Financial Services REINSURANCE ESCAPING FROM THE BEARS AUTHORS Arthur White, Partner Christopher Sandilands, Senior Manager Jonathan Hekster, Senior Manager
BEARING DOWN Reinsurers face a persistent and dispiriting problem with the investment markets. Almost regardless of individual performance, they are rated lower than comparable companies in different industries. The markets seem to be fundamentally pessimistic about the industry s ability to deliver returns above the cost of capital a bear case that no large reinsurer, and only a handful of small ones, seems to be able to refute. How can reinsurers escape from the bears? There are ways, but they require reinsurers to understand what drives investor pessimism, and to make major changes to their business models and communication strategies. In this paper we suggest four possible business model enhancements for reinsurers. BEAR CASE HAS BECOME THE CONSENSUS The underperformance of reinsurance stocks is well documented. The quoted reinsurance sector is a persistent laggard, underperforming other sectors on a wide variety of measures and timeframes. Disappointingly for the sector s stars, over time the valuation differences between reinsurers have narrowed dramatically as well. EXHIBIT 1: PERFORMANCE METRICS REINSURANCE VALUES DECLINING AND NARROWING GLOBAL REINSURANCE MARKET TO BOOK VALUE VALUATIONS LESS DIFFERENTIATED THAN ANY OTHER INDUSTRY MARKET TO BOOK VALUE ACROSS INDUSTRIES MV/BV 2.5 2.0 1.5 1.0 75th percentile MV/BV 4.0 3.0 2.0 1.0 0.0 Average 75th percentile 25th percentile 0.5 Average 25th percentile 0.0 90 92 94 96 98 00 02 04 06 08 10 Reinsurance Banks Real Estate Non-life Const & Mat Auto & Parts Life insurance Chemicals Utilities Basic Resources Inds Gds & Svs Food & Bev Consumer Svs Pers & H/H Gds Oil & Gas Technology Telecom Pharm & Bio Health Care Oil Equip & Svs World Non-fin REINSURANCE RETURNS LOW AND VOLATILE GLOBAL REINSURANCE ROE VS. NON-FINANCIALS RETURN OF EQUITY (%) 20 15 10 5 0-5 -10 89 91 93 95 97 99 01 03 05 07 09 11 Reinsurance World market (non-financial) NO SIGNS OF A RISK PREMIUM VS. OTHER SECTORS* ROE MEAN/VOLATILITY BY INDUSTRY SECTOR 01-11 ROE STANDARD DEVIATION 14% 12% 10% Reinsurance 8% 6% 4% Broader non-life sector Banks 2% 0% 0% 5% 10% 15% 20% ROE MEAN Source: DataStream, Oliver Wyman analysis Note: Reinsurance sector data on charts is a composite Oliver Wyman sector comprising both pure play reinsurers and wholesale insurers with strong RI weighting. We have adjusted for periods (e.g. pre-2000) where some reinsurers have reported on book rather than market basis. * Each dot represents sector Copyright 2012 Oliver Wyman 2
Even if reinsurers feel that investors are treating them unfairly, it is not hard to construct a pessimistic bear case for the industry, as illustrated in Exhibit 2. On the demand side, the reinsurance premium pool in developed markets is shrinking, as primary insurance premiums have remained broadly flat, and cession rates have fallen. Emerging markets are still benefiting from growth in primary insurance premiums, but reinsurance cession is already starting to shrink in relative terms. In short, primary clients and their brokers are becoming more sophisticated buyers. These trends are also true in the life reinsurance industry. However, life reinsurers have the additional problem that regulation is increasingly eliminating historical regulatory arbitrage business, rather than creating demand, as Solvency II is doing in non-life. On the supply side, the industry remains awash with capital. Even after significant recent catastrophe and investment losses, global industry capital is at a ten-year high. This overcapacity will be hard to shift given that barriers to entry for new capital have fallen dramatically, in particular through the increased acceptance and use of alternative capital vehicles. Although the share of these vehicles is still relatively low, their impact should not be underestimated as they allow new capital to be increasingly rapidly allocated against new opportunities (instead of using the historical route of start-ups and recapitalisations). One impact is already visible as pricing trends are becoming ever more differentiated by region, line of business and risk. EXHIBIT 2: THE BEAR CASE FOR THE INDUSTRY DEMAND SIDE Flat or shrinking underlying insurance growth in developed markets Increased buyer professionalisation leading to shrinking demand Higher retention, lower quota share only partly offset by increased demand driven by Solvency II Some growth in developing markets Underlying economic growth and primary insurance market growth... but not yet enough to move the dial LONG TERM Challenging industry outlook SUPPLY SIDE Overcapacity even after major 2011 catastrophes and 2008/2011 investment conditions Significantly reduced barriers to entry to the industry Alternative capital instruments well established Increased demand for diversifying risk from capital markets Hence increasing competitor fragmentation despite M&A INTERMEDIATION Brokers broadening influence in value chain by increasing the scope of services offered More intrusive regulation making commercial environment more challenging Copyright 2012 Oliver Wyman 3
ESCAPING THE BEARS How can reinsurers escape? We suggest four areas of business model innovation below. EXHIBIT 3: POTENTIAL BUSINESS MODEL ESCAPE ROUTES Do traditional business better Find new ways of doing traditional business Find new revenue/ premium opportunities Focus on insurance risk revenue Focus on non-risk revenue Optimise the current model e.g., more effective client coverage Find new demand and build solutions for it Sweat underused assets: turn products into platforms Package risk for investors 1. OPTIMISE THE CURRENT MODEL: MAKE COVERAGE WORK HARDER Reinsurers can do the basics better. For the last hundred years, the industry has been structured around a core product set: property, casualty and marine. We believe innovative reinsurers can create value by tailoring their business model and proposition better to their clients. The coverage model holds the key. We believe that reinsurers can learn much in this area from other industries which sell commoditised products in a business-to-business environment. Commercial banks, for example, face similar challenges with their complex, multi-geography and multi-product client relationships. We believe the success factors for banking client coverage models are all relevant areas for investment for most reinsurers: Fully segment and tier service levels according to underlying client needs, client profitability or profit potential Decide where different coverage models are appropriate (e.g. product led or relationship led) and who should participate in the coverage team, and how Fight for C-suite access, and embed oneself with strategic relationships at the top of the house, not just with buyers Make sure the right people do the right things : actively manage how and where relationship managers and client teams spend their time Focus on cross-sell and up-sell, and on developing higher margin solution based propositions Create an organisational model and incentive structure which promotes talent and rewards good performance. Copyright 2012 Oliver Wyman 4
2. FIND NEW DEMAND AND BUILD SOLUTIONS FOR IT Reinsurers should seek sources of new and growing demand for cover. One obvious approach is to identify economic or sector wide mega-trends. These could include climate change-driven changes to catastrophe frequency and severity, longevity risk, pandemic risk, or information economy risks, such as supply chain interconnectedness, information piracy and reputational risks. Structured scenario approaches can be used to map out the relevant trends and risk drivers in the world economy. Reinsurers may say this is not new and that they are already taking action in these areas. However, we would argue that reinsurers are not thinking sufficiently boldly and often play second fiddle to other players such as investment banks in major deals. A case in point is the UK wholesale longevity risk transfer market, which has grown significantly in recent years. The role of reinsurers has typically been restricted to underwriting risk, with banks and boutique advisors originating and structuring deals. There is significant unfulfilled demand for longevity protection from pension funds at the moment, and a clear opportunity for reinsurers to extend their role in their market. Similarly, large corporates are becoming more aware of their enterprise-wide risk exposures. Traditional insurance products cover a narrow subset of balance sheet exposure, leaving a significant unserved demand for risk cover that neither insurance nor capital market players have been able to supply. Insurers and reinsurers have found it hard to move away from product-led thinking towards a customer-centric approach that can identify these risks and build innovative solutions. Reinsurers should emulate investment banks by understanding end customer demand, pitching solutions, putting capital against some parts of it and offloading other parts into the wider markets. In all of these areas the common challenge is putting advisory and structuring at the centre of the client proposition, not just product underwriting. To build such capabilities, reinsurers will need to bring together the right combination of technical, relationship and deal making skills in the right client-facing team structure. 3. SWEAT UNDERUSED ASSETS: TURN PRODUCTS INTO PLATFORMS Reinsurers have a range of hidden assets on their balance sheets. These include deep expertise in industries such as healthcare, automotive and transportation, engineering and infrastructure. Expertise is global or focused on particular regions and includes knowledge, contacts and access. Whatever they are, the assets are often unique to a particular reinsurer or to the reinsurance industry. We believe that there are opportunities for reinsurers to exploit these assets by creating a sales platform around the most attractive ones. This might include the following: A salesforce dedicated to the target market, identifying unfulfilled demand where new solutions can be developed A product manufacturing platform customised to the requirements of the target market and focused on customer need, not necessarily using standard insurance product categories Ancillary products, such as advisory and consulting services Vertical investments in related value chain areas, such as healthcare infrastructure Centres of expertise that cut across traditional boundaries such as facultative reinsurance and primary insurance in industrial risks. Copyright 2012 Oliver Wyman 5
Such efforts could lead to a platform for growth proposition for primary insurers, moving away from a role where they advise cedents on developing products and capabilities, towards manufacturing products that cedents can distribute for them. This would have the double benefit of improving the quality of business received from cedents and reducing the cost of processing it. 4. PACKAGING RISK FOR CAPITAL MARKETS INVESTORS Pure reinsurance risk is one of the few genuinely portfolio-diversifying exposures in the modern economy. But it is hard to get. If an institutional investor wants exposure to equity risk, it does not have to buy a stockbroking firm. So why should an investor have to buy shares in a reinsurance firm to access reinsurance risk? Historically the risk ceded by the primary insurance industry has been channeled via the reinsurance markets. Alternative risk transfer has been seen mainly as a risk management mechanism for the reinsurance industry, for example as an alternative to retrocession. However, it is increasingly being augmented by a model focused on marketing reinsurance risk as an alternative asset class to end investors, as illustrated in Exhibit 4. Many reinsurers have invested in their risk packaging capabilities via, for example, sidecars and cat bonds. However, the list of traditional reinsurers who place a larger volume of risk in the capital markets than they themselves buy is very short, and those who have succeeded in packaging this risk for wider capital markets investors (such as pension funds) are largely from outside the traditional reinsurance industry. Reinsurers have potential to boost their capabilities in this area to tap into a growing and attractive profit pool. EXHIBIT 4: DEMAND FOR INSURANCE LINKED SECURITIES INCREASINGLY A THIRD PARTY ASSET CLASS NOT A RISK MANAGEMENT MECHANISM FOR THE INDUSTRY 100% 75% Hedge funds Reinsurers 50% Life insurers 25% Pension funds Money managers 0% Source: Guy Carpenter 1998-99 2006-07 2010-11 Dedicated ILS funds Copyright 2012 Oliver Wyman 6
BEARING UP Nobody would argue that it is either easy or obvious to escape the bear trap. However, after years of broken promises to analysts and investors about how the industry will transform results by executing its business model better, it is time for more fundamental action. In fact, given the emergence of new competitors to the traditional reinsurance model, we believe that reinsurers have a similar challenge to any customer-facing organisation: how to give customers exactly the experience they want. If customers want something very different to what they are getting, this needs a change of focus and business model with which many reinsurers may not be comfortable. But for those willing to take on the challenge, the rewards are likely to be substantial. Copyright 2012 Oliver Wyman 7
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