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July 14, 2006

Soggy toast

Dear Friend,

On my travels in the last week I've been picking up the scrag ends of a hundred conversations overheard in the many dark alleys and assorted bars between Fenchurch and Leadenhall.

Here's a selection of three:

“Coast is toast” — apparently this one's getting to be quite a catchphrase at the moment.

And another: “Same layer, same price, double the retention”

I'm sure the remaining retro players are loving the sound of that one!

And how about this? “We're a quarter of a the way through the season – if we don't get a big storm soon — I think Gulf wind rates could fall off a cliff.”

How do you get from the first two to the last one? Surely there must be something wrong? Why might rates fall off a cliff when all they seem to be doing is tightening?

The answer is simple — if you believe the first market consensus that coast is indeed “toast” that fits in with the whole crème brûlée idea I'm doubtless you're sick of me spouting.

Apologies for mentioning it again, but according to this worldview, the Gulf Coast is indeed the caramelised topping on our favourite sloppy French-named pudding.

But that means that there are plenty of extremely good risks out there getting unfairly caned because of a lack of reinsurance supply. But as we must keep reminding ourselves, global capacity is undented and the only reason it is not being deployed is because of a lack of will, not a lack of financial strength.

To put it in base terms, after a crummy 2004 and a terrible 2005 no-one wants to be taken for a chump in 2006 by writing a whole bunch of Gulf wind exposure. This explains the doubling of retentions for the same premium spend.

But therein lies the opportunity – which brings us on to the third comment.

Don't forget that most of the rest of the world is in an accelerating soft market and today's prices are about as good as you can get without turning your clients away in disgust.

This opportunity hasn't escaped some well-respected market leaders — so how many more North-Atlantic Hurricane-free days is it going to take for the perception to change and the unseemly stampede to begin?

Coast may be toast, but after too long sitting on top of a congealed crème brûlée, even the most carbonised crusts can get a little soggy!

July 7, 2006

Flea-sized markets get prices wrong

Dear Friend,

“Would you like to buy a $20 note for a fiver?"

Sounds too good to be true, doesn’t it? But that’s what our market is saying right now.

Today’s market is producing one of the best underwriting opportunities likely to be available in our lifetimes and it’s all down to a lack of liquidity.

We are in an industry that produces about $200bn a year in premiums.

Now I know this sounds like an awful lot of cash, but over $40bn is traded on the New York Stock Exchange in a single day, (and that doesn’t even include what is traded on Nasdaq or the American stock exchange).

So in volume terms NYSE stock brokers get through a whole year’s worth of reinsurance business in a week — no wonder they all seem to be better paid that their insurance cousins!

But hang on a minute — look at foreign exchange transactions and stock deals start to look microscopic. The traders in the 24-hour global Forex markets notch up an awe-inspiring $1.9 trillion a day – in other words it only takes them two-and-a-half hours to put through what we do in a whole year.

To use an animal metaphor, if Forex is an elephant and stocks and shares are a mouse, reinsurance is a flea on the mouse’s back!

In the jumbo foreign exchange market when you change dollars to euro and yen and back again, you get great deals and tiny transaction costs — when you buy stocks you pay a slighter bigger spread and when you get to reinsurance the costs are vast in comparison.

Have you heard the well known apocryphal story of a private investor who was tipped a hot small-cap mining stock and immediately called his broker an placed a buy order?

The next day he opened his paper and saw that the stock was up 10% — he was feeling very pleased with himself and called his broker and told him to buy some more. The next day the stock was up another 10% so the man bought a little more.

Low and behold, the next day it was up another 10%. Now sitting on a tidy gain and thinking it would be prudent to take a little profit, the guy called his broker with an order to sell.
“But who can I sell the stock to? You’re the only one buying” came the broker’s reply!

Illiquid markets make for massive price swings and mis-pricing. The global retro crunch is the latest in a long line of pricing mismatches thrown up by our business, and it surely won’t be the last.

Admittedly reinsurance is not like money or stocks – all dollars are identical but no two reinsurance deals are the same.

But you get the picture — more liquidity required!

Spare a quiet thought for us here in London – today we are celebrating, (although this hardly seems to be the right word), the first anniversary of the multiple suicide bomb attacks on London’s public transport network.

I can’t believe a year has passed since that awful Thursday morning robbed 48 innocent people of their lives.

We all hope that the events of last summer will never be repeated — but deep down many of us here feel that it is only a matter of time before another attack comes.

We millions of Londoners carry on — life is for living, and despite being near the top of international terror’s wish-list, London is still a great place to be.

July 1, 2006

Before you get into a sidecar, make sure you know who's driving

Dear friend,

"Yes - I'm giving you my pen and yes, that means you can burn me, but remember, if you do, I'll never do business with you again."

A decade on and the simple analysis and thinly veiled threat of a long-serving Lloyd's broker binder underwriter continues to ring true. I'd just asked him what safeguards he had against our Spanish broking firm writing for income and stuffing a Spanish property reinsurance facility he was leading off for us full of absolute rubbish.

He said that quarterly borderaux were quite handy and that he could occasionally ask for chapter and verse on individual risks if he was worried, but ultimately he knew that he had no real safeguard other than the fact that he knew us well and trusted us not to act against our long-term mutual interests.

The only ultimate sanction of any power he had was the threat of withdrawal of his support when renewal time came along. As it turned out, we tried our best not to burn him - having a binder gave us kudos and leverage in the market and opened up doors to potential customers.

So, why the intro? It hints to the fact that what holds for broker binders also holds true for sidecar financiers. Sidecars are the latest manifestation of the efficient deployment of capital in the reinsurance market.

On the face of it, a sidecar deal works like a marriage made in heaven - a reinsurer is able to leverage the skills of its underwriting team and its position in the market but without having to give away ownership of the firm or unbalance its finances through piling on more debt. Sidecars also protect reinsurers from the damaging consequences of having to pull out of lines of business that they feel their balance sheet can no longer handle.

In turn, sidecar owners get to deploy capital quickly into the hardest sections of the market over a potentially short timeframe without having to invest in an underwriting team or office space. Since they only have one dedicated customer, sidecars don't have to bother with the trouble and expense of getting a rating - any security worries can be overcome by collateralising reserves if and when they appear on the scene. Reinsurers complete the work and take a ceding commission.

Additionally, sidecars work well tactically for owners as they give them the chance to test the water. If, after a couple of years, market conditions continue to appear strong, there is nothing to stop a sidecar backer adding to capital, hiring its own team, renting an office and accumulating all the trappings of a full-blown start-up, with or without the blessing of its host reinsurance company.

However the deal is structured, sidecar investors have to be aware that the key to success is going to be in the quality of the team with which they partner. Of course, quota shares contain more inherent safeguards than broker binder business - retrocedants take a decent retention and are often significant stakeholders in the sidecars - but there is no guarantee that these safeguards are going to work in practice.

Ultimately, the backers of sidecars hand over their underwriting authority to the ceding reinsurer - it's as simple as that - to do their bidding.

The troubles at Olympus Re, which in many ways is an early forerunner of the sidecar model due to its close interdependent relationship with White Mountains' Folksamerica Re, serves as a stark warning to potential sidecar passengers in the investment community.

Last month, White Mountains dropped a bombshell by announcing that Folksamerica Re had to increase its gross Katrina, Rita and Wilma loss estimates by $203m (net of reinstatement premiums). The bad news was that under the terms of Folksamerica's quota share reinsurance treaty from 2005 with Olympus Re, $143m of the loss is ceded to Olympus.

To set this in context, on 31 December 2004, AM Best reported Olympus' capital and surplus at $651m. Also, in the 2005 annual report of major Olympus investor Leucadia National, it valued its 20% share of Olympus Re's 2005 storm losses at $123.8m, putting the 100% figure at a whopping $619m. Hence the obvious need for recapitalisation - in which Leucadia did not participate - and the reason why AM Best downgraded Olympus from an A- rating to B- between October 2005 and when the ratings were eventually withdrawn in March of this year.

Fast-forward to today and almost a year after the first storms of 2005 hit, and this huge loss to Olympus is going to be increased by a further 23% at the stroke of a pen.

White Mountains confirmed that without other action, this cession would exhaust the bulk of Olympus' capital and proffered a deal to prop up Olympus to the tune of up to $137m of the ceded losses. As we go to press, it remains to be seen whether Leucadia and the other major Olympus shareholders will go for this deal.

However, the lesson is there for all - from Blue Ocean to Cyrus to Flatiron to Starbound and even Olympus' Helicon - sidecars are high-risk ventures and once into the deal, your only leverage is an implied threat never to trust the driver again if you crash.

Under such circumstances, it is imperative to make sure you trust the driver implicitly before you get in the cab.

Editor's blog, photo of Mark Geoghegan

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