Correlation is a word that often crops up in articles here on Artemis and within the financial services industry as a whole. Correlation can be better understood as an interdependence, mutual relationship or connection between two or more things. In the risk and reinsurance markets we cover, we use the term correlation to describe how tightly linked investments in the insurance and reinsurance linked asset classes are with the wider financial markets and global economic climate.
We regularly discuss the low level of correlation in the insurance-linked securities, catastrophe bond market and across the reinsurance-linked investment space. As investments in these asset classes face their largest risks from covered catastrophe events or in other lines of business triggering events like extreme mortality increases, they can be said to have little direct correlation with the wider financial markets.
Of course nothing is truly uncorrelated and when things get really bad in the financial markets we would see impacts directly on the cat bond and ILS market. The collapse of Lehman Brothers a few years ago exposed one area of correlation in the cat bond market when the total-return swap was exposed as a weakness if the counterparty failed. Total return swap counterparties remain a potential issue to this day as evidenced in our recent article on Nathan Ltd. For another example of correlation in action, see our recent article on the potential impacts of a Eurozone breakup on the cat bond market.
As far as ILS and cat bonds go, the risk of correlation is low and restricted to fairly major events which would be detrimental to almost any investment strategy. So for investors these do offer a good opportunity to deploy capital into an asset class with very low risks of correlation. For other forms of reinsurance-linked investment the divide between the wider financial markets and the risk transfer vehicle can be less clear.
Collateralized reinsurers come with different types of business models. There are the fully collateralized types who underwrite risk and keep all premiums in trust or invested in highly secure assets to collateralize the reinsurance or retrocession contracts to ensure that the capital is available should a loss occur. This type of reinsurance investment can also be considered to have a low risk of correlation and in fact are as relatively uncorrelated as cat bonds and ILS. On the other extreme we have hedge fund supported reinsurers who put the premium income to work within their hedge funds investment strategies, aiming to profit both from premiums as well as the investment strategy on the other end. These now have a much greater element of investment risk as they are investing in much more risky assets than the collateral in an ILS transaction or fully collateralized reinsurer is invested in. Recent news shows that the correlation risk in these hedge fund supported reinsurers can be much greater.
As we wrote the other day, Bermudian reinsurer Validus Holdings revealed mixed success in the sidecar segment of their business. Their collateralized AlphaCat vehicles have continued to turn a good profit but their recently launched joint venture PaCRe Ltd., which uses the hedge fund supported approach, has suffered from investment losses within the hedge funds its assets are invested in.
PaCRe is not the only hedge fund supported vehicle to suffer from investment losses. Greenlight Capital Re Ltd., considered one of, if not the, originator of the hedge fund supported reinsurer model has also announced a second quarter loss caused by investment losses. Greenlight Re has been in the market since 2004, showing how successful this approach can be over the long term, it is part of hedge fund manager David Einhorn’s group of companies. A net investment loss of $36.9m of 3.3% of Greenlight Re’s investment portfolio was reported for the second quarter, bringing the firm to a quarterly net loss of $36.1m. However over the first six months of the year Greenlight Re reported an investment profit of $34.7m.
The fact that both of these hedge fund backed reinsurance strategies have suffered investment losses in the same quarter demonstrates that the financial market has been particularly tough for hedge fund managers in recent weeks and also shows how a correlation can occur. The poorly performing investments in the reinsurers hedge fund backers have resulted in quarterly losses for the firms and as a result investors could potentially become exposed to these investment losses in the future were they not recouped. It is likely that the investment losses would be recouped, these are seasoned investment managers, but it does show that these types of reinsurance strategies can hold additional risks for investors. They also hold additional attraction for investors though, as by seeking to profit from both the returns from writing reinsurance business as well as returns from the supporting hedge funds investment portfolio, investors in these vehicles can find them very profitable.
The moral here is that there are a number of different strategies within the reinsurance sector which can offer an investment opportunity that offers a certain level of uncorrelation from the wider financial markets. The lesson is that not all uncorrelated investment opportunities in reinsurance and risk are as uncorrelated as you might think.
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