Curb your volatility to create value

Healthy earnings are vital for a healthy company, but the stability of those earnings can be just as vital in creating value. As catastrophe events become more frequent, carriers need strategies to keep a lid on volatility, writes Bill O’Keefe.

From hurricanes to wildfires and severe convective storms, the frequency of catastrophe events is increasing.

Whatever the cause of this trend, there can be no doubt about the data. The number of US catastrophe events in 2020 was more than two thirds higher than the 10-year average and this trend has continued into 2021, including multiple major events.

At the same time as catastrophes are increasing in frequency, exposures are multiplying. Populations in the US – the world’s largest insurance market – are moving to more volatile locations, with projected growth rates in cat-prone states two times higher than all other states. This combination means increasing volatility and a rising risk of carriers missing earnings targets.

Reducing volatility – creating value

In these conditions, reducing earnings volatility is a real opportunity for insurers to create value.

Reducing volatility should decrease cost of capital, increasing the likelihood of delivering returns in excess of your cost of capital. This is the essence of value creation.

When you look at the valuations of publicly traded carriers, those that have lower volatility are trading at higher multiples. And the difference is significant. Carriers that have had no hits to their quarterly earnings have price-to-book values between 30 percent and 50 percent higher than those with less stable earnings.

Reducing volatility helps to maintain dividends and capital repurchase programmes, and is vital to investor confidence. Strong quarterly earnings are good; strong and stable quarterly earnings are even better.

There are three steps that carriers can take to reduce volatility.

A customised view of risk

Catastrophe models are a helpful tool and for certain perils they are more or less robust. But at TigerRisk we believe carriers should invest in understanding their own true risk, by using the models, but adjusting for their own historic experience to build a tailored view. If you want to reduce your volatility, you must first understand how it is happening in your own business.

A conservative approach to reinsurance

Carriers that have lower volatility tend to be conservative buyers of reinsurance, they buy a lot of coverage compared to the premium volume. These companies often have stable, long-term reinsurance panels given the importance of reinsurance to their results.

Often, carriers look at reinsurance through the prism of ceded premium. Rather than solely focusing on premium, top carriers take a more nuanced view of comparing ceded margin to volatility reduction to determine the option likely to create the most value. A carrier can look at the ceded margin and realise that what looks like a high reinsurance rate is marginal compared to the earnings volatility being offset.

Of course, there is a balance to be found and TigerRisk can help in that assessment – but frequently the value being created by reducing earnings volatility makes up for marginal increases in reinsurance costs.

Capital-light structures

The third technique for reducing volatility is to adopt capital-light structures. It is no coincidence that eight out of the top 11 homeowners insurers in the US are mutuals or reciprocals. These capital structures are valuable ways to mitigate the volatility typical in homeowners lines given their policyholder ownership.

Reciprocals have been around for years, but they are now increasing in number. Many new entrants have come to the market with reciprocal models and those models have proven to attract new capital into the market given the opportunity for fee-based earnings in the attorney-in-fact.

The opportunity for value creation through volatility reduction is most obvious for public companies. But mutuals can use reciprocal models to gain access to capital, and expand into markets where high volatility is a challenge.

The rising number of catastrophe events is a major challenge that insurers must address. But reducing volatility is more than just a defensive manoeuvre. It is a vital tool for value creation.