The Right Question: Thoughts about value & margin in a disrupted industry

New Capital Brings Questions of Value and Margin to the Insurance Industry

Mark Watson discusses disruption in the insurance industry.

This article was republished with permission from Reactions.

by Mark E. Watson III

Mark Watson invested in Argo Group’s predecessor company, Argonaut Group, in 1998, joined the Board of Directors in 1999 and has served as President and CEO since 2000. Prior to joining Argonaut, Mr. Watson was one of two founding partners of Aquila Capital Partners, a Texas-based venture capital firm focused on technology and life science related companies. Before founding Aquila, Mr. Watson was an Executive Vice President and member of the Board of Directors of Titan Holdings Inc., a NYSE-listed property and casualty insurance group, from 1992 until its acquisition in 1997 by USF&G Corporation. From 1989 to 1991, he was an Associate Attorney with Kroll & Tract, a New York law firm focusing on international financial services clientele.

As new capital flows into the insurance space from institutional and individual investors, everyone in the industry is asking if these trends are the first wave of an irreversible disruption of the value chain. They are disruptive and the disruption is irreversible, but the wave crashing over us now began building more than twenty years ago.

In the mid-nineties, I first heard of capital markets and individual investors outside our industry weighing the advantages of jumping into insurance for the first time. Looking for places to deploy capital and generate positive returns, players in other sectors noticed then that insurance is quite profitable when catastrophes are absent. Free of the financial burdens faced by regulated insurance companies, they hoped to ante up in select short-tail risks, get lucky and avoid losses, reap some rewards and cash out before any catastrophe occurred. Twenty years later, they account for a substantial amount of our industry’s catastrophic capacity. Weighing risk against reward, they steel themselves against the considerable losses they might suffer if the wind blows and the ground shakes. Why not? As returns from traditional fixed investments continue to be low, such risk taking is easily rationalized. Their entry into our space was the genesis of the class of investments we now know informally as catastrophe bonds. Structured more like credit default swaps, their continuous quarterly payouts give them the look and feel of bonds. In my opinion, this development was just the opening chapter in the story of the wholesale disruption of our industry today.

Risk looks better from the outside.

The market for these catastrophe bonds grew quickly, as did other risk-transfer mechanisms we refer to as insurance-linked securities (ILS). Today, as much as 80 percent of the retrocessional market is served by collateralized reinsurance backed by investors seeking to participate in reinsurance risk directly. Similarly, the flow of this kind of capital into the insurance space has increased every year. No wonder. Outside investors have an advantage over legacy carriers. They’re able to keep expenses much lower than we are, so even a lower price will generate an adequate return. In addition, these risks are among the largest aggregations faced by insurers, while for most investors they are a diversifying investment. Between the benefits of diversification and low expense, the return required by investors in this space is lower than what the equity markets require from the insurance companies in which they invest.

That too makes sense. A required return is driven by the sum of all the risk you’re asking an investor to take. When a shareholder buys stock in an insurance company, the risk of an actual catastrophe is only one of many. That company might make poor decisions about its own investment portfolio that could directly affect net income. It might spend too much money by being inefficient, offering policyholders terms that are not sustainable, or writing a whole book of business that simply disappears. With all these issues at play, most investors judge the required equity return from an insurance company to be about ten percent, at least in the current rate environment. Not this new class of investors; other than the wind blowing and ground shaking, they risk little. As such, they can be satisfied with a return of six, five or even four percent.

All eyes on the margins.

Last year, many of us expected to see cedents buying more reinsurance as pricing continues to decline. That happened, but it hasn’t yet helped reverse the trend to undercharge. There’s still too much capacity in the market and margins are at an all-time low as a result. Where margins are low, all-digital services have an advantage. That has many of us pondering if the all-digital companies we call InsurTech will begin to target specialty insurance and reinsurance, where margins are better.

My prediction is no in both cases. Specialty insurance, where scale is smaller but margins often higher than in personal lines, may seem a desirable target for these capital-rich entrants, especially Fintech unicorns with their $1+ billion valuations. But specialty insurance is tough to underwrite without deep domain expertise in a diverse group of disciplines. As each new risk emerges (think of cyber today), the aggregate data that can be used to judge the degree of risk is slim. Even systems that leverage artificial intelligence and machine learning will have too few numbers to crunch to make an accurate assessment of likely outcome. Over time, the data will become richer, but, as it does, margins will compress as a result. (Specialty has better margins only when an insurer covers risks on the edges of the market that are more difficult to assess.) Similarly, success in the reinsurance market is complex. While underlying risks are relatively easy to identify, they can be enormous in scale. There are fewer events, any one of which can be severe. So reinsurers have two challenges. First, it’s difficult to get enough data from one event to predict either the likelihood or severity of the next one. Second, losses from these large events can quickly erode the capital base of any reinsurance company. (Some companies have been wiped out after a series of catastrophic events within a short time.) Neither of these conditions will give comfort to either capital markets looking for easy profits or investors looking at short-term involvements.

Legacy or digital. Who will emerge as winner?

Our current market’s dismal margins are as much a harbinger of imminent, massive change as they are the result of shortsightedness among those who have refused to change. But new entrants to the insurance industry—be they capital market investors seeking better profit or digital players looking for a new game to disrupt—will not have an easy time of it on their own. Our insurance industry is deeply regulated to protect those who trust us to be there when something bad happens. Rigorous public oversight of our activities has in our own lifetimes lifted insurance from an incomprehensible and suspect player in the financial sector to the very backbone of growth in a progressive and increasing global economy. Ethical behavior, proved by transparency and accountability, is now expected. And regulation, as messy as it can be in multiple jurisdictions, will continue to be the watchdog of ethics.

Great changes are upon us, and no one looking to break or overlook the rules will last for long. In my opinion, the judicious use of cutting-edge technology combined with insurance expertise and experience represents the clear and, for established insurers, successful path to continued growth. By building digital expertise, often by forging creative partnerships with existing digital players, we will collaborate in ways that bring capital closer to the risk, reduce the complexity of our offerings, and offer even greater value to our customers.

In my experience, the wise thing to do in times of change is pose the right question. In the past few years, the vast majority of industry underwriting profits have come from property risk where the catastrophes that might have occurred haven’t. The question before us all now is, “How will our industry adjust when we lose that tailwind?” Without doubt, we will be digital and our capital will be close to the risk. It’s up to us all to determine how to do that in ways that benefit our customers and, because of it, ensure our own wellbeing.

Interested in learning more about insurance industry trends from Mark Watson, CEO of Argo Group?

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