Catastrophes and Reinsurance Stocks

I’ve put together some analysis for work that never got used, so I figured I’d throw it up here.

First, there’s a strange conundrum that confuses even the most enlightened financial observers. Here’s a quote from David Merkel’s blog:

So, one friend of mine who writes a pseudonymous blog wrote me, saying:

Hi David – perhaps you can shed some light on this – for years I’ve heard the logic that catastrophes are bullish for insurers, as it allows them to raise rates.  I REFUSE to believe this.  I cannot for one second imagine that insurers would choose A) catastrophic payouts and rate increases vs B) no payouts and lower rates.

Here was my response:

They are bearish for insurers with large exposure to the contingencies, and bullish for insurers with no/little exposure to the contingencies.  But in aggregate, it is bearish – think of the “brick through the window” fallacy on GDP.

David

PS – the better managed, less levered insurers/reinsurers do tend to do relatively better out of big crises, because they will have the capital to write the juicier business in the next year…

There’s only one pseudonymous blogger out there that writes like that, so maybe I can help David’s explanation out as thanks for all of TED’s blogospheric contributions.

Below are some graphs that tell the story, I think.

First, this is a chart inspired by something I saw from AON, but it definitely shows that reinsurers have very different risk profiles:

Ok, so that means that the guys that missed the loss get to reap the benefits of all that reduced supply in the market, right?

Not quite.

Rate increases first go to reinsurers that paid the loss. It’s one of the survival mechanisms of the market and why most insurance companies can earn their way out of a disaster: profit margins are typically large after a very costly event.

So the real comparison is between companies that participate in the japanese cat market. Let’s see what the market thinks of the performace of the top few:

Ok, lots going on here. This is a graph of the price to book value of four of the top five loss-payers. I’ve left Platinum out for reasons I won’t go into here.

Now, you can see what the market thinks of Flagstone. Ick. They definitely underperformed. And Axis and Partner are roughly the same. Ok.

But what about Renaissance? What’s so hot about them?

Check this out:

This graph is of the utilization rate of these two reinsurers. The lower the line, the less spare capacity a company has. During the mid 00s, Partner moved heavily into casualty lines and, relatively speaking, out of catastrophe lines. That explains why they’re on a lower parallel than Renaissance, but it’s clear that Ren has pulled back considerably in the last couple years, whereas Partner has not, really.

My take on the whole thing is that Ren has managed to keep a keg of powder dry for the possible hard market in catastrophe reinsurance. Their stock price is going to command a premium as a result.

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