The hedge fund backed reinsurance mode which seeks to leverage premium inflows as investment capital in hedge fund strategies in an attempt to outperform on the asset-side, is not treated as a new business model by rating agency A.M. Best.
The hedge fund reinsurer, typically formed by or in cooperation with hedge fund type asset managers, often underwrites lower volatility or higher layer reinsurance business in order to treat the premium float as long-term capital to be invested in more active or aggressive investment strategies.
This results in greater volatility on the investment side of the reinsurance business, which as a result means that greater diligence into the reinsurers backing, investment strategies and the asset classes it invests in is required when rating such companies.
A.M. Best defines the strategy as; “An entity in which the hedge fund primarily acts as a conduit for attracting the investors in the reinsurer and then manages the assets for a fee,” with the key difference to a traditional model being the investment strategy and how that matches the chosen underwriting strategy.
The assets are typically held outside of the reinsurer, in the hedge fund or asset manager and the level of volatility associated with the hedge fund and its investments is typically much higher than you would find in the investments a traditional reinsurer makes.
The briefing published by A.M. Best explains the rating agencies rational for treating the business model as the same as traditional reinsurance and highlights where the agency stresses certain scenarios in order to test the credit fundamentals of these asset manager backed entities.
Best highlights the potential for liquidity and capital risk, which is inherent in this strategy, which it says leads to the use of significantly stressed capital scenarios in the rating process. Best looks to capture the volatility in a variety of scenarios it runs to represent lower probability events.
This is a sensible approach to rating such reinsurers. The core business model of underwriting and investment remains the same, it is the levels of risk, duration and volatility which differ on both sides of the business. However, with traditional reinsurers adjusting their investment strategies and portfolios to make up for lost profits on the underwriting side in the currently competitive market environment it makes sense to have a standardised rating methodology which can be tweaked to suit different levels of risk and volatility.
A.M. Best says that the rating process it follows for hedge fund backed reinsurance companies remains aligned with the Best’s Credit Rating Methodology (BCRM), which involves in-depth analysis of the company’s balance sheet strength, business profile and (projected) operating performance.
If a hedge fund reinsurer does not have a track record that it can demonstrate, Best’s analytical focus is focused on due diligence on management expertise/track record, asset management capabilities, business plans, internal operational controls and overall enterprise risk management (ERM) program.
A.M. Best maintains interactive ratings for five hedge fund style, or asset management backed, reinsurers; Greenlight Re, Third Point Re, PaCRe, Hamilton Re and Watford Re. When you consider the breadth of strategies amongst that group of five it’s clear that this niche is quite broad and so considering them just part of the broader spectrum of reinsurance company ratings is again sensible.
A.M. Best says that it does not view the hedge fund reinsurer structure as a new business model, which means they are analysed within its existing rating criteria reports. Best notes that this business model is not a replacement for the traditional reinsurance business model, nor for future capital market solutions.
Rather, Best says, the hedge fund reinsurer is a niche reinsurance strategy that when executed well should be able to succeed in its approach, albeit with a potential for higher volatility.
The emergence of the hedge fund reinsurance business model was a recognition that the two strategies, of underwriting with a complementary investment strategy, does not have to mean high-risk underwriting and low-risk investing. There is a whole scale of potential strategies, where the underwriting and investment side volatility or risk is adjusted so the two continue to complement each other, we may just have seen the start of this trend.
The strategy allows asset managers, such as hedge funds, to leverage the premiums in a higher performing investment strategy than traditionally would be seen in reinsurance, as long as the asset-side matches the underwriting tail and volatility as closely as is possible.
These asset or hedge fund managers can also use the reinsurers premium income as a source of, what many consider, more permanent capital. This capital cannot be withdrawn by its investor, except if required to pay claims, so when the underwriting is good the capital is available to invest which goes some way to explain the often longer-tailed underwriting approach adopted with this strategy.
Under the right circumstances, and market conditions, this strategy could easily outperform a traditional reinsurance business model. For the insurance linked investor, allocating capital to a hedge fund backed reinsurer could return more than a typical ILS investment, again under the right market conditions.
Of course for the insurance or reinsurance linked investor allocating capital to the hedge fund backed reinsurer is not a low-correlated investment, like ILS would be, as you gain the exposure to financial markets through the investment strategy. However as part of a portfolio of insurance linked investments a hedge fund reinsurer is a useful complement.
The strategy may remain niche, as Best says in its briefing, but the general premise of a more active or riskier investment strategy among reinsurers may become more prevalent, due to the lower underwriting returns currently available. As a result we may see many more reinsurers looking to bring asset management deeper into the firm with partnerships and outsourcing of parts of their portfolios.
Any additional return, from the asset side to boost lower underwriting returns, will be welcomed by shareholders and as a result may be something we increasingly see reinsurers trying out. For traditional reinsurers the model does pose a threat, no matter how niche, as it could increasingly move into the low to mid volatility underwriting market which, with the ILS and capital markets looking for the peak risks, could result in the traditional reinsurance model being left with a smaller piece of the overall underwriting pie.
Whether it’s a new business model or not, which really depends on the motivations for establishing such a reinsurer, hedge fund or asset manager backed reinsurers are likely here to stay and the traditional market will likely increasingly look at how it can become more efficient, and performant, in managing its assets.
The A.M. Best briefing document, titled ‘Focus Remains on Credit Fundamentals In Rating Hedge Fund (Re)insurers’, is a useful overview of the hedge fund reinsurer strategy while explaining Best’s rating strategy for these firms. You can download a copy via the A.M. Best website here.