Too early to say hedge fund reinsurance model is a failure: A.M. Best

Adverse economic conditions and reinsurance market turmoil has challenged industry participants throughout 2015 and into 2016, with hedge fund reinsurers being no exception, but it’s still too early to call this approach a failure, according to A.M. Best.

The global reinsurance industry continues to evolve, leading market participants both old and new to adopt varied business models in order to navigate the challenging environment, underlined by an abundance of capital, low investment returns, and ultimately lower rates.

The growth of the convergence space has arguably been one of the key drivers of change in the sector in more recent times, as companies look to work with and against the growing base of insurance-linked securities (ILS) capital and solutions to improve their market relevance.

One manifestation of the wealth of convergence capital, says A.M. Best, is the emergence of the hedge fund reinsurer, which seeks to utilise both the underwriting and investment side of the balance sheet, with the latter being the main driver of performance.

With interest rates remaining dangerously low, investment returns for hedge fund style reinsurance companies have suffered, which, being the main driver of company performance has hindered results in recent months.

At the same time, the softening reinsurance market cycle across the majority of business lines and geographies has dampened underwriting returns for all in the space, contributing to further struggles for both the hedge fund and more traditional players.

“While investment and overall performance has been disappointing, it is too early to jump to the conclusion that the Hedge Fund Re model does not work. The level of investment volatility experienced is not unexpected and is contemplated in our various stress tests.

“The success of these strategies has to be evaluated over the long term and through various market cycles. The robust capitalisation of these companies provides the bandwidth to achieve success,” said A.M. Best, in a recent Global Reinsurance market report.

According to analysis from the rating agency across the hedge fund reinsurer composite, during 2015, the combined ratio came in at 111.5%, while the loss ratio recorded was 70%, and the underwriting expense ratio recorded 41%.

And the investment results for the composite of hedge fund reinsurance companies didn’t fare too well either, with a 0.9% investment yield reported for the period, says A.M. Best.

With investment returns becoming increasingly difficult to come by as global interest rates remain low, with reports even suggesting they could turn negative in the future, that hedge fund re strategies are weighted towards this side of the balance sheet suggests it isn’t too surprising they continue to struggle.

But should interest rates rise and the investment market environment begin to turn and look more positive, then the potential for this type of business model to flourish becomes more apparent, perhaps something A.M. Best is alluding to noting that evaluation must be done over various market cycles.

“While this level of performance is not what one would hope for, this level of volatility has been anticipated and accounted for by A.M. Best’s stringent start-up requirements. As with any start-up, it generally takes several years for a strategy to take hold and reach adequate economies of scale,” said A.M. Best.

The majority of hedge fund style reinsurance entities remain in the start-up phase, and with the ongoing soft reinsurance landscape and investment market volatility it can be difficult to assess their potential performance in more positive conditions.

As reported by Artemis, the two highest-profile proponents of the hedge fund reinsurer model, Greenlight Re and Third Point Re, saw investment results diverge during the first-six months of 2016, although both saw investment returns improve in July, highlighting the volatility in the space.

Other industry analysts and observers have commented on the hedge fund re business model in recent times, noting both challenges and the continued evolution of this approach at boosting and optimising returns for shareholders in difficult conditions.

While not always called hedge fund reinsurers, there are also a number of investment oriented internal reinsurance strategies being employed by large re/insurers. Chubb, with its ABR Re, AXIS with Harrington Re, and also the likes of Fidelis and Hamilton, all of which employ a hedge fund style asset management strategy, perhaps show that this strategy is set to run.

Only time will tell how the hedge fund reinsurers manage in the ongoing softening reinsurance landscape, and how sustainable the model is as interest rates and investment returns remain compressed.

But given the low yield environment and pressure in reinsurance markets generally, leveraging the asset side of the balance-sheet to squeeze out a few more points of return is likely to become increasingly prevalent.