When you are in a hole the first thing you need to do to get out is stop digging. Ladies and gentleman, it looks like we have finally stopped digging (furiously, at least). While the economy has contracted for five straight years (2009-2013) we are approaching what I’d refer to as a “statistical bottom”. Although we are near this bottom and should hopefully carve one out this year, we have little to cheer regarding the resumption of robust and rapid growth. In fact there are three risks that look to limit any fragile recovery that ensues.

The Bottom Is Here... or at Least Almost Here

The bleeding is slowing. Of course, as you run out of blood, it should. Bermuda’s population, by our estimates, is now below 61,000 and at levels below those of 2000.

Bermuda’s freight/shipping levels have been dialled back to levels last seen in 1997/98.

Real retail sales are also approximately back to levels seen in 1993 while real GDP is all the way back to about 2002 levels.

The contraction has simply reset the dial and base. All contractions must end at some subsistent base level. The key determinate for this level is population.

Barring any further major reduction in our employed workforce due to further net emigration, Bermuda is approaching its base from which levels of aggregate demand begin to finally stabilise. The new base will be much smaller but small changes on the margin will then help the “statistics” to improve. It won’t feel much better but it won’t feel a lot worse either. When you go from ten to five it hurts but there is also no guarantee you’ll go from five to six, not to mention back up to ten. In fact it’s unlikely we will get back to ten ever again unless we grow the local working population substantially.

This is a problem we will need to urgently consider. Bermuda’s infrastructure and services have been built for a population of roughly 65,000 or more and if we don’t seriously consider new avenues for growth to get us back there then there are likely still some sectors that will require further contraction. Thus any risks to growth need to be taken seriously. Here are three worth noting.

Government Austerity and Fiscal Consolidation

Bermuda’s public sector needs to shrink. Let’s make this crystal clear. The edifice of the public sector built over the last few decades is simply unstainable for the current size of this economy and is acting like a leach on the private sector with its persistent budget deficits that threaten the very future of Bermuda’s ability to remain competitive. Thus any fiscal consolidation and efficiency enhancements should be applauded and encouraged.

This does not, however, suggest that cuts will be inconsequential. In fact they most assuredly will have some impact on the growth rate of the Island. In the past government spending essentially inflated our growth. Now fiscal conservatism will slow and even restrict growth. There is virtually no way I can see the Government hitting its budget reductions targets next year without job cuts and/or salary reductions as the math is pretty much impossible at this stage. The wage and salary line item in the public sector is simply too large and extensive. Lower employment income from the public sector will exert a negative drag on aggregate demand in the medium term due to the fiscal multiplier.

Construction’s Secular Decline

The recently announced St George’s hotel development is a very important win for Bermuda’s construction industry. However, this doesn’t really alter the growth profile of the Island. If we look out to the medium or longer term there appears to be little in the way of “sustainable” growth for the construction industry given the level of infrastructure developed over the last decade. There is still about one million square feet of vacant commercial property left in Hamilton, approximately 4,000 vacant rental units and a population that is back to levels not seen since 2000.

The St George’s development (which may take a year to see the shovel hit dirt) helps prevent an enormous vacuum that is developing from the result of the completion of some major projects. In fact it will simply help fill the void left from the hospital and Fairmont harbour completions. It is true that we do have other projects developing (Pink Beaches, and perhaps Morgan’s Point) but these also appear to be offsetting other completions.

The risk, ironically, that most people seem to be ignoring, is that if new hotels are developed will they cannibalise existing inventory? In many cases the hospitality industry is not a zero sum game and a refreshed hotel/tourism industry may be able to attract more tourists for the benefit of all. This theory, however, is by no means guaranteed. And while we may see a small uplift in air arrivals that benefit the new projects we might also see increasing competition that harms existing players (especially those who are not allowed equal access to gaming development). Thus the air-pocket in the construction industry still hangs like Damocles sword over the island.

Insurance Rationalisation

The reinsurance industry is coping with some very difficult conditions. The market environment is very competitive at the moment as the relatively low level of catastrophes over the past two years and profitable underwriting has left firms over-capitalised. Add to this the huge surge in alternative capital that has poured into the market and you have an environment where pricing power is essentially non-existent. As a result we are seeing very little to no top-line acceleration and conditions are not conducive to much growth.

The longer term outlook appears less encouraging as well. As capitalisation continues to rise, it becomes less and less likely that reinsurance pricing will respond favourably after a major industry loss event like in the past. In fact for every $1 of alternative capital currently employed there appears to be $3 waiting to jump in post-event to snag any semblance of firming pricing. When a $30 trillion market (pension funds) collides with a $250 billion market (reinsurance gross premiums) pricing pressure is virtually guaranteed. As a result of the challenging industry dynamics, growth may be somewhat elusive.

Couple this with the shift of many insurers seeking more comprehensive coverage under one umbrella results in a sector environment where scale and size is becoming more attractive. Thus consolidation is more likely for smaller reinsurers given the pressure they are facing from competition, reduced reinsurance rates, the continued low-interest rate environment and increasingly stringent regulation. Those reinsurers with capital of less than $5 billion or gross written premiums less than $5 billion are likely being pressured to merge or consolidate to prevent becoming less relevant or challenged. We are likely to begin hearing more of this in the second half of this year as pricing in many lines of reinsurance continues to fall with some lines potentially falling an additional ten to 15 percent after dramatic decreases of 25 percent in prior periods.

Taking these factors together, an increasing and dramatic risk to Bermuda, at this point, is actually the insurance industry.

Although the alternative capital market should continue to offer opportunities for growth, there will likely be fewer jobs created than lost as the new model offers dramatic scale and efficiency. Five guys can sit around a table and control billions. The traditional reinsurance model that comes with a host of administrative/support positions and a suite of new executives is not likely to proliferate on the Island again. In fact the next major disaster will likely bring closure to this model as Bermuda comes to realise that a new wave of reinsurers are not likely to wash onto our shores to fill capital — pension funds and the hedge fund models will factor more prominently in future creation. These models, again, involve far fewer jobs and have proven to be highly productive and efficient.

If the weakening pricing environment persists, the traditional industry almost by definition needs to shrink to remain disciplined. Thus through consolidation or forced reduction it’s probably fair to suggest that the reinsurance industry is not going to be a significant source of growth in the developed world, let alone in Bermuda. In fact, depending on the evolution of the market over the next few years it may actually be a risk to future employment and offer reduced opportunity for growth for Bermuda.

This commentary is not negative on the insurance business in Bermuda per se. Bermuda’s insurance industry, in my opinion, is strong, viable and very competitive. It is simply the acknowledgment that what was once a shining beacon of substantial growth for the Island is at best a flickering light of opportunity and in many cases a very cloudy and blurry one. The future is not the past and industries do mature.

Although the economic bleeding is subsiding, there are a few risks in the medium term. Bermuda needs to grow in order to tackle its escalating indebtedness, unsustainable entitlement programmes and healthcare system that is in critical condition. The Island has a “denominator problem” that can only be addressed through the resumption of growth. Now is not the time to get complacent simply because the bad news is slowing and things are looking up. I’ll float a few ideas for growth in the next article.