Third-party capital adds up to 200 basis points to Validus’ returns

Leveraging third-party reinsurance capital, through its ILS and third-party capital manager AlphaCat Managers Ltd., can add as much as 200 basis points to Validus’ expected returns, according to the firm’s Chief Executive Officer (CEO) Ed Noonan.

During Validus’ first-quarter 2016 earnings call, CEO Noonan discussed the composition of its catastrophe portfolio and how it utilises retrocession and third-party investor capacity to generate positive returns in a challenging market landscape.

The CEO explains that both the use of retrocessional reinsurance and ILS capacity adds to Validus’ expected returns, supporting the growing supplementary benefits the use of alternative reinsurance capital can have on traditional balance sheets.

Noonan explained that it’s cat portfolio construction is really a three-stage process, beginning with the basic construction of the book that sees Validus use its research, analytics, and its own view of risks to select the business it writes that will maximise returns relative to risk appetite.

This is followed by the purchase of retrocession, which, Validus uses to improve its return on equity by “reducing the capital required to support our business, and importantly accessing markets in the events of lower cost of capital for the risk,” said Noonan.

The firm said earlier this year that during 1/1 insurance-linked securities (ILS) capital helped it secure its most comprehensive and affordable retro programme to date.

The final step in the process concerns AlphaCat and the use of ILS, or third-party investor capital, which Noonan says is really about “harmonising” the catastrophe portfolio in conjunction with AlphaCat investors.

“We specifically work with AlphaCat as the last step in our portfolio management process to identify business in which their investors have both appetite and a lower cost of capital. Typically this is peak risk U.S. business.

“This part of our process adds an additional 150 to 200 basis points for our expected return,” said Noonan.

So Validus utilises the wealth of third-party investor-backed reinsurance capital via its AlphaCat platform to cover its peak U.S. risks, bringing down its cost of capital and also providing investors with access to business they would otherwise find difficult to assume.

The efficient and increasingly sophisticated capital markets investors continue to gain a greater understanding of ILS as an asset class, appreciative and attracted to its diversifying and uncorrelated nature, so they are often seen to be willing to take on lower returns than perhaps Validus would want itself on certain business lines.

As a result, Validus is able to utilise AlphaCat investors to increase efficiency, diversify its capital base and ultimately add an additional 1.5% to 2% to its expected returns, so clearly, a benefit to the firm and investors alike.

The firm’s use of retrocession also adds to its expected returns explained Noonan, stressing that the second phase of its catastrophe portfolio construction typically adds an additional 150 to 300 (1.5% to 3%) basis points to its expected return.

And, as highlighted by Validus previously, the majority of its retrocession programme for 2016 came from the ILS market, so the sector really is adding significant value and profits to Validus at times of limited profitability on the reinsurance underwriting and investment side of the balance sheet.

In fact, Validus has revealed that it actually bought a greater portion of top-layer aggregate retrocession during the first-quarter of 2016, reducing its 1-in-100 year probable maximum loss (PML) from U.S. windstorm by 6% compared with the last quarter of 2015.

Validus’ 1-in-100 year U.S. windstorm PML is now 15.9% of total capital, with additional business ceded to third-party investors in AlphaCat also contributing the 6% reduction.

Clearly, AlphaCat and its investors provide strong value to Validus, particularly during the softening reinsurance landscape when efficiency and cost reduction is seen as vital to navigating the testing times.

During the first-quarter and beyond the firm looks to utilises the willingness and sophistication of capital market investors to reduce its cost of capital and create additional returns.

This is something that those insurers and reinsurers that are still lagging with regards to ILS utilisation are clearly missing out on, and as platforms like AlphaCat continue to perform well and add value to both investors and re/insurers, it’s likely companies like Validus will continue to reap the benefits in the coming months and years.