In its recently published alternative reinsurance market update, Fitch Ratings highlights potential concerns over recently formed casualty risk focused part-sidecar, part-third-party capital vehicle, part-hedge fund strategy reinsurer Watford Re.
Watford Re, which is backed by part-owner insurance and reinsurance firm Arch Capital Group, with third-party capital investors also providing backing and a hedge fund style asset-side strategy managed by Highbridge Principal Strategies, LLC, a subsidiary of J.P. Morgan Asset Management, launched this year with an intriguing business model.
Targeting a diversified reinsurance strategy, but with a particular focus on casualty risks and an investment strategy composed primarily of non-investment grade credit assets, which it believes will generate attractive risk-adjusted returns for its shareholders over the long-term, Watford Re is unique currently.
The underwriting of longer-tailed, casualty type reinsurance business, with a high-performance asset manager investing the premium float is a strategy that will aim to outperform over the longer-term. Watford Re, with an experienced leadership team and sufficient capital already to acquire some scale in the market has every chance of achieving this.
However, Fitch Ratings raises a number of concerns it has and also highlights the fact that Watford Re is causing concerns in the market place. Fitch’s concerns are really just potential issues to watch out for, from a rating agency point of view. The market concern on the other hand is interesting as it shows just how disruptive Watford Re could be and that it likely has incumbents in the areas of the market it operates in worried.
Fitch’s concerns are perhaps more focused on the model and the fact that Watford Re targets casualty risk. The rating agency said; “Watford Re’s entry into the non-traditional reinsurance market is causing concerns, as its focus is on multi-line casualty risk, rather than the customary property risk.”
Fitch expects the amount of alternative capital targeting casualty risks will grow. However, it expects this growth will be constrained to; “A limited group of capital market participants that are willing to accept longer tailed, generally un-modeled risks in a more permanent vehicle.”
Fitch notes that currently the investor pool that is ready and willing to take on casualty risks is considerably smaller than those that have grown comfortable with well-modelled property catastrophe risks which are more easy to price.
Fitch says that Watford Re, which it describes as a sidecar, underwrites general casualty, professional liability, workers’ compensation, nonstandard and standard auto lines, within the casualty risk segment of the market.
If Watford Re is successful, with its longer-tailed casualty underwriting and high-performance investment strategy, Fitch notes that the reinsurer “Could be formidable.” Watford Re could strategically use its higher investment returns in order to lower underwriting prices, something it clearly wants to do to a degree. Fitch says that this could allow Watford to gain a firm foothold in the traditional reinsurance market and to compete effectively “At an enduring price advantage.”
However, Fitch notes some risks and concerns with the strategy:
It would be particularly concerning should the hedge fund push too hard for business to be written to add to the investment portfolio, resulting in the latest version of cash flow underwriting. This would expose the company to not only direct heightened risks in the investment portfolio and losses to capital should defaults come in higher than expected, but also the risk of future reserve development risk.
Fitch warns that this could risks a “double-whammy” worst case scenario of reserves “blowing up” while at the same time investment returns decline or defaults in the portfolio rise.
Fitch has a broader concern, that Watford Re, particularly if successful, could draw more widespread replication of the strategy, pushing the market to accept lower overall returns for casualty risks.
The rating agency says that the market fear of more casualty focused sidecars launching is already affecting behaviour, with concerned traditional reinsurance firms already ready to accept lower rates in order to “Thwart the ability of Watford Re to establish a sustainable market position.”
Now, we would venture that this is a prime example of disruption on action. An innovative new business model, which seeks to bring new capital, traditional underwriting and a hedge fund style investment strategy together, is pressuring incumbents into reacting. Is that such a bad thing or is this simply market forces at work?
Fitch says that the next 12 months may be enlightening, as we see whether the market will accept ventures like Watford Re, or whether these new business strategies will fail to gain traction needed to survive.
And it’s not just nontraditional reinsurance capital and new start-up business models that the casualty reinsurance market needs to watch out for. The rating agency explains that it believes that:
There is an increasing risk that pricing softness will accelerate in casualty lines more generally. As property rates grow softer, traditional capital will increasingly be redirected to casualty lines, pressuring them as well.
That, we believe, is a given in the current market and has already begun to happen. It is going to be interesting to see how the launch of initiatives like Watford Re, as well as the traditional market habit of moving into casualty to avoid price softening in property impacts rates at the January reinsurance renewals.
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