat risk. This raised the cost of capital and meant reinsurers had to raise prices.

There was not as much fear as ’93 or ’02, but the higher cost of capital and the mistrust of the cat models meant reinsurers needed to raise their hurdle rates.

The Present

What is going on today is totally different. There have not been excess or unexpected losses. If anything, Hurricane Ian looks like it might be light of the modeled losses. Also, the global insured losses for the year are only slightly above expected.

So if the losses aren’t that bad, what is going on? We are having a seller’s strike. Just as in the oil industry last year, companies are refusing to add new capacity because they don’t trust capital markets.

There are no new companies being formed. The ILS market isn’t interested in growing because they are licking their wounds from prior years of disappointing returns.

Most of the large reinsurers who retreated from property in the last year or two continue to suggest they don’t have the appetite to grow their limit.

There is a mismatch between long and short term expectations. Just as the oil companies are hesitant to commit to long term capital projects in the face of uncertain long term demand, reinsurers don’t want to raise capital for a short term opportunity if the long term economics are still highly uncertain.

This is why you are not seeing the typical batch of new companies. Who wants to put up $1B in capital to make great money for a year or two and then be stuck with a 6% return business for the next ten years?

Even temporary capital like sidecars is proving hard to come by. This is likely a function of other capital market pressures due to the bear market.

The Future

So where does this all lead? The oil bulls will tell you as long as there is a hesitancy to add new capacity (due to the long term uncertainty in energy transition away from oil), we will continue to be exposed to shocks which requires a higher risk premium and thus higher prices.

This is good for the incumbents as they have visibility on their CAPX and can take advantage of periodic spikes to maximize cash flows. While overall demand may decline over time, the more stable competitive environment (reducing the risk of busts from overproduction) can mean good financial prospects for those who remain.

Similarly, if fears over climate change losses or the return of the next ILS tidal wave keep new entrants out and current participants from expanding, then returns will probably be better than expected.

That doesn’t mean we are in a long term hard market. If we have a couple of light cat years, prices will certainly come down like normal. However, unless we see a flood of new companies formed next year, we are unlikely to reach the same overcapitalized state where events like a large Japanese quake or unexpected storms like Sandy produce only marginal responses.

Just as with the oil market, the unwillingness to believe that the long term could be good will lead to a greater likelihood of short term disruptions.

The Buyer’s Perspective

So how do you respond to this as a buyer of property cat? You need to be prepared to retain more risk going forward.

Not just for a year, not just for two, but as an ongoing plan. If the risk of shocks is higher, then you have to be ready at any time to hold more risk net.

Think of it like a retailer that had grown used to just in time inventory. That is a harder strategy to manage in a world with more geopolitical uncertainty, trade tensions, and demand shocks. You have to hold more inventory as a cushion.

Insurers need to learn the same lesson. You can use reinsurance, but you can’t overuse it. You need to re-underwrite your book to reduce gross volatility given the cost of reinsurance, especially for low layers.

If reinsurance prices come down, then great, buy some more for a year or two opportunistically. But if you’re going to go right back to writing marginal business to lay off on the back side, you’re letting reinsurers control your destiny.

The only way to ensure you can maintain your capacity to your clients is to manage the gross book and your balance sheet in a way that you can keep more risk than the reinsurers want to assume from you. Then, you have leverage with the reinsurers rather than the other way around.

That’s been a forgotten lesson over the last decade that needs to be relearned.