November 10, 2010

ReInsurance and Discounted Book Value - The New Normal?

ReInsurance executives are painfully aware of their discounted valuations as measured by enterprise book values. With an excess of underwriting liquidity and a soft market for short tailed liabilities, Reinsurance executives point to "the cycle" as the culprit, implying better days ahead. Many believe that capacity destruction through reduced capital (either via buybacks, special distributions or industry loss) will create a tighter market, hence bankable premiums and an expansion in enterprise values.

With real interest rates zero to negative and nominal rates near zero, it makes sense that the short tailed trade (CAT) has become flooded with capital (pun intended). These near zero investment rates mean that Reinsurers are completely reliant on underwriting returns in the short tail.

Reinsurance price to books have typical ranged from 0.85 to 1.6 with the current idiosyncratic environment driving books in a lower 0.7 to 1.0 range.The industry assumption is that the soft market, low combined ratios, and historically weak returns on capital have collectively caused investors to discount Reinsuance enterprise values.

But every actuary knows that correlation does not imply causality. The discounted book state that the industry finds itself in could be the aggregate result of some emerging factors that may lead to a new normal in valuations.

Consider the alternative: The ISL ILW secularized market is gaining traction as the returns (having shown uncorrelated to credit) are reinforcing alternative asset investor's view that insurance exposure is an asset class. The long awaited adoption of securitized reinsurance is no doubt catalyzed by an extremely favorable comparison to near zero investment yields. It is important to understand that this short tailed exposure can be accessed at par. This means that an investor can gain access to short tailed reinsurance exposure at or near the equivalent enterprise value of book.

Another factor that may influence discounting is the market's fear of financial non transparency, driven by the events and subsequent disclosures of 2008. Reinsurance accounting allows for some flexibility in loss reserves that make the tangible nature of book difficult to grasp. It seems reasonable for a rational investor to discount this uncertainty, particularly in light of the existence of a fully transparent alternative means of access.

And finally, as underwriting returns in the short tail should be more volatile than investment returns in the short tail, and the mix of return contribution shifts to 100% liability returns, it would be logical for investors to factor in the volatility of the enterprise returns when considering valuation.

Dismissing the impact and persistence of these emerging factors in explaining the current state of reinsurance price to book valuations, may prove wishful thinking. Of course future book premiums may be in the offing, but these new headwinds certainly won't facilitate that scenario. Alternative access will most likely keep a tight lid on book values for short tail predominated businesses, while the uncertainty in the meaning of reinsurance book value will weigh heavily on valuations.

Of course there are actions Reinsurers can undertake, given the current valuation and interest rates environment. Reinsurers capital structure can be adjusted by swapping equity for debt on the balance sheets. Accretive buybacks of equity and access to cheap financing make for a compelling argument.

Regardless of the course of action existing Reinsurers take, new entrants will find capital formation difficult in an environment where sub book investment alternatives persist. In turn, alternatives will continue to gain traction. Paradoxically, discounted book itself may help facilitate a further adoption of alternative structures at the cost of traditional company capital formation, thereby reinforcing the persistence of discounted book.

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