S&P questions viability of hedge fund reinsurer business model

In a newly published report ratings agency Standard & Poor’s questions the viability of the hedge fund backed reinsurance strategy, asking whether combining the hedge fund and reinsurer strategy can create higher risk-adjusted returns.

As the current reinsurance market is crowded, with pricing falling across the sector, S&P says that hedge fund reinsurers may find it hard to find the pockets of business where they can underwrite risk at adequate prices and create relevance for themselves in the market.

The question then is whether the combination of a reinsurance strategy with a hedge fund investment-side strategy, which is typically riskier than a traditional reinsurers investment strategy would be, can achieve a better return than the two strategies could when operated separately.

S&P says that hedge fund investment strategies typically take on more risk, consume vastly more capital and introduce more liquidity risk, than a traditional insurance or reinsurance investment play. However, readers will be aware that a more active investment strategy is becoming a focus even for some traditional reinsurance players, such as with Bermudian Platinum Re and even the large European reinsurer Swiss Re, both trying out more aggressive investments.

So having a more active investment strategy, to boost returns, is actually no longer purely the domain of the hedge fund reinsurer. However, where the strategy differs is in its approach to underwriting typically lower-volatility reinsurance business, while allocating almost all of their capital to a higher risk hedge fund investment strategy.

The search for alpha, better than benchmark risk adjusted returns, is the goal here. Leveraging the cash coming in from reinsurance premiums, on lower-volatility underwriting business, within their investment strategies gives these hedge fund backed reinsurers the chance to generate an outsized return for their investors.

So here the strategy can be two-fold, if the reinsurer is launched by the hedge fund manager. A source of new capital from shareholders in the reinsurance company, who are seeking to benefit from access to the hedge fund manager’s performance, as well as a source of capital considered more permanent from the premiums, which can be put to work in its investment strategies.

S&P raises what it believes is a fundamental question for the hedge fund reinsurers; does combining the hedge fund and the reinsurer generate better risk adjusted returns than they could achieve separately?

S&P highlights the divergent cultures, between hedge funds and reinsurers, saying that there is a need to find a common ground and that hedge fund managers may find it hard to adopt the risk controls that traditional reinsurers use making growth more difficult without them.

Another factor to consider is the risk diversification between the reinsurance underwriting portfolio and the hedge fund asset portfolio. Add to that the liquidity risk inherent in a hedge fund asset portfolio, something that hinders the ability to provide credit ratings for these reinsurers according to S&P, and strategies to manage this become important.

“In our view, traditional reinsurers’ and HFRs’ risk-taking frameworks are far apart, and these differences need to be reconciled, possibly more toward the traditional reinsurers’ approach, so that HFRs can achieve higher financial strength ratings,” commented Standard & Poor’s credit analyst Taoufik Gharib.

S&P notes that it does believe that if implemented in the right way, with the proper risk controls in place, diversification and liquidity factors considered, it is possible to create a more efficient capital vehicle with the hedge fund reinsurer strategy. However, to achieve this the gap between reinsurer and hedge fund risk cultures needs to be narrowed and prudent risk controls need to be implemented in order to realise the potential benefits.

S&P closes by saying that it believes that the hedge fund reinsurer model will carve out a niche for itself and compete with smaller reinsurers, but it still believes that traditional reinsurers will dominate the landscape and provide stable capacity to their clients.

S&P’s analysis is timely, given the recent growth in popularity of the hedge fund reinsurer strategy and the fact that some traditional reinsurers are now seeking to boost the returns they gain from their investment side by restructuring their portfolios in favour of riskier assets.

With underwriting returns for reinsurers generally softened, due to the highly competitive, over-capitalised traditional market and the increasing competition from alternative reinsurance capital, an increased focus on investment returns is inevitable for some.

Also potentially adding to this need to make a better return from their assets is reinsurers shift towards casualty risks, which tends to come with a higher combined ratio meaning that something often needs to be boosted to compensate for that. That could well be the investment strategy for an increasing number of the global reinsurers who have shifted their strategy towards longer-tailed casualty.

There are a lot of factors converging to make the investment strategy more important and more of a focus for the traditional reinsurance market. In such an environment being a fully-collateralized player may be seen as far more stable, given the near complete elimination of investment side risk due to the underwriting collateral being held in trust. That could play into the collateralized markets hands, in terms of being seen as a stable and secure source of underwriting capacity.

The final point to note on S&P’s note on hedge fund reinsurers is that the strategy may not always be to make “one plus one equal more than two”, as S&P puts it. In fact, for some of the new breed of hedge fund reinsurers the strategy is to leverage more active investment, alongside a low-profit underwriting venture, in order to benefit from the float capital plus investment from shareholders just to add a new source of capital.

Hedge fund managers who think they can make “one plus one equal more than two” (as in reinsurer + hedge fund = more than reinsurer AND hedge fund) should probably beware (unless they have all the risk controls and liquidity issues, S&P highlights in its report, in place). It might be better to adopt this strategy as; reinsurance float + investment capital + hedge fund strategy = an attractive risk adjusted return that investors would like to access and grows your assets. That seems a more prudent and realistic approach to us.

As with any of the new reinsurance strategies, there is more to the hedge fund reinsurer than meets the eye. New startups are clearly leveraging reinsurance as a source of capital and to offer new investors access to their return strategies in a differentiated vehicle. We would expect other strategies to emerge in time as interest in accessing the returns of reinsurance grows and hedge fund managers increasingly become aware of the float generating opportunity. That should benefit investors, but as S&P says it will also make putting in place risk controls even more important for those who want these vehicles to become permanent fixtures of the global reinsurance market.

You can find a link to the full S&P report on hedge fund reinsurers via its press release here.