Investment oriented reinsurance model best when sponsored: S&P

The total return reinsurance model, or investment oriented reinsurance model, or hedge fund backed reinsurance model (depending on what you prefer to call it), remains a challenging strategy to execute on well, but more recent start-ups that are sponsored by an existing re/insurer and asset manager are favoured by S&P.

Rating agency Standard & Poor’s (S&P) has repeatedly questioned the logic behind the hedge fund reinsurance business model, first questioning its viability in 2014 and then asking whether the business model had longevity in 2016.

Once again S&P is asking similar questions in 2017, but the rating agency now says that it believes that the hedge fund or asset manager supported reinsurers that are sponsored by established industry players look like the ones more likely to succeed over the longer-term.

The oldest proponents of the hedge fund reinsurance model that still survive today are Greenlight Re, backed by David Einhorn’s Greenlight Capital hedge fund, and Third Point Re, backed by Daniel Loeb’s Third Point LLC hedge fund. A newer comer is Fidelis Insurance, which operates its investment strategy with the help of Goldman Sachs.

Both of these firms have experienced significant challenges on the investment side due to volatile financial markets in recent years, although some level of stability is perhaps emerging in 2017. However on the underwriting side these companies have never broken even from a technical point of view, at least consistently, and the to the rating agency that raises questions.

The hedge fund reinsurance model was never about underwriting profits, it was about just about breaking even on the underwriting side, while accumulating premium float that when invested in the hedge fund strategy would deliver returns sufficient to enable the reinsurer to generate market leading returns.

There have been glimpses of this performance, but it hasn’t been consistent and in fact has been more down than up. Although one premise has played out as predicted, the companies have accumulated asset pools that are growing and if the investments can outperform while the underwriting breaks even they would have every chance of delivering outsized returns. The problem is that’s a lot to ask, especially when we live in volatile times (financially).

In more recent times we’ve seen a wave of sponsored total return strategy reinsurers, which are a play on the hedge fund reinsurer, where an established insurance or reinsurance company partners with an alternative asset manager to operate a new start-up reinsurer.

These sponsored reinsurers operate on investment oriented strategy, looking to just about break-even on the underwriting side while delivering a growing pool of assets to the manager in order to deliver outperformance through investment returns.

Given they access a significant proportion of their business from the sponsoring re/insurer, these companies have a much better pedigree in the underwriting market and access to business is perhaps enhanced from the launch.

In this group are Arch’s Watford Re, Chubb’s ABR Re, AXIS’ Harrington Re and Enstar’s KaylaRe.

However, there is more to the above four reinsurance start-ups than just a play on the hedge fund model, we believe, as they are all also a third-party capital play, providing the sponsors with a way to benefit from leveraging efficient third-party capital alongside their own.

They also add scale to allow the sponsors to ship risk into these vehicles that would otherwise be going out into the wider reinsurance and retrocession market, enabling them to benefit from fee income and investment returns on portions of business they either couldn’t have underwritten before, or that they would have passed on to their own reinsurers.

So retaining more premium from the business they underwrite, requiring less external reinsurance support, while generating a source of fees and a share of investment profits. For the sponsors these vehicles clearly make a lot of sense.

But S&P also feels they have more longevity, which is promising for their third-party investors and shareholders.

“We believe that sponsored HFRs have typically outperformed stand-alone HFRs and are better placed at least to break even from an underwriting perspective,” explained S&P Global Ratings credit analyst Taoufik Gharib.

S&P says that overall these reinsurers, hedge fund backed and the sponsored variety, exhibit performance that lags the Bermuda reinsurance market norm.

We’d venture that’s more of an issue for the stand-alone hedge fund reinsurance firms, as the sponsored variety are a broader play on third-party capital, providing an internal source of reinsurance, and extracting more premium profit out of the underwritten business that in many cases flows from sponsor to total return reinsurer.

However, over the long-run it remains to be seen whether even the sponsored variety of total return or hedge fund reinsurer can remain a viable strategy.

If leveraged as a kind of sidecar they perhaps can, as the total return reinsurance vehicle can then remain very lean, with minimal operating costs that can help to make its underwriting capital even more efficient than the sponsoring parent.

Then, as a vehicle that can help the sponsor to remain relevant in challenged reinsurance markets and act as a source of efficient reinsurance or retrocession, we’d argue the vehicles can add a lot of value to the overall sponsors re/insurance platform.

Of course the asset management motives remain similar across both stand-alone hedge fund reinsurer and sponsored total-return player, to accumulate assets from the premium float of medium to longer-tailed business and to outperform significantly on the investment returns.

S&P says that the sponsored variety stand the best chance of breaking even from an underwriting perspective, likely down to the heritage they benefit from through their sponsor, and the fact they can access some of the risks from the sponsor too.

But overall, Gharib commented on S&P’s view; “We continue to view the HFR business model as generally more sensitive to earnings and capital volatility than traditional reinsurers.”

S&P says that the business model employed by these companies will likely continue to evolve, learning from their predecessors mistakes and continue to “nibble at the edges of the reinsurance market as they carve out a niche for themselves.”

“However, the rubber meets the road for HFRs over the next few years as so many promises remained unfulfilled,” the rating agency says.

Elements of the business model are more than adequate and as a response to the challenging reinsurance market environment and investment focus is a valid strategy, and as a way to leverage third-party capital and bring efficient capacity into your existing business model the sponsored approach has plenty of merits.

Perhaps we just haven’t seen the right execution of this strategy yet? Getting the balance right between underwriting and assets, to crack the benefits of bringing this efficient capacity within your own business, while extracting income through fees. It’s not something the start-ups will learn overnight.

Over time though we’d expect the total-return reinsurance hybrid will remain a core piece of some larger players strategies, rather like a third-party capitalised sidecar with an asset strategy these vehicles make sense in this evolving reinsurance market.