While reserving will almost certainly play a role either as a backdrop or as a catalyst in the next cycle turn, another less analyzed industry metric that tends to coincide with pricing cycles is industry underwriting cash flow. Here, too, the indicator is suggesting a change.
Underwriting cash flow measures the difference between checks being received by insurance companies and checks being written. Here, again, US P&C industry data are analyzed as they are most readily available. Figure 15 shows that negative underwriting cash flow is closely correlated with pricing cycles. Prior to last hard market, underwriting cash flow turned negative. It is significant that underwriting cash flow has turned at least marginally negative in 2008 and 2009.
If all of the above trends were carried forward, they would eventually create enough pressure to moderate the current soft underwriting cycle. Stronger-than-expected
GDP growth in coming years could accelerate this or even serve as a primary driver on its own.
More immediately, however, the low valuations mentioned at the beginning of this section may themselves prove a catalyst for change by driving reinsurance sector
consolidation. Figure 16 plots quoted reinsurance companies on price to book ratios and forward consensus returns on equity. The shaded area below 0.9x book value
which now comprises the majority of the sector, is where mergers and acquisitions (M&A) have tended to take place in the recent past. Combined with significant share
buybacks already taking place in the sector, additional M&A could slow the growth of dedicated reinsurance sector capital, thereby restricting the supply of reinsurance.
This, in turn, could eventually drive rates higher.
Conclusion: Awaiting a Catalyst
The market outlook presented in this section is a challenging one. As discussed, low yields, high levels of sector capital and lower rates on line are contributing to low valuations and forward earnings. In this environment, one of the questions that astute company managements should be asking is: “What happens if nothing happens?”
There is, at present, immense pressure on company managements to return capital to shareholders and to avoid “growing into a soft market”. Constituents of the Guy Carpenter Global Reinsurance Composite alone have returned nearly USD5 billion in capital to shareholders in the first nine months of 2010. Nevertheless, it has always been our opinion that with the right tools, the right strategy, and with the best access to reinsurance and retrocession capital, carriers can select risk strategically and navigate a softening market.
A recent study of forward returns on equity and costs of capital of selected Guy Carpenter clients seems to bear this out. Figure 17 shows percentage point spreads of one year forward consensus returns on equity over weighted average costs of capital (WACC) both at September 1, 2010 and at present. As is evident, the majority of constituents should retain capital and use it to navigate their way through the soft cycle, according to academic corporate finance theories at least. But there is a caveat: Only with the right tools, advice and access can the mistakes of the last soft cycle be avoided.
We are confident that those carriers that emerge with critical mass when the hard market eventually does come will be better for having managed risk and expertly
navigated the current challenging environment, no matter how long it takes.