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Insurance Liabilities Could Be Next Big Thing for Investors
Start-up Extraordinary Re is bringing much-needed change to the insurance industry by securitizing underserved risks.
William Dove started thinking about the benefits of a market for insurance risk back in 2005, when he headed structured products in the U.S. for Swiss insurance giant ACE. Zurich-based ACE had built a new credit-default-swap business, underwriting credit protection so it could better hedge its insurance risk and create more-predictable revenue. But Dove convinced his bosses to put the CDS business on hold and start liquidating the insurers $100 million portfolio.
Pricing of these swaps made no sense, argued Dove, who had been in the insurance business for 17 years at the time, starting as an actuary at Bloomfield, Connecticutbased Cigna after he earned a mathematics degree from Haverford College near Philadelphia. The 200809 financial crisis would prove him right.
Although Dove finished selling the swaps three months before Bear Stearns Cos. hedge funds blew up in March 2007, earning ACE a substantial profit, it was clear to him that insurers needed a different way to manage risks and solve the problem of so-called trapped capital. Thats when insurers get stuck with liabilities on their balance sheets, a situation that poses dangerous uncertainty and freezes funds that might otherwise be used to expand and take on fresh business.
Today, Dove is doing something about it. Hes chairman and CEO of Extraordinary Re, a four-year-old start-up that will package insurance liabilities into securities and allow them to trade in a centralized market. Once Princeton, New Jerseybased Extraordinary Res trading platform is operational, insurers will be able to transfer risk and give institutional investors a new class of security that can offer a different source of returns.
Extraordinary Re is targeting new and extraordinary, or baffling, risks, such as damage from cybercriminals, that are underserved by insurers thanks to lack of historical information on claims and losses and the constantly changing nature of the threats.
For the ten years ended in 2015, the gap between losses and what was insured stood at $1.3 trillion, Zurich-based reinsurer Swiss Re estimates. Only 2 percent of the costs of this Julys floods in China, which created an estimated $33 billion in damage, were covered by insurance, according to Impact Forecasting, the catastrophe analysis team of Aon Benfield, U.K. insurance brokerage Aons advisory division.
Insurers are expected to be able to underwrite new types of policies once they begin to transfer some of these risks to traders like hedge funds and commodity trading advisers and get better pricing information from a working market.
Extraordinary Re is counting on demand from institutional investors for the brand-new asset class. As alpha risk-adjusted returns beyond a benchmark has become harder to find in equity and bond markets, investors have sought to be early into unexplored areas where they can earn big profits before competition grows fierce. Timber, high-yield bonds and emerging markets are just a few examples of once-undiscovered assets that are now mainstream.
The new insurance-backed securities also are a novel way to diversify investors risks and sources of return, the Holy Grail when constructing portfolios. Theres zero correlation between the events that cause profits or losses in insurance Did a hurricane happen or not? and the drivers of equity and fixed-income prices, says Dove, the seventh in a line of William Franklin Doves from Madison, Wisconsin, who is surprisingly mild-mannered, given his desire to shake up the historically conservative insurance industry. So this is high-return, low-correlation thats the appeal to investors. Extraordinary Re is the story of the birth of an investable asset and the potential transformation of an industry.
Jonathan Hook, chief investment officer of the $2 billion Harry and Jeanette Weinberg Foundation, based in Owings Mills, Maryland, agrees that pension funds, endowments and others will gravitate to the asset class. Investors have recognized that higher returns will come from areas outside the mainstream, but the low-interest-rate environment that has persisted since the financial crisis has made the search more critical, Hook says. Insurance is intriguing because of the industrys consistent cash flows, he notes: But it hasnt been an investable asset.
Extraordinary Re will operate like many centralized markets. With access to underwriting information, traders will put up capital and buy and sell securities based on proprietary models and their own views of the risks embedded in the insurance contracts. Quantitative managers, including statistical arbitrage hedge funds, may be able to bring innovative ways to assess risks to the insurance industry, such as analyzing social media data or satellite imagery.
Joseph Rosen, Extraordinary Res head of capital markets and chief marketing officer, who previously headed trading technology at the New York Stock Exchange, says it will be especially interesting to see what data and analysis participants on the platform use to inform their trading decisions. But he emphasizes that trading strategies are confidential and that the particular method of analyzing risk isnt important. How is a hedge fund trader going to understand how to price cyberrisk when an insurer cant do it? asks Rosen, who was founding chief information officer and head of quantitative research at New Yorkbased hedge fund firm Highbridge Capital Management from 1990 to 1993. It doesnt matter whether any individual can get to an exact answer on the number of claims or any other metric; its the wisdom of crowds, adds Rosen, an American who volunteered to fight for the Israel Defense Forces elite Golani Brigade in 1974 and is as talkative as Dove is careful with his words. The more participants the platform can attract, the better. The mean of all estimates of smart people is very close to the exact price.
Extraordinary Re, which will be incorporated as a Bermuda-based reinsurer, was founded by Oakley (Lee) Van Slyke with investments from almost 20 individuals. Van Slyke is a four-decade veteran of the insurance business, having founded several start-ups and spent 15 years consulting to insurers on their capital structures. I thought a lot about how tied up the capital of insurance companies is, he says. I wanted to know what would happen if we had a market for these insurance liabilities, like we have for stocks, bonds and commodity futures, and we could see the price. Thats what led to the concept of XRe.
The firm plans to have a working version of the market by the end of the year. Still, it needs to attract insurance companies and about 40 to 50 trading houses before it can open its doors.
Extraordinary Re isnt the first player to want to introduce liquidity into insurance markets. Insurers and reinsurers have already been successful in bundling hurricane and other catastrophic event risk into catastrophe bonds, creating a $25 billion global market, according to Artemis, a U.K.-based news and analysis service specializing in catastrophe bonds and insurance-linked securities. Investors are hungry for the insurance-linked paper, which yields far more than other fixed-income instruments. But these bonds have addressed only a few types of risk that can fit into a bond structure, and theres no active market where investors can buy and sell such instruments.
The rise of the catastrophe bond market highlights investors appetite for new securities, particularly those linked to insurance. A growing number of institutional investors are interested in insurance as an asset class, say experts in insurance and asset management. In 2014 the Canada Pension Plan Investment Board acquired Wilton, Connecticutbased Wilton Re; a year later money manager BlackRock teamed up with ACE to launch a reinsurer. But there have been losers. Traditional reinsurance companies have seen profit margins squeezed as they find themselves competing with catastrophe bonds. Historically, reinsurers were the only game in town, giving primary insurers a way to mitigate their risks.
Still, the industry needs a fresh source of capital for underserved parts of the market. Investors in the new securities will be able to share in the ups and downs of insurance. Insurance is buy and hold, says Todd Bault, a former insurance analyst at Citigroup. You write a policy, and then youre stuck with it. In a 2015 report titled Insurance, Disrupt Thyself!, Bault wrote that it is clear that [Extraordinary Re] could generate a lot of interesting new price discovery and could well change assumptions about how various lines of business should be valued.
Besides cybersecurity, Extraordinary Re will target a handful of other classes of insurance, including contingent business interruption, or protection of companies from global supply disruptions; hurricane insurance in emerging markets; product liability for medical devices and pharmaceuticals; and flood protection, a threat that is increasing as the climate changes. In insurance industry jargon, these are low-information risks, which are difficult to price.There is a need for a broader pool of capital to absorb new business risks, and the easiest way to do that is building a bridge between the insurance industry and the broader capital markets, Dove says. The bridge is Extraordinary Res market.
Extraordinary Re may find its acceptance into the market slowed by concerns about complexity. Although the firm will be ultimately responsible for the liabilities as a reinsurer, few have forgotten how mortgage-backed securities allowed banks to transfer the risks of home loans to investors, with dire consequences in 2008.
However, the insurance industrys response to gloomy economic conditions might work to Extraordinary Res advantage. Insurance companies hold securities 90 percent of them in fixed income to back their promised payouts to customers. But interest rates are at historic lows, and insurers are suffering as some of their investments earn almost nothing. Extraordinary Res service may get a tailwind from insurance executives who need to make bold moves.
Insurance companies could operate more like banks, which get paid to advise on structured debt and initial public offerings, says Leonard Goldberg, founding CEO and director of Cayman Islandsbased Greenlight Reinsurance Co. For example, Chubb (ACE took its U.S. peers name when it acquired Chubb in January), which has expertise in underwriting, pricing and claims, could originate insurance and sell it through an exchange like Extraordinary Re. Right now only a small number of insurers make such deals via reinsurance companies.
Rather than keep all the risk on their books and waiting years to see how the insurance works itself out, they can get paid as an originator, says Goldberg, who emphasizes that insurance companies running this way would require less capital and could become more valuable to shareholders. One of the frustrations of insurance is that most companies trade close to book value, he adds. Under this model, they could sell for a double-digit multiple of earnings.
Goldberg says a liquid insurance market could better the world. He gives the hypothetical example of offering a drought insurance policy in Ethiopia to promote much-needed farming. Were talking about billions of dollars in risk for a single event with little data available. A drought policy might get underwritten if an insurer or a government agency could transfer the risk in an efficient market filled with capital providers willing to buy a piece of the liability because of their unique views on climate, world poverty, farming and other factors. You could underwrite products that no one has ever thought of before and support millions of people by helping them take a risk like farming in an uncertain climate, Goldberg concludes. With investors like Weinberg Foundations Hook eager to find reasonable returns and conduct the research required to put money into new areas, insurers may find it a good time to change
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