With our Future of Reinsurance panel. The reinsurers delivered strong results in 2013, where pricing is being impacted in part by the entrance of new alternative capacity and capital. It's something that's certainly important to explore. Here to help us address the future of the reinsurance industry, we have two very important CEOs with us, Kevin O'Donnell from RenaissanceRe, and Ed Noonan from Validus. With that, let me turn it over to Sarah, and she'll lead the discussion.
Great. Well, thank you. We have first from RenaissanceRe is Kevin O'Donnell. Kevin was named CEO of Ren in 2013. He was previously global chief underwriting officer. He's been with the company in a variety of roles since 1996. Then on my right here immediately is the CEO of Validus, Ed Noonan. Ed has been chairman and CEO of Validus since its formation in 2005 and has 34 years experience in the insurance and reinsurance industry. Thank you both for joining us.
Clarification.
Sure.
That would be one year, 34 times.
Okay. To start off, there's been a tremendous flood of capital into the reinsurance industry. What does that mean for the future of reinsurance? Maybe, Ed, if you want to start, that'd be great.
The various forms of capital coming into the industry, the one that I think gets the most attention has been pension plan money coming into the catastrophe business, hedge fund money coming into the catastrophe business. You also have hedge fund money coming into the broader reinsurance business in search of float to create ongoing permanent capital vehicles for hedge funds, and that each has different effects. I think the ILS money that's come into the catastrophe business has largely been complementary in that it has tended to play at the higher levels of risk and more remote risk, which are pretty capital intensive for people who underwrite against their own balance sheet. From our vantage point, that's been a very comfortable phenomenon, although it may not always be. To date it has been.
You see some of the hedge funds investing in sidecars to write retrocession and lower layer risk in territories like Florida, which are premium intensive and more volatile. Again, that's been largely complementary and both we and RenRe have, I think, done well in managing money in those spaces and getting paid well for it. I think the real issue is how long does that go on? How much money comes in? Obviously, the global pension funds dwarf our industry many times over. It's really, I guess the forward issue that is more critical.
Do you have a view on that?
Yeah. Look, I'm getting old. Kevin's a young guy. He'll figure it out. No, I think the ILS money has kind of captured the low-hanging fruit, that high layer of risk. There's the notion that there is a lower cost of capital. To some extent, that's true. Pension funds in particular may have a lower hurdle rate for return on capital because it's a non-correlating asset, and they just want exposure to the sector. If they're willing to accept a 6% or 7% return on that money, that's better than we can do using our own balance sheet. That doesn't actually translate very well, though, as you get lower and closer to the loss. I think, as I said, they've kind of gotten a low-hanging fruit.
To continue to move down risk, they'll have to overcome some structural hurdles and return hurdles to accomplish that. I think the second perceived cost of capital advantage is that they have a lower cost of capital for peak zone risk. You see ILS money playing for the most part in Florida and more broadly for U.S. wind. It's broader than that, but the vast majority, I think, is in those two areas. Again, if you're underwriting against your own balance sheet, those are your peak exposures, your highest cost of capital risks. Again, that near-term advantage is pretty comfortable for us as a reinsurer. We're happy to manage that money on their behalf and not have to use our capital in those spaces.
From here, where it goes, I think to move further down the chain of risk is going to be there's some real structural challenges in it, not least of which is that customers aren't yet, at this point, anywhere near as comfortable using index products or cat bonds or even traditional reinsurance from ILS players in the same way that they do the traditional reinsurance product with long-term continuity reinsurers.
Okay, great. Kevin?
I think we think about the world in a similar way as to what Ed described, I think you've asked about capital. I think it's important to think about the risk side as well. If you look at the capital, it's kind of interesting where we're used to capital coming in, it comes in historically in very intense periods, it's come in after events when rates are going up. What we're seeing now is capital looking to come in when rates are going down. I think that's kind of a unique thing for this cycle. The other thing we're seeing is the amount of risk that's coming to the market outside of some small increases in Atlantic hurricane really isn't expanding. You've got reasonably flat supply, increasing demand, and falling prices.
I think you break down the type of capital that's coming in, and I think Ed touched on the two most prominent types. One is that that's interested in property cat or the type of capital that we've managed for a long time, and the new hedge fund capital coming in looking for very different type of returns. The capital that's coming in on the reinsurance side I think is capital that there's a lot of talk about the efficiency that that capital brings, and Ed touched on it being very capital, can be capital efficient for peak zone, which we agree with. I think there's an extension that it's always cheaper capital, and that's just not true.
If you take different vehicles that we've put together and Ed's put together, those vehicles are like, if you take Top Layer Re, for instance, that is the most efficient vehicle to write high-layer international risk. For a pension fund to come in and say that they're more efficient capital, they're actually just competing on standalone price. They're writing risk cheaper than we are willing to accept it on a standalone basis. With that, I think there's going to be, although this capital is going to be permanent, I believe, or we wouldn't have built what we've built here, and you wouldn't have built what you've built. I think there'll be cycles. The fact that risk is being priced at levels that we think is challenging for us to commit to, it's not an efficiency issue, it's a standalone issue.
I think that will create some degree of cycles, although the capital will be here. The other piece of capital that's coming in is the hedge fund capital. What we've been paid for is to write risk that brings an underwriting return. With the hedge fund capital that's coming in is largely being paid to write risk to facilitate a highly liquid or theoretically highly liquid tax advantage way to participate in hedge fund returns. I think if you think about it, these things are coming in for different reasons. One of them, they're paying us to underwrite.
The other one, they're saying, "I need underwriting risk or reinsurance risk in order to facilitate this capital stream that my investors want." I think there's value that underwriters can add in each of them, but it's a very different approach to the value that one can bring to servicing that type of capital. In the end, all of the efficiency that this capital brings in is something that will ultimately need to be transferred to the buyer. The excess returns that you can have from a first-mover advantage or from having the most efficient capital, this is a transparent, this is an efficient market. Those efficiencies will ultimately move to the buyer.
I think those that are best situated to add value as the conduit between desirable risk and efficient capital are going to be the winners, but not everybody's going to be able to do that or make that transformation as efficiently as they need to.
Okay. You touched on this a bit, but maybe you could just elaborate. What are the competitive advantages or disadvantages of traditional reinsurance versus the alternative reinsurance? You mentioned non-peak zones, traditional is just as competitive or more competitive, as well as lower layers. Is there anything else you would add to that list?
Well, there's structural issues in the products.
Okay.
First, the traditional reinsurance product has been around for hundreds of years, it has been litigated, tried, tested in the courts, there's a rich body of legal precedent that you can generally rely on. Inability to pay is relatively infrequent, willingness to pay relatively infrequent, it matches up perfectly with the customer's needs. It covers their underlying ultimate net loss. It doesn't introduce basis risk. It introduces counterparty risk, but no basis risk. It's actually a very efficient product. The ILS product has other positive attributes, but in most areas, it does introduce basis risk. It doesn't have the long tried and true kind of legal interpretations that you can rely on. We don't know yet about willingness to pay. Ability to pay isn't really a question because most of these are collateralized in the end.
Willingness to pay will take time to sort out. I don't mean to imply that there's an issue. It just hasn't been tested yet. The traditional reinsurance product is an evergreen product. If a claim occurs today and 5 or 6 years from now it develops adversely, you go back to your reinsurer and say, "Gee, sorry, but my earthquake from San Francisco in 2014 just developed." That traditional reinsurer says, "Okay, well, we owe you the money." In the typical ILS, you release the collateral at some point 3 or 4 years out, you don't have that evergreen nature of it that you can go back and rely on to the same extent.
It doesn't have necessarily the same continuity value in that if you have a mega event in September or October, all that capital is going to be tied up for the following year. If you're a buyer of reinsurance through that product mechanism, can you count on being able to renew coverage the following year? They're going to have to literally double their capital at risk. Can pension funds go back to the investment committee and make that decision very quickly in the span of a few weeks to be able to meet the market need? Some will, I'm sure. Maybe all will, but I think there's an unproven element to that. The traditional reinsurance mechanism works extremely well for customers.
I think the ILS, there's no reason it shouldn't ultimately work extremely well, as with any new product or structure, there's a sorting out period that we'll have to go through before you can get to that point where you say, "Yeah, this is just a good ready substitute for the reinsurance product.
Okay. Kevin? Your thoughts.
Yeah, no, I think those are all great points.
Kevin, by definition, I made them. They're great points. Come on.
Yes, they are. That's an excellent point as well. I think from a capital, I think the peak zone is one. Another one I'll touch on a little bit, I think another area that non-rated balance sheet or third-party capital can be effective is where you build leverage into the product. A worldwide retro or something like that, where you're taking lots of different territories that can be exposed, being paid for each of those territories, but only providing a single limit. I think there's an efficiency there because it uses a lot of capital on a rated balance sheet. The reason it uses a lot of capital on a rated balance sheet is because we do that by writing a lot of different types of cover.
By having excellent ERM and different ways to think about our exposure, we can expose our capital more than once. I think we have a natural benefit in being able to do that against ILS capital. I think ILS is effective in certain situations. That's why we both brought it to the market. I think the way in which it's sold, there are some structural issues that are difficult to overcome. Ed touched on a lot of them with regard to the rated balance sheet, the evergreen nature of it, the fact that we all deal in an utmost good faith environment. We understand what people are buying and the risk that they're ceding to us and how we're underwriting it. Ed touched on another important point, which is ability to pay and willingness to pay. Having collateral provides and gives you assurance of the ability to pay.
I think it is a different thing to have to take the money, it's a different discussion to say that, "Yeah, it is yours to take," and that's what the agreements say. I think there is a long history in reinsurance of how to solve those sorts of issues. There's less of a track record of how to solve those issues, which are sure to emerge in the ILS world. Overall, I think there is room for both types of capital in this business, it's funny, when we're on these panels, if we were to go back 5 years ago, it would've been underwriting discipline and how do you underwrite. Now all we do is talk about the cost of capital. That's really why it's here. If it's more efficient capital, we have an obligation to deliver it to our customers.
Our role is just to make sure we provide a valuable service in the delivery of that risk and delivery of that capital. I think it'll be here to stay, I don't think either one's going to be the 100% winner of the future. I think it's going to be a blended platform that's the winner.
Let me put in a plug for the Renaissance and also Validus model on this. RenRe's been at it longer than anybody. When you're representing third-party investors, if you're a reinsurer, you come from that same context of utmost good faith, you say, "Look, I don't want to deal with third-party investors that don't understand the risk they're taking on. I don't want to sell them a product that is based on just me having bought a single license to a commercial model running the most basic version of it and saying, 'All right, so that's all good.'" The reason I bring that up is that when you think about what will have to be ultimately the source of arbitrations, litigations, however you want to think about it, is there will be events that happen where investors say, "Wait a minute. I didn't expect that.
I never saw that." Then they'll say, "Hey, that was a non-modeled peril. You told me you model everything, but that's not even in the commercial model. How can that possibly be?" There's a little bit of an element there of you get what you pay for. If you pay 65 basis points for somebody to manage your money, they're not going to have the type of in-depth analytics and research that a Renaissance or a Validus has. On some level, their job is simply to put the money to work as quickly as they can take it in. From an investor standpoint, there will be some sad stories and all the associated legal actions that will go with that. That makes me uncomfortable. It will discredit the product in some quarters when it comes to the fore.
In some ways, slow down what should be a very positive structural change in the capital, the industry, and how the industry uses capital. We see it every day. That's not a good thing. That isn't to say that all ILS managers are alike in that regard. There are some that are very professional and very knowledgeable, but not all. That gives me a little bit of concern.
Okay. Given that there's still a lot of third-party capital on the sidelines, do you expect prices to still spike after a big event if this capital comes into the market?
The way we approach the world, we price risk based on the amount of volatility and the amount of capital that it's using. I think, in the market, if you look at it more generally, there has been a tendency for prices to rise pretty materially after an event. The discussion that third-party capital has brought to bear is really whether there'll be cycles or that sort of punctuated equilibrium will occur again. I think my belief is there'll always be cycles. There'll be times where different types of risk are more in favor or less in favor, but the amplitude of the cycle may be less. If you go back at one-one, we saw pretty materially softening at one-one. That would challenge that. Well, on the downside, we've seen that there's still a cycle.
The evidence we have is that there's a cycle on the downside. I believe there'll be a cycle on the upside. It'll be interesting to see whether the amplitude is truly less. Part of it'll depend, as it always does, as to the type of event, how large the event is, how surprising it is, what else is going on in the world.
I think what will change is, it already has to some extent, you only get one shot at it after an event today. Something happens, it's not like the market is going to correct and then correct again the following year. One shot.
Yeah.
I think Kevin's right. The amplitude is a bit unknowable, but probably there's a downward bias there. Certainly the duration of market corrections is now instantaneous and over, which is a very different circumstance.
Okay.
What does that mean, Ed?
You have a big loss. Sandy happens. You get to charge for it at January 1 for all those renewals, at July 1 for those renewals, that's it.
Yeah.
The following January 1, there's no more market movement based around Sandy. You get one shot at, if it's pricing correction or pricing adjustment, however you think about it, that's it.
Do we see the same with more concentrated markets, like the big international losses in 2011, 2012, Tōhoku, New Zealand earthquakes, Chile? Is it pretty much a one renewal opportunity?
The Aussies, you're lucky if you get one renewal opportunity at it. Yeah, no, the Japanese market corrected. Rates basically doubled and stayed there. That's it. There was no ongoing correction from that.
Yeah, I think if you take it was regional, and it was short-term. From an underwriter's perspective, you need to act more quickly and probably with less information. I would argue that we were probably headed there anyway. I think whether this new capital came in or not, I think people had greater confidence in understanding the loss. People had greater confidence, not only what was being ceded to them, but to how much risk they took. With that, I think there was more certainty to put out limits post-event. With or without third-party capital, this was a trend I think we were going to see.
Okay. Looking at your own third-party vehicles, how do you think about the economics of managing that business for a fee or taking the underwriting risk yourselves? Maybe Kevin, if you want to start.
Sure. Obviously, it's fee income versus risk income. The first thing we do is when we're thinking about bringing in capital, we look to the customer and see if there's a market need. Once we recognize there's a market need, we figure out whether it's our capital or somebody else's capital. I think it's one in which there's no right answer as to exactly how to calibrate it, but it's one that having more capital under management is not a victory to us. I think what we look at, one of the things I've said before, we can double the size of DaVinci, find investors who will take half the return and keep our fees the same. Everyone's like, "Oh, that's been a huge success. They manage more money," but nobody in the economic system's made more money.
I think we look at it as kind of delivering value to the customers and delivering value to the investors. The other thing I think one needs to be careful about is to determine whether this is incrementally new business to you or if it's cannibalistic to your existing book. You can set your fees based on that. If it's incrementally new business that you may not otherwise be able to write, you can accept a lower fee than if it's, at least the way we would analyze it, than if it's cannibalistic or business we already have, but we're going to share it with a third party. I think there's multiple ways to kind of come in and think about the right pricing of it, but it's not one simple solution, one simple formula for all sorts of capital, all sorts of situations.
We're not terribly dissimilar. We're not terribly interested in cannibalizing our existing business. When we look at high-layer third-party capital, we look at that as being additive in two ways. First, it's nice to get fee income, more importantly, it makes us more valuable to the customer. If Validus Re puts down a line AlphaCat puts down another big slug of capacity next to it, that customer just got more and better value from us, and that makes us more important when they think about their reinsurance next year and the year after that, et cetera. For us, we tend to start with the market positioning strategy more than the fee income strategy. On sidecars and that, a bit different.
Yeah, in some ways it makes us more valuable to the brokers because we can help them solve problems, but that's more of a straight in, we like 2 and 20 economics like everybody else, and when there's opportunities to put sidecars together, that's a good way for us to monetize our skill set in generating business and underwriting it and analyzing it and bringing it to investors. It's just kind of two completely different segments in the way we think. The one very much strategic in building our core business, and the other one pretty opportunistic.
Okay. Looking at your own vehicles as well, what are you seeing more near term in terms of demand for these investments and opportunities for you to deploy that capital?
You went first last time, huh? I was going to wait for Kevin to answer and then go do what he was doing. There's still some demand out there for retrocession-based sidecar product.
Okay.
You can put more capital to work in that space. We feel a little bit cynical about that because we think that the retrocession market is getting pretty aggressive. Again, we're only interested in dealing with investors that understand fully the market dynamics they're walking into. There's still some opportunity there. There may or may not be a high-layer opportunity. Like Kevin, we don't measure success in terms of assets under management. Simply taking in more assets isn't success for us unless we know in advance how we're going to put it to work with what customers, what type of returns, et cetera. There may be some opportunity. It's not a huge opportunity today. Right now, the market is kind of, at least for a very short moment, at some sort of equilibrium.
Okay. Kevin?
Yeah, I think extending Ed's point on the retro, one of the things we did, we increased the size of our retro sidecar last year. We got rid of our Florida sidecar, changed some of the investors in DaVinci. All in all, absent the retro, we didn't bring new capital really to the market. I think that's likely to be what we see this year. I don't see us putting together, unless something materially changes between now and June 1, a Florida sidecar. With that, I think we're going to end up being pretty comfortable with the platforms that we have. If you look at the way we're structured, there's already a lot of flexibility as to where we can move risk in or move risk out.
It's not one that I would say. There's one hole or something where we need to add a particular type of vehicle to meet some demand in the market.
If you look out longer term, how large do you see the third-party management business becoming as a % of your overall business? Kevin, maybe you want to start.
Again, that's one that there's kind of, I guess there are two ways to think about that. One is, are we growing as an organization or are we changing the mix between risk and fee? I think if we're growing, I would expect that we'll continue to grow our risk and our fee. Whether that becomes materially different than what it is really going to be where the opportunity is and what type of capital to service. We're constantly looking at the right balance that we have between how much risk capital we have exposed and how much fee capital we have exposed. Right now we're comfortable with that mix. We're going into a big renewal at June 1. We'll reassess it throughout that renewal and reassess it post the renewal.
Right now, I would say that where we are is someplace that we're very comfortable. The best case scenario is that we can grow the pie and there's more risk for everybody. Right now, that's not the environment we're operating in.
It's hard to actually plan forward on that issue just because there are a bunch of moving pieces. If in fact there are tens of trillions of dollars of pension assets and they want into our business, which is kind of a $400 billion industry in terms of limit provided, and they want in badly enough, then the day will come when we'll simply not be able to underwrite against the balance sheet because we've been able to generate good returns. We'll give back all the capital and be an asset manager. I don't think that day's on the horizon, you can't rule it out. I mean, when structural change happens, you have to, I guess, be prepared for anything. Like Kevin, it's kind of what do you do in the meantime? I think we feel very good about where we've gotten ourselves positioned.
If suddenly assets under management in and of itself were a legitimate strategy, okay, then we can go out and raise assets and start putting them to work. In the near term, I think we're more comfortable saying, "Hey, here's how it fits strategically and makes us more important in the marketplace and to our customers, and here's the opportunistic piece where we think we get paid really well for what we do and helps us monetize our skill sets." At any point in time that mix will shift based on what's happening in the reinsurance market, in the global interest rate environment. It's a little bit difficult to look out even 18 months and know what that will look like.
Okay, great. Well, maybe if we switch gears now to more of your core business. What ROE are you writing new business at, and where do you see that headed? Maybe Ed, you could start.
Yeah, we don't give guidance, and so if I gave you ROE, somebody would quickly back into that and translate it to guidance. What I would say is that we think of our business as needing to return something on the magnitude of about 1,000 basis points over the risk-free rate, and our risk-free rate is kind of two years. We're currently underwriting business above that target. Not as far above as we were last year, but we're still underwriting business in the reinsurance segment at or above that, in the Lloyd's segment at or above that, and in the aggregate, clearly above it.
Kevin, anything to add?
Yeah, I think when we think about the world, we divide it into acceptable return, low return, and negative return. The negative return, nobody's making money. Low return, you can argue that there's different types of capital. These are our measures that might be able to make some money in it. There's acceptable return. We still have ample access to acceptable return business for us to continue to build attractive portfolios. I feel with where we are today, the risk that we're taking is risk that we're well compensated for, and we measure that in really two ways. We measure it on a standalone basis. Is the risk and the volatility embedded within the session to us or within the risk being sold to us adequate? How much capital does this support, therefore measuring what's the marginal return to us?
By doing both, I think we avoid some of the mistakes that can be made from overemphasizing the benefit of diversification. It's one that we've seen some cracking in the armor as to how we think some other people are looking at it, not only within the rated balance sheet environment, but within the third party capital environment as well. I think for the foreseeable future, I feel very comfortable we can continue to build attractive portfolios.
Is there a quantitative hurdle for that, Kevin?
For our measures between? Yes. What we do is in order to do that, what we do is we capture all the risk that we see, we bring it, we rate it, and then we divide it out as to what sort of returns, not the risk that we're writing, but what returns is afforded to the overall market. Then we can figure out at what segments and what percentage of each segment that we have. It is a very quantitative process that we run.
What do you view as the right run rate premium leverage for your business, and how low do you think this could fall?
Our business has a couple of different components to it. We've got a syndicate in London that can write.
Right
2 to 1.
We've got a reinsurance operation in Bermuda that probably can't write much more than half to one. We could comfortably take on a significant amount more business against our current capital base through the syndicate. We tend to right-size our capital around the reinsurance opportunity at any point in time. While we always leave a reasonable cushion around that, if we were to seek to grow the reinsurance operation by 50%, we have to commit more capital to that. I still don't know that you get much more above 0.6 to 1 in the reinsurance business. A lot of that has to do with mix and where you're attaching and that's a pretty crude way of describing it.
For us, in the aggregate, as I say, we could comfortably probably take our overall business up to something in the 0.8 to 1, particularly if most of the growth is coming from the syndicate as opposed to the reinsurance operation.
Okay. Kevin?
Yeah, I think it's smart to have lots of different ways to think about how much risk you're taking, how to measure risk. That's not one we spend a ton of time with.
Okay.
We think much more about what's the portfolio distributions that we have and how much capital is required to support it. Questions like, what's the probability of losing 1% of your capital, 10% of your capital, 15% of your capital? That'll help drive much more about how much capital you need. Premium, it's much harder to think about premium in the context of understanding the amount of capital required, particularly for the types of lines that we have. I think within Lloyd's, it is a more prescribed environment. Premium will dictate a little bit more of your leverage. In general, I think thinking about it against the stochastic distributions is a more robust way to think about the capital you need to have in your business.
Okay. Maybe you could talk a little bit on what's your view on consolidation in Bermuda, Ed, as an active acquirer in the past, maybe you could start out.
It kind of feels like, "Ed, you've been a serial killer. We haven't seen any bodies lately. What are you up to?" No, for us, there's diminishing returns, certainly in the catastrophe space. There's no need to. Acquiring another catastrophe company doesn't really do much for us, unless it was an attractive financial transaction. When you get beyond that, I wouldn't say that there's no company in Bermuda that we would find attractive. I don't particularly feel compelled by other Bermuda reinsurers at this point in time. I think we would prefer to continue to grow the direct insurance part of our operation. We're about 50/50 today, and I think longer term, we have a bias towards growing the direct insurance operation. That isn't really the Bermuda market. I think there should be more consolidation in Bermuda.
You can see lots of natural fits. I suspect we'll be less the catalyst around that than we've been in the past.
Is that through Lloyd's you would want to grow it or through a different vehicle?
Lloyd's, different vehicle, doesn't matter. We can continue to grow through Lloyd's very nicely almost anywhere in the world. Whatever the right vehicle is to capture market opportunity is what we'll do.
Okay. Kevin, any thoughts?
I think a lot of what we talked about today is just increased efficiency in the business, and I think whenever there's increased efficiency, there's going to be some change. There'll be winners and losers, and I think those that are adding the least in contributing to the rising rate of efficiency are likely to be those that are less needed by customers and by capital. I think we probably will see some consolidation. I think I would've said the same thing if I was sitting here last year.
Yeah.
Okay, great.
You're not sure on the catalyst of consolidation?
I think valuations, if you look at it, were more compelling last year, and we didn't see it than they are this year. I'm not sure what sort of catalyst we'll see in order to have it happen. You would think whenever there's changing efficiency in a market, and I believe our market is becoming more efficient, you'd expect to see those who are performing at a less high level to be taken out.
You measure that based on what? Capital efficiency, expense efficiency?
I would say returns. Yeah.
Great. Well, I can't have a reinsurance panel without a discussion about the mid-year renewal. Maybe if you just give your thoughts on what your expectations are for the mid-year reinsurance renewals, that'd be great.
In the interest of never being willing to talk the market down, I will assure you there will be mid-year renewals. That far, I'm willing to go that far. There's pricing pressure in the marketplace for all the reasons we've been talking about, and so that will probably continue to be reflected in June in Florida and July 1. Florida is, if you're in the ILS business, it's kind of ground zero. You have to put a lot of money to work in Florida. That's the most premium-intensive part of the market. That adds to the competitive dynamic in Florida. I would say last year, the competition in Florida was as much or more driven by reinsurers than by ILS funds. The competition at 1/1, I think, was largely driven by reinsurers and not very much by ILS funds.
I think that's what we're likely to see at 7/1. The competition will be a function of reinsurers to a much greater extent than ILS funds. I don't see the market falling off a cliff, but not kind of willing to try and get specific and give the customer something to shoot for.
Okay. Kevin?
Ed was perfectly vague as I would've been, so I have really nothing to add.
We should have let you go first. Damn it.
The one thing I'll say, there is some demand coming out of Florida.
Okay.
I think there'll be a little bit of uptick in demand, which is something we didn't see at one one. All that said, I don't think that's going to necessarily change the direction of the tide.
Where's that direction coming from?
It's just with all the things we talked about. There's more capital than demand, people want to deploy capital into risk and-
I thought you said demand was going to go up.
Demand will go up. I think we've seen there's been a couple of good things that have happened. The FHCF had a discussion about potentially buying more. Citizens, they've instituted the clearinghouse where some risks have moved away from Citizens. They've also started another round of DPoPs. A lot of the primary companies have had some growth. Whenever there's risk that moves to the private market, there's more reinsurance dollars associated with each dollar of original premium. I think there'll be naturally some expansion there, again, it won't be enough to change the tide of all the things we talked about with rate pressure.
Okay. Absent a large catastrophe loss, how much further do you think reinsurance prices could fall before they hit a floor and you start walking away from business?
I'll go first.
I think every risk has a price. I think, going back to what we said before, we look at a standalone return, and then we look at a marginal return. To think that at one price you walk away from everything, it really matters to the construction of your book. It matters to the volatility embedded in the deal. I think there is scope. I think it has gotten tighter. If you take even just to move outside of cat, and let's look at some of the specialty lines. We've written more quota share. We saw that the underlying fundamentals to some of the specialty quota share business we've written, we actually kind of like. What we've seen, though, is ceding commissions going up.
I think there's places where the price that you're seeing on the primary, the price that you're seeing on the reinsurance, it's not going to be a binary point. What will happen ultimately, if the fundamentals of those businesses begin to slide back, ceding commissions will probably come down. You probably have more runway in that than you do in some other lines, but it's not going to be a single point down 10%, everybody's out. I don't think it'll work that way.
Picking up on Kevin's point, I think we kind of broadly see the world in the same terms on this. We have lots of risks today that we're pricing at 40 and 45% return on equity. That's a function of how it plays against our book or some different insight we have about the risk or perceive that we have about the risk. Most often how it plays against our book. In assembling a portfolio, you have to know that as competition grows, this pool of attractive business shrinks. You're not immune to it. Therefore, the overall portfolio you can construct may have to shrink. That isn't to say that there is a moment in time I say, "Thus far, no further," because everything operates on a continuum.
I think what happens is more business kind of becomes marginal, and you end up kind of pulling back and cutting back your lines as frankly, there are customers that you've worked hard to build a position with that you're not going to leave over short-term pricing. You reduce your lines as much as you can, but you're not going to walk away from the customer. You're willingly accepting a lower return in that circumstance. I think the big thing that helps the industry is that all the money that's flowed in has also flowed into the retrocession market. Our job is to continually try and move the portfolio out towards the efficient frontier. We do that deal by deal. In your retrocession purchasing, you get the chance to do that in a big step all at once.
What we've seen this year with both of the nature and breadth of coverage available and the pricing of it, we're able to move out considerably all at once towards the efficient frontier. That offsets an awful lot of deterioration in other aspects of the book. Yeah, maybe price came down, but the impact of the book isn't nearly as direct as it would seem because we also were able to structure a much more efficient and economical retrocession program. There's a number of moving dynamics that all feed into how well you can construct the book. At the end of the day, every reinsurer stands before the rating agency that says, "Here's how much risk I have," and the rating agents say, "Here's how much capital you need to support that." That kind of becomes the ultimate governor on risk.
That's actually a constructive thing for the industry to the extent that it means that you can't have rates just kind of go into free fall and fall through the floor. I don't suspect that anybody is scraping along near their rating agency minimum, but I suspect they're closer to it than they were a year ago or two years ago. That kind of moves us closer to the point where in aggregate terms across the industry, hey, pricing probably is going to have to reach a bottom.
Okay. That's great. Why don't we stop here and open it up to the audience, see if there's any questions.
As we're doing that, I think Sarah mentioned another part to that question. How significant of a loss do you think it would take to need to turn the property cat market? Warren Buffett, in his annual letter, talked about the potential for a $250 billion insured loss. He said Ajit would be ready to write business the next day.
As a point of reference, that's five times Hurricane Katrina. It's almost half the U.S. industry capital. How big of an industry loss do you think it would take to turn the market?
I think there's a couple things to that. One is it surprising? An example I would give is, I think like a New Madrid earthquake at half the size of a Florida hurricane is a lot scarier to people. Because even though everybody knows New Madrid's out there, nobody really expects to see it in their lifetime. I think there's lots of different ways that the market can change. We saw models change markets. We've seen financial crises change markets. We've seen terrorism. I think, Bill, the other thing I would say is, what does a changed market mean? I think it's a market where there's more capital coming in, but we have that now. Is it a market where rates are going up? Or is it a market where companies are going down? There's insolvencies.
I don't really spend a lot of time worrying about when a market will change. I try to build as much optionality into being able to perform at levels that we want, regardless of where the market is and regardless of what types of capital are available. Building optionality into our business for different types of capital, for different rating environments, and thinking about it from that context. If a $250 billion happens, I would imagine that that'll change the market. Warren probably didn't take a lot of risk in saying that. I also think that we'll be there the next day writing business alongside with the G. That's going back over time. What's been a hallmark of ours, being one of the first people back in the market writing risk.
That is, in this business, the most critical moment is to make sure you've got your doors open the morning after.
Yeah.
That's when you get disproportionate benefit. The whole idea that it takes an event to turn a market, we've just watched the U.S. commercial industry go through its pricing cycle. There wasn't a bloodbath. There weren't 12 insolvencies. 20 CEOs didn't get fired. Returns got unacceptable, kind of stayed there for a couple of years, suddenly, there was a gradual upturn in pricing, that upturn seems to be peaking, the second derivative has gone negative. It's still a constructive rate environment, it didn't take agony. It didn't take big surprises. There's no reason to think that there's any less excess supply available for U.S. insurance than there is for catastrophe, even with pension money coming in, et cetera. I'm not sure that the concept of an event changing the market is necessarily. We don't think about it.
It's not relevant to us.
Great. Do we have any questions on that?
Just going back to the topic of retrocessional coverage where it's become cheaper, is there a moral hazard risk where you're reliant too much on someone else's balance sheet?
By the way, I wouldn't describe it as cheaper.
Okay.
It's become more efficient for us. What's efficient for us, our outward retrocession might form a very nice part of somebody's overall portfolio. I wouldn't describe it as cheap or cheaper or that. It's just grown considerably more efficient for us and effective for us. No, I don't see moral hazard whatsoever. The market operates on an extraordinarily high level of disclosure, and we only deal with very sophisticated counterparties. No, I don't see that at all.
Okay. A related question on the alternative capacity. Do you see that moving into new areas like flood insurance? Is that a viable market?
It should be. I've said this a couple of times, sooner or later, I'll probably regret it, but the federal government has no business being in the flood insurance business at this point in time. It was necessary at a point in time. It isn't any longer, the private industry could administer the transition to sound actuarial pricing very effectively. There's ample capacity available for the risk, I suspect over time, the risk would be more efficiently dealt with in the private sector. Yeah. That would very much include my ILS capacity.
We write flood in many places around the world. The U.S. is kind of unique in having a national flood program.
Okay, great. Why don't we go to the audience response questions? This is the keypad that you have in front of you. We'll put up a series of questions, if everyone can punch in their answers, then we'll show the results right away.
I don't even know if I like this one.
It's a catastrophe. Yeah.
For the first question, if you currently don't own shares in RenaissanceRe or Validus Re, what would cause you to change your mind? There's a series of responses there.
Thank you for not having change in management.
Yeah, I was noticing that as well. I think that's code for none of the above.
There's no way I would ever own that stock.
Okay, looks like the winner is, with 50%, improved reinsurance pricing. Okay, why don't we go to the next question. My confidence level over the next few years in RenaissanceRe or Validus Re's ability to deliver a double-digit ROE.
You had to split this between RenRe and Validus Re to make it much more interesting.
I know. Validus is not quite there yet.
Medium confidence is the winner at 49%, but it looks like skewed to the upside with the next being high confidence.
Kind of what I observed, that 79% of the respondees felt that with medium or better confidence, we'd be generating double-digit ROEs.
Yeah, I agree.
Yeah.
I think that's the right way to look at it. What are your thoughts on that?
It makes me feel good.
Okay.
I'm impressed with your math skills, Ed. Simple addition I'm still really good at, yeah. It's 89. Yeah. Actually, I'm not really good at simple addition. I'd like to retract that last statement. I've clearly got the math wrong. A lot of people in the room seem to have confidence in it. Let's retake that now.
All right, why don't we go to the next question? Property catastrophe reinsurance pricing for the mid-year 2014 U.S. renewals will be We also want you to answer that one as well. Okay, it looks like it's pretty evenly split, but more people think it'll be down 10%-15%, then 39% think down more than 15%. Do you have any thoughts on that?
I think the 17%, down by more than 15%, that's pretty aggressive.
Right. Okay. Let's go to the final question. Alternative reinsurance capital now represents roughly $50 billion, 15% of the global property catastrophe market. How much more could alternative capital grow to in the next few years? 50% think it could be $75 billion or 25%+, it's evenly split between $100 billion or more than $100 billion. What are your thoughts on that?
The thing I'd say is, I think it is a distribution, I think $75 billion is a reasonable central point. I think it can dislocate into nothing. It could go to be 100% of the market. I think those are very remote probabilities. I think the thing to think about is, as a reinsurer, we participate in this type of capital coming in. What's traditionally come in historically is new companies have started, which compete with us. It's a bit of a double-edged sword. If this capital's coming in because there's been a large dislocation, we have an opportunity to participate, where in the old cycles, it was the class of 2001, the class of 2005, which was just competitive forces against us.
Regardless of which answer it is, there's a good side and a bad side as an existing reinsurer.
Great. Well, thank you very much. Everyone, please join me in thanking Kevin O'Donnell from RenaissanceRe and Ed Noonan from Validus.
Thank you.