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Make sure you're near the door

Financial analysts, especially those who are independent and who live or die by the perceived quality of their research, bring an enormous amount of value to our industry

With so many in-house researchers paid to toe the party line, attempting independent thought about the reinsurance sector can be a lonely occupation at the best of times. So, imagine my pleasure when a kindred spirit appears on the airwaves

The research firm in question is Keefe, Bruyette & Woods, and the analyst is William Hawkins. Here is the opening paragraph of Mr Hawkins’ postcard from Monte Carlo:

“This time last year, many hailed Katrina as a global pricing event and sought rate increases across the board. That has not happened, and while ‘soft market’ has rarely been uttered, few would argue that rates outside of US property/catastrophe are going anywhere other than down. This may prove pessimistic, but our conclusion is that this Monte Carlo is giving the first top-down sell signal for reinsurance shares.”

Luckily, Mr Hawkins has the luxury of having a job where he gets to tell it like it is. He is subject to the ultimate monetary discipline by which his success or failure can be measured: whether or not his readers outperform the market. Therefore, poor Mr Hawkins has a much tougher job than I do. But let’s get back to his wise words: “However, life is never that simple, and while competition is healthy, absolute returns — such as they can be judged — appear good. The kind of price competition discussed below can easily, in our view, be lost in the rounding of the large companies and still allow them to post positive earnings surprises

“At this stage in the cycle, reinsurance shares should be trading at peak multiples and hence are vulnerable to this kind of news flow. However, the multiples, in our view, remain depressed, meaning that the likely earnings evolution could still drive an out-performance of key global players over the next 12 months.” He’s absolutely right — reinsurance shares are on paltry ratings — these days even cigarette makers, ports and utilities are more beloved by the wider investment community. But that wider investment community has evolved beyond all recognition since the last peak in valuations for reinsurers back in late 2000. It is playing a much different game, with private equity and hedge funds having multiplied in size and influence since then

Now, instead of looking to buy the shares of a mono-line catastrophe writer as an investment play on increased catastrophe rates after the worst year for catastrophes on record, institutional investors are just as likely to entrust their money to a hedge fund that then goes and sets up a sidecar, or to a venture- capital fund that bankrolls a start-up

Perhaps it is this phenomenon that explains some of the lowly valuations we are seeing at this stage in the cycle — or maybe the investment community has just finally become more savvy to the reinsurance industry’s historically poor track record? Better still, some in the investment community may have gleaned a better understanding of the pricing cycle itself, and know that now is precisely not the time to bid up the industry’s stock

No less a figure than David Spiller of Guy Carpenter hinted as much when he explained how today’s breed of capital providers are much more knowledgeable about our industry than they were in the past

Either way, today’s investors seem as happy trying to beat reinsurers as they are joining them, and see no reason to give reinsurance shares a premium rating — hence Mr Hawkins’ view that for the best players, there could still be a bit of unexpected extra juice to come on the upside. I believe this is highly probable — after all, we are constantly being reminded that underlying terms and conditions are still holding up strongly, and we are starting from an excellent base

Reinsurers have also spent the last four years rebuilding their balance sheets — they have been so successful that that the reserving adequacy gap has now almost been closed. We may even soon be in a position some time next year where technical reserve adequacy is a reality for the industry

As such, the last factor underpinning overall price discipline will have been removed and competition will intensify. At the margins, savvy capital will exit, and naïve capital will overstay its welcome and make the soft market more intense than it perhaps might have been

I’ll leave you with another of Mr Hawkin’s words of advice: “The party is far from over, but make sure you can see the door.”

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