Michael Millette is the Founder and Managing Partner of Hudson Structured Capital Management Ltd. Before that, he spent 21 years at Goldman Sachs where he was the Global Head of Structured Finance. In the first part of the interview, he discusses the drop in cat bond issuance, the bottoming out of the reinsurance cycle and the size and nature of loss that would be required to improve returns.
Users who have registered (for free) can read the second part of the interview here.
Mr Millette wrote the foreword to 'Hedging Hurricanes - A concise introduction to reinsurance, catastrophe bonds, and insurance linked funds'
Why do you think the growth of the cat bond market has stalled? Do you think it will pick up again?
There are a couple of reasons for this. Maturities have stretched out a little so the renewal pace has slowed down. A more profound and important reason is that the cat bond market has become the price leader for cat risk, and that costs volume in a rising rate-on-line environment. John Seo was talking about this just the other day. The pricing you see in the cat bond market tends to lead the pricing in the traditional market by anywhere from a year to a year and a half. The cat bond market is trying to harden in a still-softening reinsurance market. Of course volume is falling.
The industry has spent 20 years thinking about the cat bond market being the new money, the interloper and the traditional market being the source of expertise. My observation is that liquid markets tend to price risk more accurately moment to moment.
Cat bond market issuance blossomed in 2013/2014 during a period when the cat bond market led the traditional pricing down. Starting in 2015 the cat bond market flattened out. Pricing stopped falling. The traditional market took a year after the cat bond market to really start falling but once the traditional market started falling it had incredible momentum and it fell right through cat bond pricing.
So in 2013 and 2014 the cat bond market priced risk lower than traditional markets and that was when there were stories in the press about decoupling. At the time I remember saying, 'no, this is just an optical illusion, it's just that the capital markets move faster'. The traditional markets will get there, they will flatten out and re-converge on the cat bond market and this is probably already happening. I expect the same on the upswing in ROL.
What would it take to change the current soft market in cat reinsurance? Have we seen a secular change in pricing?
You have to divide it into endogenous and exogenous forces and there are already endogenous forces at work. Companies are unhappy with their RoEs, especially on a loss adjusted basis. In 2016 we had a series of middle-sized events outside the US and they succeeded in causing many reinsurers' quarterly earnings to go to near zero or through zero. Those sorts of events shouldn't have that effect. That shows that mispricing has now become endemic. The industry is already pulling back capacity from some lines of business.
Another endogenous force is consolidation. We've had a little bit of a breather but I fully expect consolidation will continue apace. And yet another is regulation. We've already seen the Corporation of Lloyd's stepping in and seeking to arrest pricing, for instance. On their own, those endogenous forces should stabilise pricing. It will generally take an exogenous forces to drive hardening, and that will generally be a major event.
What kind of event would it take to turn the market?
An event that is market hardening will have two characteristics: It will be large and it will be surprising. If we have a large event that fits everybody's notion of how a large event should perform it may accomplish some market hardening, but it will also attract more capital in very quickly and so the hardening will be modest.
For instance, if we had a strong category 3 hurricane hit Miami and cause $50 billion of losses, that would cause some hardening and draw some capital into the industry, but it wouldn't cause a capital shortfall or a profound hardening. In fact, if you had a cat 3 hurricane hit Miami you would have investors lining up even before the storm even made landfall.
What would cause a profound Andrew or 9/11-style hardening is an event the market claims not to expect. So not only is capital drained from the industry but the industry does not feel they are pricing risk properly anymore and there's a great pause. That could be a shockingly large event, like a cat 5 hurricane hitting Miami and causing $140 billion of loss.
The surprise there would not just be that the cat 5 occurred, but also that you would see losses unfold in ways that you usually don't think about. You would have social infrastructure losses, governments ordering insurance companies to pay people without questioning claims, you would have companies feeling they needed to cover storm surge... a whole host of things that would be different from expectations.
Alternatively you could have a smaller event such as a hacker taking down the computers of the power grid in a way that causes a whole series of transformer stations to burn out during a cold snap across New England. You could have frozen pipes from Bangor, Maine to Greenwich, Connecticut. And you could have homeowners losses on a scale of $50 billion.
You would have executives and politicians parading in front of cameras saying, 'we could have never predicted these losses'. Which of course in untrue because we are anticipating those losses right now. That would harden the market because two things would happen. First, actuaries and underwriters would feel the need to radically adjust their pricing and second of all there would be a little bit of a suspension of confidence. Investors would come back into the market, but they wouldn't come back immediately and there would be much greater constraint around how that capital is put to work.
What would be your response to those who say the claims-paying ability of the non-traditional market has yet to be tested by a major event?
The traditional industry has more clear and present evidence of willingness to pay issues than the capital markets. The capital markets has paid every claim that has ever been presented, in full so you see good evidence of robust willingness to pay. One of the things people worry about is distressed cat bonds will move from regular cat bond holders hands into the hands of restructuring types, but it's all hypothetical and at the moment the burden of proof is on the traditional industry.
Users who have registered (for free) can read the second part of the interview here where Mr Millette discusses opportunities beyond natural catastrophe risk and how technology might change the structure of the industry.
Posted: Monday, February 27th, 2017