In a news article published yesterday, rating agency A.M. Best highlight the investment-side risk that comes with the hedge fund backed reinsurer strategy which has been becoming more popular in recent years. These reinsurers, backed by large hedge funds, typically try to access the premium income available in the reinsurance market as a source of new capital inflow to put to work in their hedge fund investment strategies.
A.M. Best aren’t the first to highlight this added risk, Fitch Ratings discussed the same issue in September last year.
Yesterday’s article from A.M. Best is about hedge fund backed reinsurer Third Point Re, one of the more recent to enter the reinsurance space as a company with hedge fund backing. It is backed by major hedge fund Third Point LLC, managed by Daniel Loeb, who have a great track record for returns, with funding also from Kelso & Co and Pine Brook Road Partners.
A.M. Best affirmed its rating of Third Point Reinsurance Company Ltd., citing as positive factors the excellent risk adjusted capitalisation of the firm, the successful first year Third Point Re has had including building a strong management team and the above average performance of its investment portfolio.
Partially offsetting the positive factors, said A.M. Best, are the start-up nature of the firm, the greater investment risk in its alternative investment strategy and also, interestingly, the increasing competition and capacity in the reinsurance market. That last risk Best cited would seem to allude to the consistent inflows of third-party capital into the reinsurance space, which effectively acts as increased competition for every participant in the reinsurance market, not just hedge fund reinsurers like Third Point Re.
On the investment-side risk, A.M. Best said that Third Point Re, and this applies to any other reinsurer with a hedge fund investing its premium assets, could be exposed to a convergence of events that could test its capital strength. The dual risks of the underwriting risk and the investment-side risk could have a duplicative impact on a reinsurers capital base, said A.M. Best.
This is the core of the argument, which Fitch had put forward last year as well. That as well as being exposed to risks due to the business it writes the fact that those premiums are then invested in, sometimes aggressive or alternative, investment strategies by the reinsurers hedge fund backers, puts extra risk on the firms.
We’ve written before that investment losses at hedge fund backed reinsurers showed a correlation risk and this continues to be an area which is on ratings agencies minds. That’s not to say this is any more risky a strategy than that employed by reinsurers using collateral such as a bank sourced letter of credit, which has its own risks associated with it.
On Third Point Re, the low underwriting leverage of its book of business, the experienced underwriting team it has built and its 18 year successful investment track record are factors that alleviate concerns, according to A.M. Best. The news article notes that Third Point Re’s assets are managed in separate portfolios at hedge fund Third Point LLC and will not be combined with other investors assets at the hedge fund.
Additionally Best said that Third Point Re could be pressured by competition from both traditional reinsurers and new start-ups. The addition of more capital to what A.M. Best terms an over-capitalized market could add pressure on the firms underwriting margins.
It’s interesting to hear the rating agencies opinions on the different strategies which are becoming more commonplace in the reinsurance market. Hedge fund backed reinsurers will naturally receive a greater level of scrutiny, due to the high-profile nature of some of their hedge fund manager backers. However the risk cited, of investment returns being negative and so perhaps impacting a firms ability to pay claims, could be said to be unlikely to occur given the strong capitalisation of the hedge fund backers. It is a risk though, no matter how remote some might think it to be, so the rating agencies are correct to raise it.
It’s worth adding that some traditional insurers and reinsurers are becoming much more aggressive in the investment strategies employed for their own assets, even partnering with asset managers in some cases, so in years to come we may find this investment-side risk becoming much more prominent in the insurance and reinsurance market as a whole.