Watford Re, and start-ups, a blank canvas for reinsurance innovation

For Bermuda-based insurance and reinsurance group Arch Capital, the launch of multi-line reinsurer Watford Re looks set to be a chance for it to pursue innovation and to do things differently from the start with a blank canvas.

Watford Re, which announced that it had successfully raised $1.13 billion of capital including $100m from Arch Capital Group Ltd., has generated a lot of discussion in the reinsurance market for a number of reasons.

Once again many of the reasons cited boil down to one concept, Watford Re’s cost-of-capital and its ability to lower it compared to the incumbent competition.

The fact that the firm is expected to target the casualty reinsurance market, with a predominantly third-party funded capital base, has led to much speculation about its ability to lower its cost-of-capital and disrupt this segment of the reinsurance market.

The fact that the business model, with Arch Underwriters Ltd. acting as Watford Re’s reinsurance manager, its option to take quota shares from Arch Capital Group business if it chooses (sidecar type play) and Watford Re’s ability to leverage the scale and expertise of the Arch group in its operations, all help to lower the friction to launch a new reinsurer and keep its cost-of-capital down.

So on the underwriting side Watford Re has some benefits over the incumbent competition but on the asset side it has a completely different strategy, with hedge fund style investment manager Highbridge Principal Strategies set to invest its premiums in non-investment grade credit assets.

This is a similar strategy to hedge fund backed reinsurers, who try to underwrite low volatility business while leveraging the premium income or float to create outsize returns for investors. However in Watford Re’s case the firm is not targeting the lowest volatility underwriting at all, rather it will seek to match and complement its underwriting with appropriate non-investment grade bond assets.

That could create a much more attractive return than a typical investment grade strategy, which on top of underwriting profits has the potential to turn Watford Re into a high-return opportunity for shareholders and its founders like Arch. The higher risk investment strategy can also be used as a way to reduce the firms underwriting cost-of-capital even further if it is a success.

But for Arch, being involved with Watford Re from the start gives it a chance to leverage some third-party capital in a different type of structure, with a different product focus and a different investment strategy than it uses within its own operations. Almost like a blank canvas and providing a solid base for experimentation and innovation.

In a statement published yesterday, Marc Grandisson, Chairman and CEO of Arch Worldwide Reinsurance and Mortgage Groups, commented; “We look forward to working closely with our broker partners and clients to create innovative products and structures not available in today’s traditional reinsurance market.”

That could be very interesting. If Arch really does try to do something different with Watford Re it could be disruptive for the sectors it targets. Watford could provide real competition for incumbents at a time when they are already under pressure from high levels of capital in the market, the threat of third-party capital entering their sectors, as well as traditional reinsurers expanding their focus to avoid pricing pressure in catastrophe risks.

While Watford Re looks set to try a new model in the reinsurance space, providing a testing ground for new products, structures and innovation, it will also benefit Arch’s existing clients. Grandisson explained; “Our ability to solve the needs of our clients is enhanced through adding Watford Re’s capabilities to our existing range of product offerings.”

And, if Watford Re performs as expected and the business model looks attractive, Arch Capital has an option to increases its position as the firm has secured a warrant giving it the right to purchase additional common equity in Watford if it chooses. It will be telling if it decides to exercise this warrant, a good sign of how successful Watford Re has been and whether Arch appreciates its model.

There have been a number of interesting twists on the traditional reinsurance business model which have seen elements of the non-traditional or third-party capital approaches embedded within new start-ups. The sidecar-like New York Stock Exchange listed Blue Capital Reinsurance Holdings, the hedge fund style but data driven investment backed Hamilton Re and now the third-party backed, casualty focused, more-active investing Watford Re.

While competition is aggressive in reinsurance and levels of underwriting capital are at record highs, both on the traditional and non-traditional side, entrepreneurial companies believe it’s a good time to start-up something new and different. It is often the case that when markets come under pressure enterprising incumbents take the opportunity to try something new.

While many are rooted firmly to the ground watching the disruption being wrought on their core business, the nimble and entrepreneurial will launch lean, technology focused enterprises, with new models to doing traditional business. This is how innovation often occurs in many business sectors and reinsurance is really no different.

Having a blank canvas, with a lean and low-cost start-up model, which leverages service providers for core operations such as underwriting, asset management and technology allows a new reinsurance company to be a test-bed for real innovation. Evidence is building that incumbents are increasingly seeing this as a good time to try something new.

Expect to see more hybrid approaches to reinsurance start-ups emerge over the coming years. Now that reinsurance has really converged with the capital markets some of the most attractive aspects of the traditional and non-traditional reinsurance business model are being brought together to create new platforms for underwriting, managing and investing in risk.

With the changes we have been reporting on in property catastrophe risk, through the influence of lower-cost alternatively sourced capital, collateralized and insurance-linked securities (ILS) strategies and asset manager backed reinsurers, likely to spread, we are set to witness very interesting times.

As new reinsurance business models are tried and tested, new products created, new capital structures devised and new technologies applied to the underwriting, managing and investment of risk, the disruption the reinsurance sector has seen to date may only be the beginning.