S&P warns on longevity of hedge fund reinsurance model

The performance of hedge fund reinsurers diverged in the opening months of 2016 following investment market volatility. Consistently being outperformed by traditional reinsurers Standard & Poor’s (S&P) questions the longevity, and success of the hedge fund reinsurance business model.

Hedge fund reinsurers continue to struggle in the softening reinsurance marketplace, exacerbated by low interest rates and minimal investment profitability.

A lack of underwriting profit and continued top-line growth coupled with diminished returns on investments – the key focus area of the business model – sees traditional reinsurers continue to outperform the divergent hedge fund reinsurance strategies.

In a new report, ratings agency S&P explores the recent performance of hedge fund reinsurance firms, warning that to succeed in bridging the gap between reinsurers and hedge fund risk culture, the ability to increase capital-efficiency via diversification and prudent risk control, is key.

So far, the hedge fund model hasn’t endured the best of times, struggling to compete with traditional reinsurers as the pressures of a difficult investment environment hinder profits and performance.

Furthermore, the competitive reinsurance market is resulting in higher costs for all in the space, hedge fund reinsurers and traditional players alike, but the heavy focus on investment returns suggests the hedge fund players are feeling the force from both sides.

Stand-alone firms such as Greenlight Re and Third Point Re, and also sponsored entities such as ABR Re and the recently established Harrington Re, have aggressively increased their top-line in the last three years, says S&P, something that might not be the best route to success in a softening landscape.

As a result of their aggressive growth, the softening landscape and resulting lower pricing, S&P notes that since their inception, hedge fund reinsurers have largely underperformed their traditional peers.

Artemis discussed recently the divergence in performance among hedge fund reinsurers in the opening three months of 2016, with Greenlight Re reporting a profit while Third Point Re slumped to a loss in the quarter.

Prior to this both firms experienced a full-year 2015 investment loss, and highlighting just how volatile the marketplace is and also how the hedge fund model continues to evolve, Third Point Re returned to profit in Q2, while Greenlight Re saw its fortunes reverse, reporting a loss in the quarter.

The ratings agency notes that another negative trend is the declining industry return on equity (ROE) in the hedge fund reinsurer space, which despite top-line growth continues to fall, as does the combined ratio, and particularly when compared with traditional reinsurers.

“We continue to observe that soft pricing has been affecting traditional reinsurance and HFRs alike. Under such pressure, coupled with restrained investment returns that aren’t offsetting the weakness in underwriting, we may begin to see fissures start to form in certain HFR models,” said S&P.

S&P notes that there’s scope and potential for the hedge fund reinsurer model to succeed, and that it will likely continue to evolve over time as reinsurance and capital markets continue to converge.

Fellow rating agency Fitch noted earlier this year that the hedge fund model still has its challenges, but again noted that continued evolution was needed.

“The crossover between hedge funds and reinsurers offers compelling possibilities. However, we believe HFRs need to focus as much on the additional risks of their strategies as they do on the higher investment returns.

“We believe that the traditional reinsurers will continue to dominate the landscape and provide stable capacity to their cedents. However, the HFR model will continue to evolve and nibble at the edges of the reinsurance market as it carves out a niche for itself, competing primarily with small reinsurers while leaving some HFRs’ carcasses on the side of the road,” said S&P.

As those in the space look to offset the challenges of the softening landscape, attempt to improve efficiency and returns on both the investment and underwriting side of the balance sheet, the hedge fund model will surely continue to evolve.

Should global interest rates rise and the investment market become less volatile and challenging, the hedge fund reinsurance business model has the potential to generate impressive returns for shareholders. However, in a softening market where returns are down across the board, the strategies of these types of firms appear to be struggling to keep up with the traditional reinsurers that they aim to outperform.