Watford Re’s first full quarter is negative on startup costs and loss ratio

The first full quarter of business for the 2014 launch hybrid-strategy reinsurance company Watford Re sees a negative result, as the part-sidecar, part-third-party capital vehicle, part-hedge fund strategy reinsurer, saw high expense and loss ratios dent performance.

Being the first quarter of full operation for Watford Re the strategy has not yet fully bedded in and there are always startup costs to bear, especially in terms of acquisition expenses. For Watford Re this has made a dent in its first full quarter and alongside the highest loss ratio among part-owners Arch Capital Group’s business segments for the quarter dragged it to a net loss of $1.4m.

Watford Re began its operations in the first-quarter with a sidecar-style cession from Arch, as it made good on its strategy to leverage the relationships its part-owners bring to it. Watford Re’s hybrid strategy aims to leverage the lower-cost of third-party capital, being able to source risk as a type of sidecar for part-owners Arch Capital. On the investment side of Watford Re, it takes an active, hedge fund style strategy, thanks to asset manager Highbridge Principal Strategies.

So bringing a new model to the reinsurance industry in the current market environment was never going to reap massive rewards in the first-quarter, particularly when the investment side will only just be getting gong, so it is no surprise that it’s a slow start for Watford.

Watford Re reported $51.8m of net premiums written and a net loss attributable to common shareholders of $1.4m during the second quarter of 2014. In the first quarter the cession Arch made to Watford Re amounted to $32.2m. It’s not clear from the results statement whether Watford has actually done any underwriting with other cedents, or whether the Q2 premiums are also solely as a result of further cession from Arch.

What’s interesting to note is that Watford Re has the highest loss ratio of any segment of Arch Capital’s business, at 63.1% for Q1 and for the first-half. This is nearly 20% higher than Arch Capital’s reinsurance segment experienced in Q2.

At the same time the Watford Re segment of the results also experienced the highest acquisition expense ratio, which if it has only been involved in cessions from part-owner Arch is interesting to note as well.

The combined ratio of the Watford Re segment hit 108% for the first-quarter and 114.1% for the first-half, well above the 74.3% experienced by Arch’s reinsurance segment.

It is to be assumed that this is largely down to start-up costs and the higher loss ratio. Watford Re will need to bring these numbers down though or it is going to result in a focus on how a company operating largely as a sidecar is reporting worse results than the firm it is receiving these cessions from. Definitely something to watch in quarters to come.

If the premiums in Q2 are largely cessions from Arch Capital then the question on investors lips has to be why Watford suffered higher losses than Arch? The answer is likely in the specific casualty reinsurance business that Arch ceded to Watford and if Arch’s book was broken down to show its share of the same block of business, we would likely see the same, or at least very similar results.

It’s important to note that Watford Re intends to invest more aggressively than Arch would, being a hybrid strategy of underwriting and float investment, so the business mix is different as the investment assumption is for a higher return strategy.

However, transparency here is important and we would expect there to be some discussion on this topic during the reinsurers results call when no doubt analysts will be asking why Watford Re’s results look so negative, despite Arch’s generally looking ok for a reinsurer navigating the current tough market environment.

Of course a big driver in the business ceded to Watford Re is in the strategy of investing the premium float at Highbridge. The firm targets a total return, across the underwriting and asset side and in reality the asset side has yet to kick in with any significant results as you’d expect.

In quarters to come the asset side will begin to perform, which will offset the underwriting of business at a higher combined ratio. We will only then begin to see whether the Watford Re strategy can truly outperform other investment options in the reinsurance space, as it no doubt will seek to.

We do believe this is largely due to startup costs and the loss ratio of the specific business ceded as well as the business model to invest the float, which as we said probably shows in Arch’s business if you had that level of granularity.