Is Capital a Barrier to Entry? (Property Catastrophe)

Greenwald's Competition Demystified focuses on the barrier to entry as the key competitive advantage. That is, the difficulty of new entrants to enter is the main factor to focus on when determining if a company can earn excess returns (i.e. high roic/return on invested capital).  

Given current investments in a variety of (re)insurers and experience in catastrophe modeling. I was struck by the stampede into reinsurance by traditional investors. Reinsurance as an industry may be losing its competitive advantage.

Estimates now show up to 15% of the industry as from traditional capital markets and thereby push rates on line lower. That is, the premium rates paid by primary insurers to reinsurers are coming under pressure by new investors. It seems like in age driven by low interest rates generally, investors are seeking yield again in areas - namely the relatively stable catastrophe reinsurance. As a result, a flood of money has broken through industry barriers. This, to me, is an ominous sign for reinsurers. Given the stable recent returns of catastrophe (ILS) indices, investors believe that stability and consistent 5-year performance means similar thoughts going forward.

The above graph, in my opinion, is exactly what has the capital markets salivating. It breezed through 2008 with problem! The catch? It is missing 2005's Katrina+ losses, 1992 insurer-busting Andrew hurricane. As a result, fund managers may be blindly running into this arena and are unfortunately supported by 2 erroneous beliefs:

1) Price volatility = risk. I already disagree with this for equities, but for property catastrophe reinsurance (the most popular) it is even crazier. Why would a hurricane care about previous price trends made by humans? The fact that many of indices quoted don't even reach back before 2002 show the lack of data that investors are using. Hurricanes rates are not stable even over decades, yet investors believe the returns from just one.

2) Models are accurate and precise. Catastrophe modeling as a quantitative industry has really only grown in the last decade as well. Major commercial vendors such as RMS, AIR, EQE produce very deep models with 100,000+ simulated events and output losses to the dollar. Most industry veterans recognize that this is just the starting point, but new investors can easily look at results such as standard deviation and expected value/loss to make decisions. 

More specifically, the problem is that most of the risk for higher layers happen in the 100+ year return periods, that is once every hundred years. Veterans use say TVAR 99% (tail value at risk, that is the expected value of the tail beyond 100-yr (1-1/100=99%) events). Even they are wrong.



Bottom line - oversupply in reinsurance (especially property catastrophe) will probably lead to subpar returns going forward. On the other hand, for the first few years (or shorter), primary insurers will get cheap protection and may get an additional boost in earnings.


Careful investing to all,
-Stanley