Watford Re, not your typical third-party reinsurance capital play

The recently announced plans of Bermuda-based insurance and reinsurance group Arch Capital and investment management firm Highbridge Capital to launch a third-party capital backed venture named Watford Re are an interesting take on the trend.

Many reinsurers are dipping their toes into insurance linked investment management with the launch of third-party reinsurance capital management units. Some are taking the traditional approach of launching sidecars, others are following an investment management style with funds and managed accounts, another strategy is to launch a third-party capital backed collateralized reinsurer.

Arch Capital is taking a slightly different route, launching a new reinsurer which looks likely to have equity akin to a traditional reinsurance firm, but with third-party capital welcomed into the structure, a high-performance hedge fund manager on the asset side of the business and the ability to cede quota shares to it almost like a sidecar.

Watford Re is expected to be more distinct from Arch’s main book of reinsurance business, but giving it the option to cede quota shares to it like a sidecar, as well as to underwrite separate reinsurance contracts within the reinsurer.

Watford Re will certainly not be a traditional reinsurer it seems. On the underwriting side of the business, sources say Arch intends to leverage third-party investors to lower the cost of capital of Watford Re’s underwriting products, thus taking advantage of the capital markets price advantage in the reinsurance underwriting space.

The addition of a hedge fund style investment manager in Highbridge Capital, on the asset side of the business, into the mix gives this strategy an interesting twist, which makes Watford Re an interesting hybrid of a reinsurer, backed by some third-party capital, with a hedge fund managing the asset side and sidecar traits due to the relationship with Arch.

The initial announcement on the launch of Watford Re said that it would be a multi-line reinsurance company, principally funded with third-party capital. Analysts suggest that Watford Re is likely to be predominantly focused on casualty lines of business, rather than property which is more typical in third-party capital facilities, which should make it a very attractive proposition for investors.

Highbridge Capital is in the process of raising capital for Watford Re, according to Arch Capital CEO Dinos Iordanou who discussed plans for Watford Re during the Arch fourth-quarter earnings call.

Iordanou said that analysts should think of Watford Re as a ‘kind of a semi-virtual company’, with its own leadership team, underwriters and operations. However the bulk of the underwriting activities will be undertaken by Arch employees and the Arch underwriting system, he explained, while Highbridge Capital will provide the investment operations through its Principal Strategies unit.

Both Arch and Highbridge are bound to Watford Re through agreements mandating that they provide those services, for what Iordanou said would be as a ‘long time’.

Watford Re will take some business that Arch Re would normally write as well as participate alongside it, thus providing a way for Arch to boost its line signings using a source of lower-cost, third-party capital if it chooses. Iordanou explained; “They will take sometimes business that we ship out today to our other participants and they will participate with that. Sometimes, we’re going to be side-by-side and sometimes there might be deals that they will do on their own.”

But whatever is written by Watford Re will adhere to the same level of underwriting discipline as Arch’s core business. Iordanou said; “The underwriting standards of Watford Re will be the same underwriting standards as we have at Arch. I’m not reprogramming the brains of our underwriters.”

There will be an element of matching liabilities with the investment strategy within Watford Re, explained Iordanou. Some business may be selected to go into Watford Re because of the duration of the liabilities, depending on the expected return of the Highbridge Principal investment strategy.

Iordanou commented; “So there might be situations that some accounts might not make the cut for Arch, but if it will make the cut and produce north of 15% ROE for Watford then we’ll do those too.”

Iordanou continued; “I want to emphasize that our underwriting teams, when they’re working on Arch accounts or Watford accounts, they’re going to use the same basic tools and the same principles that we have established over the last 12 years.”

Now that may raise some questions of its own, about how Arch intends to ensure separation between its own book of business and the book underwritten at Watford Re. Questions on the potential for conflicts of interest are sure to be raised by investors and analysts looking at Watford Re, but as long as Arch can explain why one piece of business goes into one book, and not into another, then investors will likely appreciate this strategy of utilising tried and tested underwriting methods and skills.

Overall Watford Re looks set to provide a very interesting investment opportunity to institutional investors, such as pension funds and equity funds, looking to access the returns of the reinsurance market. Not only does it come with a pedigree, with Arch Capital and Highbridge Capital both highly respected, but it also offers something a little more unique at this time.

There aren’t many other insurance or reinsurance linked investment opportunities where third-party capital providers can access the returns of a multi-line book, with an expected strong casualty focus, backed by an experienced underwriting team and where the potential returns could be boosted significantly through a hedge fund style investment strategy from Highbridge.

Reports suggest that Arch will itself put up to $100m into an equity share of Watford Re, clearly showing its committed to the launch of the new reinsurer. Highbridge Capital is expected to also take an equity share. The rest of Watford Re’s start-up capital, which some reports suggested may total as much as $1 billion, is expected to be raised from third-party investors.

So while Watford Re may, to all intents and purposes, look like a traditional reinsurer, there is a lot in its structure and the motivations it is expected to operate with which make it another very interesting example of an insurance linked investment. This makes it one of the most interesting third-party reinsurance capital plays seen this year and with it set to bring significant capacity, with the lower costs of the capital markets, into the casualty reinsurance space it can certainly be seen as disruptive.

Arch acknowledge that Watford Re is a reaction to the inflows of alternative capital into reinsurance and to the threat posed by hedge fund backed reinsurers. It also acknowledged that the more aggressive investment strategy is not without risk.

In the firms latest 10K filing it said;

In recent years, capital market participants have been increasingly active in the reinsurance market and markets for related risks. Certain of the new companies entering the insurance and reinsurance markets are pursuing more aggressive investment strategies than do we and other traditional reinsurers, which may result in further downward pressure on premium rates. In this regard, we are co-sponsoring, along with Highbridge Principal Strategies, L.L.C. (a JP MorganChase company) (“Highbridge”), Watford Re Ltd. (“Watford”), a new property and casualty reinsurer for which we will perform underwriting services and Highbridge will manage the investments, seeking higher yields and potentially assuming more risk than in our investment portfolio. If the investment and/or insurance underwriting strategy are not successful, we may be exposed to a risk of loss on our investment and in respect of the reinsurance cessions.

One final point to note is that a typical hedge fund style reinsurer strategy may target very low volatility underwriting business in order to invest the float, or premiums, in a more aggressive hedge fund strategy to boost the return.

With Iordanou saying that Watford Re business should produce more than 15% ROE, that suggests that it may not be hunting quite as low volatility underwriting as other hedge fund reinsurers. That could make the returns achievable by Watford Re for its investors, from the combination of the underwriting premium and the investment return achieved by Highbridge, very attractive indeed.