Total return reinsurance vehicle Watford Re, the Arch Capital and Highbridge Principal Strategies joint-venture investment-oriented, hybrid reinsurer, has reported its best quarter yet, with a small underwriting loss being countered by impressive investment income.
In the first-quarter of 2016 Watford Re bounced back from the tough investment climate experienced through the second half of 2015 to report net income of just over $22.8m, delivering $2.01m of income to Arch and its shareholders and around $20.8m to the reinsurance vehicles third-party investors.
Like the rest of the total return style reinsurance joint ventures between an established underwriter, in Arch, and a hedge fund style investor, in Highbridge Principal Strategies, Watford Re aims to profit on both underwriting and investments, but writes a longer-tailed book in order to invest the premium float for a longer duration.
The strategy has shown promise for Arch and Highbridge, with the underwriting improving and the combined ratio nearing break-even point, while the investment performance has been impressive, except for in the second-half of 2015 when it suffered along with almost everyone else.
So the second quarter 2016 result shows that the investment performance seen in Q1 has continued into Q2, with Watford Re benefiting from impressive returns on its float and helping it to a profitable quarter, in fact the most profitable the total return reinsurance vehicle has seen to-date.
During the Q2 2016 Watford Re underwrote just over $109m of premiums, which is down on the $128m underwritten in the prior year quarter, but premiums earned were up at $120.6m, beating Q2 2015’s $107.2m.
Watford Re’s loss ratio for the second quarter improved, coming in at 69.3% in Q2 2016, down from 72.5% a year earlier. The combined ratio has improved again, registering 102.3% for the latest quarter, beating the 103.8% from Q2 2015.
The result of that is a small underwriting loss, once again, as Watford Re has not yet got to the stage of managing its underwriting combined ratio under the 100% mark, which is a stated aim of the firm but can take time with a longer-tailed strategy.
Watford Re’s underwriting loss for Q2 2016 was just $1.724m, an improvement from the prior year quarters $3.229m loss.
But investments is the story of the quarter, as the investment oriented, total-return reinsurance strategy pays off once again for Watford Re. A traditional reinsurer strategy might add 1% or 2% to its results from a typically conservative investment portfolio, but Watford Re’s investments turn that small underwriting loss into a much bigger profit.
Net investment income of $17.941m, plus realised investment gains of $27.291m, during the quarter helped Watford Re to an impressive net income after interest expenses and foreign exchange factors but before tax of $42.478m.
That’s significantly higher than any previous quarter for Watford Re, and well up on the $10.686m reported in Q2 2015.
After $33.7m of income distributed to third-party investors in Watford Re, plus almost $4.6m of dividends, there was $4.176m of income available for Arch shareholders, which is again the highest amount seen to-date.
So Arch itself is starting to benefit more, in terms of income, both for itself and for its shareholders, while the third-party investors and joint-venture partner Highbridge will also have received their highest income from Watford Re for a quarter to-date.
For Watford Re and the other total-return or investment oriented reinsurance ventures, growing the investment float is key as it means much greater profits when the markets are conducive.
It’s a virtuous circle, of sorts, that Watford Re can increase its scale and ultimately profitability as the float builds and it generates income, and grows its capital base which increases its underwriting clout and also relevance in the marketplace as well.
Interestingly though, there was no real growth in the all important premium float at Watford Re in Q2 2016, with investable assets reported as $1.703 billion, almost level with the end of Q1 2016, and total assets $2.207 billion which is actually a slight decrease from the $2.32 billion reported at the end of Q1.
It’s not immediately clear why this is, whether its due to distributions of capital among shareholders, or simply less premiums returned on the underwriting capital deployed at key renewals so far this year, however the float is still significant and when investment conditions are right, as seen in Q2, the size of the float will help Watford Re to profit.
The Watford Re continues to look like a sensible strategy for Arch, as it provides a second balance-sheet, largely third-party capital backed, generates income as well as providing an efficient source of reinsurance or retrocession (in a sidecar or active capital style manner). And for investment manager Highbridge Watford Re delivers benefits from management, performance fees for investing the growing float and from its own investment in the vehicle.
Still, a sub-100 combined ratio would be the icing on the cake, to turn the underwriting loss into a profit, but that could take time. The main thing investors in Watford Re will be looking for is consistent performance over successive quarters, an area the reinsurer has started off well in 2016.
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