Warren Buffett had previously bemoaned the fact that reinsurance had become a “fashionable asset class”. Now, his own business model is being blamed for creating further pressure on reinsurance prices, as new entrants look to operate with a reduced cost-of-capital.
The Berkshire Hathaway reinsurance business model that Warren Buffett has seen so much success with, essentially puts insurance and reinsurance at the heart of a diversified investment conglomerate, in order to add diversification and bring in longer-term, cheap capital from the premium float.
This strategy has worked for Buffett for years, and likely will for many more, but increasingly large investment groups, many from Asia and China, are looking to emulate the Berkshire Hathaway model by adding reinsurance to their portfolio of businesses.
For years the hedge fund reinsurer model has been said to be an emulation of Berkshire Hathaway, but the truth is that Buffett invests his premium float in buying businesses like railroads, when hedge fund managers invest the float in their alternative investment funds.
But the premise is the same, of obtaining access to more permanent, cheaper flows of capital, which can then be put to work at higher return rates in order to augment an underwriting return. It can be a volatile strategy, as evidenced by recent results of some hedge fund reinsurers, but perhaps the new breed of Berkshire Hathaway copycat has more chance of outperforming.
The new breed of companies that rating agency Standard & Poor’s calls “Berkshire Hathaway copycats” are large and already diversified investment groups, such as EXOR which recently bought PartnerRe, and of the others many come from China.
These investment groups or conglomerates have diversified holdings, across industrial, property, mining or natural resources, financial, retail, automotive and other industries. They’re already diverse and adding a reinsurance business to this should provide them with a new source of capital, from another diversified source, which can flow back into their investments.
The strategy worries S&P to a degree though. The rating agency notes in a recent report that emulating the Berkshire Hathaway model is no guarantee of success for these investors seeking to enter the reinsurance market.
S&P has noted the recent increase in appetite to enter the reinsurance market following a diversified investment conglomerate style approach, but says that “The success of this strategy remains to be seen.”
S&P explains the strategy:
Through their investment holding companies, they are acquiring re/insurers with strong operating cash flows that ultimately will be upstreamed to the parent company. Re/insurers receive premiums up front and pay claims later. This collect now and pay later re/insurance model generates cash flows or “float” that these BKR copycats invest. Through this scheme, these investment holding companies gain access to capital with minimal cost.
However, S&P warns that despite the attraction to reinsurance, this model in particular, is “hard to duplicate and it is becoming a crowded trade in an already saturated reinsurance market.”
That’s true, it’s not easy to emulate Warren Buffett’s success. However, for an established, well-diversified investment conglomerate, adding a successful reinsurance business as another string to its bow, while not guaranteed to be easy, is no more difficult than the time reinsurers face operating as stand-alone entities.
However, what the diversified approach of an investment conglomerate does bring to reinsurance, is a reduced cost-of-capital as the company can lever its different business groups to offset each other, while also seeking to put the income and float to better use than a traditional, stand-alone reinsurer can do.
That can make the approach compelling and if the conglomerate is clever enough to ensure that it uses some of the benefits of this approach to make sure the reinsurers employees receive market-leading compensation and benefits, then there is absolutely no reason why these copycats can’t make a success of their entry into re/insurance markets.
And the growing interest in operating in reinsurance is set to add additional pressure to an already pressurised market.
“We expect more similar deals to come to the market during the next 12 months, which will likely continue to put pressure on reinsurance pricing given these holding companies’ lower cost of capital relative to stand-alone, publicly traded reinsurers’,” S&P explains.
By operating a reinsurer on a decentralised basis, while managing the investments centrally within the conglomerate, the cost-of-capital can be reduced through diversification and also offset by other activities.
Similarly, if reinsurance losses rose, capital from other areas of the conglomerate operations can be used to maintain the reinsurance units capital adequacy, with an expectation that future premium float and profits will more than repay it.
It’s easy to see why investors like John Elkann of EXOR find the reinsurance industry attractive, it’s a pure diversification for their holdings, with all the benefits of longer-term, cheaper capital and an attractive business return anyway.
In fact, some believe that the EXOR or perhaps China Minsheng (who are buying Sirius) approach means that they can actually target a much lower return on equity (ROE) than a traditional stand-alone reinsurer.
Reinsurers typically target low double-digit ROE’s, but as part of a diversified group perhaps 8% would be acceptable over the longer-term, with all the additional benefits available of putting the float and investment capital to work centrally.
S&P notes that with the interest from these groups having increased recently and a number of transactions underway, “it is still unclear how these to-be-acquired entities will operate under the new ownership.”
“Questions involve the prospective capital management, investment strategy, growth strategies, upstreaming of dividends, composition of the board of directors, and direction of the enterprise risk management framework, including any changes to risk tolerances and aggregation processes,” S&P explains.
However, the conglomerate groups buying into insurance and reinsurance are sophisticated investment oriented players and it’s hard to see them making any risky moves with the re/insurance businesses when what they really want is a stable flow of capital from them.
With as many as 40 Chinese investment conglomerates said to be actively looking at opportunities in insurance and reinsurance, while hedge fund managers and others also continue to probe the market for the right way to enter, this pressure from players with a lower cost-of-capital seems assured to continue.
While S&P notes that emulating Berkshire Hathaway won’t be easy, we feel that most investors are looking to recreate themselves with the addition of insurance and reinsurance capital flows to augment their investment operations.
Copying Buffett, while a noble aim, is unrealistic and to us it seems these new entrants are simply seeking diversified sources of lower-cost capital to add to their overall business mix. Right now, even in a soft market, reinsurance has gained in profile and these groups have gained a liking for it. It’s yet another trend which looks set to continue the structural change that incumbents have been dealing with in recent years.
As reinsurance increasingly becomes about capital efficiency, we can expect to see more players look to enter the space because they feel diversification, or something about their operations, can give them an edge, access to float and reduce their own capital costs.