In this continuing podcast Mike Sapnar looks at:
- Property cats & strategic capital relationships
- The insureability of pandemics and other systemic exposures
Can’t listen now? Read the edited transcript
ILS: How is trapped collateral affecting the market as we approach 1/1?
Locked up ILS capital has been somewhat problematic for people’s balance sheets. The interesting thing, when we talk about a hard market, it that if you go through the published reports of the publicly traded reinsurers, you’ll see that their peak zone exposure is not anywhere near their tolerances. They’re not running at max tolerance, so they have the ability to go out and write more business against their equity – if the pricing is adequate enough.
So I think people are saying ‘this is the amount we’re willing to take at this pricing’. Once ILS gets locked up or it’s not available, you will see pricing increase significantly because its got to meet my equity return requirements, not some fixed income diversified pension fund returns. To the extent that new ILS capital replaces it, or to the extent that capital remains trapped, you will see a differentiation in pricing as it stays on people’s balance sheets because there’s different ‘hotel rates’. That will be mostly peak zones. Non peak zones tend to be diversifiers for balance sheets, and typically have lower pricing and higher combined ratios. Maybe to our detriment probably, aggressively pricing for its diversification benefit, but non-peak is not really attractive to ILS capital because of the pricing. That should tell us something! But non-peak risk is attractive to balance sheets because of the capital diversification benefit. As peak zones go up, non-peak zone pricing/diversification becomes more important on one level. However, as it shrinks as a share of the overall portfolio, the benefit becomes less and therefore could wind up requiring pricing tweaks.
I think ILS is a big indicator or a big determinant of what the balance sheet pricing will be. The one thing that bothers me is that ILS capital doesn’t use its own balance sheet in most cases. Markel’s purchase of Nephila was an acknowledgement that the one thing that can crush ILS is that if no one gives them the leverage or the balance sheet, the evergreen promise to pay their product is not a great substitute. And we’ve seen that time and again, and we see it right now. So we’ve kind of cut our own throats and under-priced the leverage that we give these fund. To our own detriment. I think all has to be recalibrated, rebalanced and redetermined, especially if ILS is going to be close to a majority of the capital behind the cat risk.
If ILS is 10% of my capital and I give them leverage and I blow through the top of the program, I’m probably sunk anyway because 90% of my portfolio would be at such an extreme loss event that I’m insolvent. But if it’s 50% of my capital (or 60% or 80%) maybe I would be in business on just the business I’ve kept net, but that tail risk could actually be enough to put me out of business. And what is the price for that? We need to be paid better for our distribution and leverage and that’s not happening. So I think we’re in a whole period of time where that price discovery is going on.
What new strategic capital partnerships has TransRe established?
We have Pillar where we own a significant share of the general partner, and we’re invested in their funds. But Pillar is off-shore and we’re on-shore so there are restrictions on what we can do for servicing. They’ve built a great business. Steve Velotti is building an outstanding track record, but we are disconnected from a servicing standpoint and from giving business to Pillar. We’re just an investor and an owner and Steve runs that business. So that’s worked out great. So that really meant we didn’t have a strategic partner as respects our own portfolio of business. So we entered a partnership with Integral as a way to mutually optimize our portfolios.
We have a distribution network and a bunch of risk on our balance sheet, and Integral have a portfolio they need to build. And we think there are ways to optimize our respective needs for our respective capital bases. We will be compensated for the services and the portfolio construction we’re providing, which is wholly different. We’re not invested in their funds. We don’t sit on boards. It’s a different deal.
You have aligned capital, non aligned capital, and then ‘integrated’ capital. There are situations where insurers just front for people, where they have no investment in the funds or the general partner. In one case, we have an investment in the GP and in the funds. In the other case we provide services (which we think will be mutually beneficial). I think you have to make yourself available in all parts of the spectrum. We’re really just a reinsurance company, so we want to play in all spaces and with (the team) having a longstanding track record, we think they’re quality people, good underwriters, good investors.
What do you think of the ‘big three’ brokers becoming the ‘big two’?
I think that in the long run, I’m probably neutral. It’s hard to say it’s better, but it does make a lot of the independent, smaller brokers (who are very creative and have been attracting talent) more viable in some ways and more of an interesting alternative. An oligopoly is sometimes worse than a monopoly, so maybe the two will merge and we can get to fixed brokerage that is standardized and a reasonable amount.
I say that a little tongue in cheek, honestly, but I do think an interesting thing here is that we’re getting down to a choice of two and these brokers feel that they are really the client advocates. At what point does it move to a fee based structure, where the client decides what the value of those services are and they pay for them, and take them out of the reinsurance transaction costs?
For me, the broker market is a great model. I have a variable cost for my distribution. If I write more, I pay more. If I write less, I pay less. A big problem with our business is managing volume against fixed costs. People chase the top line because they don’t want to cut the expense line. You know, we pay about 4%, so for us that’s around $160-$170 million to run a distribution. That’s probably fairly reasonable, but if we write $10 billion, should that be $400 million? If it’s profitable business, I guess there’s nothing wrong with that. The thing is, what’s the right amount of brokerage? Who’s really paying the brokerage? Are brokers overpaid on excess of loss, underpaid on quota share? We keep hearing the term ‘market brokerage’. What is market brokerage? When I came into the market, it was 1½% on gross, 2% on net. Now everyone thinks the standard is 2 ½% on gross. I don’t know when that became the market brokerage. I don’t know when that was decided and who decided it.
But now, there’s a lot of non-concurrency going on, in terms of pricing and distribution costs, both up and down. There are people paying kickers and additional commissions for productivity and vice versa. It is structured in different ways, not always disclosed. I don’t think that’s an issue. I’m just saying the value of paper and distribution mean different things to different people. As a $5 billion company, it wont be up to us. The market will have to decide (to change). Clients will have to decide.
There are both positive and negatives that come out from consolidation. So short run probably worse for me. Long run, I’m not sure. We’ll see.
What lessons can we learn from Covid-19? What’s the key message?
First, this was not an unknown exposure. As VJ Dowling likes to point out, pandemic risk was on the cover of Time four times in 20 years. We had pandemic as one of our extreme events. We had policy exclusions for it. I don’t think it was well underwritten in some cases, and I don’t think the aggregations were fully appreciated in terms of government shutdowns. What is interesting is to extrapolate this to cyber. If you ever want to know what a systemic cyber loss would look like, this is it. And you wouldn’t be able to work from home. People should be thinking ‘are we really properly underwriting our cyber risk when we’re giving business interruption and contingent business interruption in policies?’ That has systemic implications.
This also reminds us that at the tail, everything is correlated: investments, property, casualty, worker’s comp, med mal, D&O – it’s all correlated. That needs to be thought about.
Is pandemic insurable?
To be honest, it’s not insurable. Insurance and reinsurance basically goes on the premise of the law of large numbers and diversification – that not everyone will have a claim at the same time. Look at our industry’s capital against the size of economic loss – we’re a very small part of it all.
I know there are public/private partnership proposals out there, and they will happen, but it’s not about paying the losses when it happens. It’s about preventing losses or mitigating the losses before it happens. I would rather see the industry pay for loss mitigation/preparation plans where you’re buying the proper PPE, you’re educating the people, and you have a reserve to buy a bunch of tests so you have the ability to do contact tracing. We have the infrastructure to get dollars to policy holders quickly. Maybe we get paid for part of that. Or maybe that’s just our ‘social good’. I’m not convinced that on such short notice, the industry could have processed all those claims. We need to build a system that can deliver those monies. I don’t think it should be optional. This is a governmental issue. This is a public service, a public health and a public policy issue.
The private market should be involved, but it is difficult for us to be involved in the risk transfer if different countries do their own structures. How are we supposed to deal with that? It’s a pandemic. You can’t look at little solutions, country by country, because by definition it’s a global issue.
What are you doing to combat racial inequality?
You must start by admitting you have a diversity issue, and then you must attack it.
We can change how we offer internships and manage equality of opportunity. We must be self critical and educate our employees, by sharing stories and feelings. These are all valid things to do, and things we have started to do. We have a diversity and inclusion committee that’s a good place to organize internal actions. But corporations are made up of people and we are a reflection of society. And really the issue is in the homes, in the schools, right? It’s in our everyday environment. Corporate America is not the problem. It is a symptom of a greater problem.
So, in my opinion, corporate America can do more, and it’s a good place to start, but at that point, you’re trying to change behaviors that have already been formed. We need to volunteer in communities. We need to give our time, not just our money. We need to support grassroots efforts – help revamp what’s taught in public schools. Areas where we can provide better opportunity or assistance or make an impact outside the workplace.
Our workplace is made up of the people in it. More minorities in senior positions would certainly help. But you have to get them into your company first, and you have to get them to that spot. But you really have to change the entire external mentality for everything to take hold inside companies. We can lead by example to a degree, but a lot more of that leadership should be from the public domain, as opposed to just behind the four walls of the office.
What about the generational talent challenge?
Attracting talent is part of the grassroots change in terms of diversity I spoke about, as well as scientists and other skillsets.
We tend to prefer to hire people already in the insurance industry. We think you should understand the underlying asset at the end of the day, but that doesn’t have to be the case. Historically, we have hired more from liberal arts. We do more than just crunch numbers. You make deals, you’re marketing and you’re dealing person to person. These relationships might have to change. If this isn’t as much about personal relationships, we might consider hiring more people right out of school with analytical skills to build within the company.
The Economist used to run a great ad: ‘who would you want to sit next to at dinner?’ I still tell our employees they should be a well rounded, cultural, diverse person. Who’s interesting to talk to a one trick pony? But maybe the world is turning into more one trick ponies. You do your job, you stay focused on it, you specialize. There are many reasons why I don’t like that, but I may have to change my view if we don’t interact face to face as much. If there isn’t much value in building that personal relationship, then maybe that skill set needn’t be as predominant.
As for career advice. Young people today will live to be 100 years old. If you’re 22 years old, you don’t have to figure it out on day one. Take some risks. Take some chances. Go live in another state, or another country. Take a job outside your comfort zone. But my biggest piece of advice is – don’t ask for more until you’ve done something with what you’ve got. So if you get something, make the most of it then say ‘Look what I’ve done. Please give me more’. I find too many times people are looking for the next job before they’ve finished the job in front of them.