Hedge fund backed reinsurers investment assets pose a risk: Fitch Ratings

In an article published by Fitch Ratings their director of insurance Martyn Street says that hedge fund backed reinsurers may find achieving their goals, of “using stable premium flows in lower-risk underwriting business to support higher returns on the companies’ asset portfolios” a challenge. As simple as the hedge fund reinsurer business model sounds, there are risks associated with the hedge funds ability to continue generating high investment returns.

Fitch notes that making a profit on the asset side has always been a fundamental part of the re/insurer business model, although the low-interest rates and yields from mainstream investments have significantly reduced earnings from investments for most re/insurers, making it harder to offset technical losses.

For these new reinsurers who are reliant on the hedge fund returns, as they invest substantially all of their premium income in the hedge fund strategies, the difficulty will be in maintaining double-digit returns over the longer term. As an example Fitch cites PaCRE, a reinsurer that was launched in April by hedge fund manager John Paulson’s firm in collaboration with reinsurer Validus Re. Paulson’s Advantage Plus hedge fund suffered a 50% decline in 2011 versus a 17% rise in 2010.

Fitch says that any huge fall in the value of assets of a hedge fund which backs a reinsurer could result in a depletion of the reinsurers available capital, which would put them at risk of default if it coincided with major catastrophe events or large claims.

We’ve written about exactly this risk before in an article from July titled ‘Investment losses at hedge fund backed reinsurers show correlation risk.’ This is one area of the reinsurance market where systemic risk is perhaps more prevalent and the risk of correlation between an investment in reinsurance and the wider financial markets or economic climate is more apparent. That’s not to say that these reinsurers are any more risky as an investment opportunity or an underwriting partner, rather the risks are different to those presented by the traditional reinsurer business model. In fact some of these hedge fund reinsurers have significantly greater financial resources due to the huge sums of money their hedge fund parents have made in recent years. And it’s worth remembering that traditional reinsurers are often collateralized by instruments such as letters of credit from banks, so what if the bank backing that line of credit failed?

Fitch does have some positive words to share on the new breed of hedge fund backed reinsurer. They note that some people in the market believe that these reinsurers will help to promote underwriting discipline and provide an alternative to traditional reinsurers. Fitch believes that hedge funds could contribute to a more competitive pricing environment in some sectors. When the hedge funds generate particularly high returns they won’t need to make such a profit from their premium income meaning that reinsurance prices could be reduced. The hedge fund backed reinsurers will be able to remain profitable as long as their assets keep delivering returns and they don’t suffer major losses, while traditional reinsurers could struggle due to low returns and an inability to hike their premiums.

Those final comments are particularly interesting especially when the consensus is moving towards agreement that alternative forms of reinsurance capital are beginning to have an impact on rates.