Last time, I wrote about the trouble balance sheet oriented startups have had getting funding in recent years due to some structural changes in the appetite of various funding sources.
Today, I’m going to suggest one new approach that might help solve the problem.
MGAs Need Balance Sheets
Something I’ve written about a number of times is the risk that comes with being a MGA. Namely, that, at any time, your reinsurance capacity could disappear.
In down cycles in pretty much any financial business, originators who offload risk go bankrupt when their source of capacity abandons them.
This happens in mortgages, commercial real estate, auto lenders, you name it.
As I’ve suggested before, there are (at least) three ways this could manifest for MGAs:
– poor underwriting results lead your reinsurers to drop you
– your reinsurer has poor underwriting results from other clients and drops you as they retrench
– your reinsurer has surprising investment losses and needs to cut underwriting exposure to conserve capital
What is a forward thinking MGA executive to do in order to avoid this outcome?
It’s very simple. Build a balance sheet.
We’re Going To Need A Bigger Captive
Now, some of you will say that many MGAs have captives where they share risk. Bingo! What I am suggesting are much bigger captives.
Instead of retaining 10 or 20%, why not 30, 40, or even 50%?
Yes, this will lower ROEs but it also creates more $ of profit. If the incremental profit is at an IRR above the cost of capital, who cares that it brings down the weighted average ROE?
Oh, I get it, you’re worried about your EBITDA multiple valuation! Sorry, but that’s a terrible excuse.
Valuation should never be more important than the economics of the business.
If you are originating quality business that your reinsurers like, you should seek to keep more of it for yourself. (If you are originating poor quality business, well, start preparing for your reinsurers to abandon you.)
If, instead, you choose to cede it away to bolster your near-term valuation, then you have destroyed long term value.
The Return of Arbitrage
In fact, a savvy MGA should act like the old Lloyd’s “arbitragers” who would retain more on their balance sheet in good markets and cede more in competitive markets.
This is a great way to add value, as well as providing leverage over your reinsurers. They don’t want to pay a higher cede? OK, we’ll retain more this year.
Having a balance sheet as a stalking horse will improve your reinsurance terms. There is real value creation from having a flexible model!
But how do you get that balance sheet? Who is going to give you capital?
Private Equity Contingent Lines
While private equity has lost its interest in traditional balance sheet deals, it loves investing in deals where the capital isn’t required until later.
This lets them collect fees today while holding onto their cash until tomorrow.
So why not arrange a contingent call for an insurance balance sheet? It doesn’t even have to be a startup.
Why not go to an existing MGA and help them gradually transition to a balance sheet? You put in $100M a year for 5 years.
The trick is the PE firm gets paid fees on a $500M deal, but they only have to disburse $100M of cash upfront.
This is how PEs game their returns to investors. (That requires a longer explanation than I have room for today but, trust me, PEs love to commit to big deals where they dribble out the cash over time because it makes their IRR look better.)
With this structure, the MGA gains stability as well as greater negotiating leverage with their reinsurance panel.
In a soft market, where they don’t need the capital, they pay a big “dividend” to the PE sponsor through a statutory dividend or paying off a surplus note.
PEs love return of capital from their investments almost as much as they like staggering their outflows to their firms!
The point here is rather than commit $1B upfront to a new balance sheet and wait 10 years to cash out, PEs can optimize their cash flow (in and out) by having more flexible commitments.
The Portfolio Approach
Take this to the next step, which is a big PE shop may have six or eight or ten of these MGAs they are providing capital to.
So maybe they are sending out $1B a year in actual cash to help numerous MGAs build balance sheets, but some of those MGAs will need more in a given year and some will need less…or none.
The PE firm gets to play the role of capital disciplinarian. If a MGA wants to write more on its own paper and the PE backer doesn’t think market pricing is strong enough, they can say no.
If PE has a view that certain lines are underpriced, they can tell their MGAs in those lines they won’t provide extra balance sheet capacity for it, so they need to either shrink or buy more reinsurance.
When you play this out to a steady state, PE can have a lot of influence over the direction of pricing in the industry by its willingness, or lack thereof, to provide incremental balance sheet capital.
I don’t think this would be a bad thing. I trust PE to have a more disciplined process around premium growth and pricing adequacy than most insurance CEOs.
The End Result
The future state of MGAs in this world would be most having hybrid balance sheets that are funded largely by private equity.
This eliminates the risk of reinsurance disappearing by replacing it with permanent capital. There would also be a flex component of capital tied to market conditions.
For simplicity, let’s assume the target range is 50% of GPW funded by permanent capital and 50% by reinsurance, but it could move to 70/30 in better markets and 30/70 in worse.
These adjustments would be “governed” by PE who would work with management to ensure incremental capital is being used wisely and remove the natural tendency for insurers to hoard capital.
While there is some risk in outsourcing capital management to PE, I find it a smaller risk than letting reinsurers control the fate of your company.
MGAs would end up with more disciplined underwriting, better terms from its reinsurers, and, ultimately, better valuations.
Do I think this will happen? Doubt it, at least in the near term. But I suspect a few years out it will come to pass.
The financial returns just make too much sense for PE, so eventually they will come around to it and there will inevitability be some scare that leads to MGAs wanting permanent capital, and this is the most optimal solution.
Next time, I’ll have more to say on how the market can find capital to launch new reinsurers.
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