Watford Re continues to scale, investment returns show promise

Watford Re, the hedge fund or investment-oriented, hybrid strategy reinsurance joint venture vehicle operated by Bermudian re/insurance group Arch Capital alongside asset manager Highbridge Principal Strategies, gained further scale in the second-quarter.

Watford Re, which operates a little like a reinsurance sidecar for Arch as it takes some cessions from the reinsurer, while also leveraging third-party investor capital and on the asset side using a hedge fund style strategy thanks to Highbridge, made its first positive return of income to Arch thanks to impressive investment performance.

In an investment environment where many hedge fund managers have been struggling, Watford Re, which is reported under ‘Other’ in Arch’s results, saw strong investment income helping it to return its first positive income to Arch.

Watford Re achieved investment income of $19.79m for Q2, foreign exchange gains of nearly $3m, minus realised losses of nearly $8.9m, resulting in income before tax of almost $10.7m.

This compares to Q2 2014 when the reinsurance vehicle only managed investment income of $532k, with realised gains of $3.2m, resulting in income before tax almost $3.5m. After dividends to shareholders Watford Re resulted in a $216k loss for Arch in the quarter last year.

This year, thanks to the much stronger investment results in Q2, the quarter has resulted in positive net income of $657k for Arch, after having distributed almost $10m to its investors. Note that Arch has a 10% stake in Watford, so it will also have benefited from dividends as well.

So, now Watford Re is making a positive contribution to Arch earnings, helped by the increasing scale which allows Highbridge a larger pool of investable assets to work in its hedge fund style strategies.

Watford Re underwrote another $128m of gross premiums in Q2, taking the total underwritten since its launch to around $545m. Some of this is underwritten directly by Watford, the reinsurer puts its lower cost of capital to work to underwrite business that does not always suit Arch. Some of it comes from cessions that Arch makes down to Watford Re, meaning that Arch benefits from retrocessional reinsurance from the vehicle as well.

Arch explained again that a change in its own results was due to increasing cessions to Watford, saying that a; “Difference in gross versus net premiums written primarily reflects an increase in cessions to Watford Re in the 2015 second quarter compared to the 2014 second quarter, primarily in casualty lines.”

In Q2 Watford Re saw a higher loss ratio of 72.5%, 12 points higher than the prior year quarter. It was also 22 points higher than Arch’s reinsurance segment combined ratio, showing that Watford’s casualty lines focus does result in a greater risk concentration.

It’s interesting as, despite the high level of losses in Q2, Watford Re’s scale is now enabling it to contribute positively anyway. Lower expenses, likely due to the vehicle now being established, helped to keep the combined ratio at 103.8%, lower than a year earlier and still making progress towards a sub-100 combined that Watford has been targeting.

For the first-half of 2015 the Watford Re results look even more impressive, as the scale helped it deliver income to Arch of almost $3.2m on top of almost $35.5m to its investors (which again, Arch will also have taken a piece of). That compares to Arch seeing negative income of $565k for the first-half of 2014 from the joint venture.

The combined ratio for the first six-months is even more impressive, coming in at 102.4%, compared to 114.3% in H1 2014. The loss ratio was significantly lower in Q1 2015. The results and high loss ratio certainly seem to show that Watford had some major losses to deal with in this second-quarter. Even more impressive that it returns a profit.

The investable asset growth at Watford Re is one factor that has helped to drive its performance and returns to investors and to Arch. At the end of Q1 Watford Re had almost $1.268 billion of investable assets at its disposal.

That number grew to $1.341 billion at the end of Q2, with total assets of $1.76 billion and liabilities of $648m.

As the investable assets, or insurance float, grows it provides an increasingly impressive sum that can be put to work in Highbridge’s asset management and hedge fund strategies. As this pool of float capital scales Highbridge can leverage it to enhance returns, which is becoming more apparent in the results this quarter.

As this scale continues to grow and if the loss ratio can be kept down, the investment returns up and the combined ratio maintained close to 100, the benefits to Arch as a partner will increase and the strategy become increasingly clear.

Watford Re provides Arch with a way to leverage third-party capital through a sidecar or companion reinsurance vehicle with a hedge fund style investment strategy.

That means Arch can leverage Watford’s cost of capital, cede business to it, allow it to underwrite on its own perhaps even gaining two program signings at times. So gaining efficient retrocessional capacity to help it optimise its own portfolio, lower-cost capital for underwriting, more options for its clients and a way to extract more premium out of the risks it underwrites.

Add in a high performance investment strategy on the asset side, which is now appearing to be reaching optimal performance levels, and it’s easy to see why Watford Re generated so much interest at launch.

It remains surprising that we haven’t seen numerous such vehicles appear in the market. But one of the issues is finding a good asset manager partner. Arch got to the market early with Watford Re and the only real follower to date appears to have been ACE Group with ABR Re, its joint venture internal reinsurance vehicle with Blackrock.

There will almost certainly be more of these joint ventures to come, but perhaps for now the reinsurance market has been sidetracked by M&A activity and the pressure on rates.

And, once again, scale will enable Watford Re to become increasingly profitable for Arch, Watford’s third-party capital investors and the joint venture partner Highbridge. The investment income and investable assets, when returns are good, will continue to grow and provide valuable additional performance for the vehicle.

At the same time Watford Re continues to allow Arch to optimise its casualty reinsurance, book which is key to the strategy in this challenging market. As time passes these strategic ventures are likely to look increasingly prescient as they provide a way for the participants to offset the wider market challenges.