Subscale ILS funds may follow AQR’s lead, exit reinsurance: Moody’s

Some of the smaller, or subscale, insurance-linked securities (ILS) funds may follow the lead of AQR Capital Management’s AQR Re and leave the reinsurance sector, in the opinion of rating agency Moody’s.

Global alternative investment and hedge fund manager AQR Capital Management told Artemis last week that it had decided to exit the reinsurance business and wind-down its Bermuda-based AQR Re unit and the ILS funds it managed.

AQR representatives said that the reinsurance business and its relative returns remained attractive, but that the market’s fundamentals had moved so much that it was concerned about its ability to continue to put clients’ money to work in the quantity and quality of business that would enable it to generate the risk-adjusted returns it desires.

As Moody’s says, the “tough industry outlook” certainly influenced AQR’s decision to exit the space, however it still felt returns were adequate. Moody’s says that the withdrawal of AQR from the space is credit positive for traditional reinsurers which have been squeezed by insurance-linked securities (ILS) fund businesses like AQR Re.

“We expect that more subscale ILS funds will follow AQR’s lead and either exit or partner with traditional reinsurers, either of which would alleviate competition for traditional reinsurers,” Moody’s analyst Kevin Lee writes in an article.

Moody’s says that AQR’s exit demonstrates that ILS funds cannot simply continue to lower rates to undercut reinsurance prices, despite being able to offer a cheaper product. ILS fund returns have suffered at the same time as they have won market share from traditional players. This has resulted in some investors choosing to exit the space, such as the Illinois Teachers Retirement System pension fund, which pulled out of AQR Re last year.

Moody’s shares the exhibit below, which shows just how much returns have fallen both for traditional reinsurance firms and for ILS funds.

Comparing the Returns of Traditional Reinsurers and Insurance-Linked Securities Funds - Source: Moody's

Moody’s believes that AQR’s exit shows that ILS face the same competitive forces as traditional reinsurance firms, resulting in an increasing need for economies of scale and scope. The same challenges that AQR cited in our article from last week, are the issues that are largely responsible for stimulating the M&A among traditional reinsurers that is ongoing today.

Due to the fact that ILS funds and traditional reinsurers are facing similar challenges, Moody’s expects to see more partnerships emerging, as reinsurance firms look to partner with ILS to harness third-party capital and ILS managers seek access to more risk through reinsurers.

However, Moody’s expects that many of these future partnerships may see reinsurers partnering directly with investors, rather than with established ILS fund managers.

“Third-party investors provide cheap reinsurance capital and management fees to traditional reinsurers, which, in turn, provide underwriting expertise and access to products and sales channels to third-party investors. Partnerships can also run in reverse, as is the case of Allied World and Aeolus Capital, where Aeolus is the ILS fund that provides underwriting expertise and the reinsurer provides capital,” Kevin Lee writes.

The rising competition faced by ILS managers is undeniable, which puts the smaller managers and funds in a more difficult position where they struggle to access as much business and to maintain returns. Just how credit positive this is for traditional reinsurance firms remains to be seen, with pressure affecting both alternative and traditional sides of the market.

The AQR case is perhaps a little more complex than it seems as well, the market factors may not be the whole story behind its decision to exit the space, according to speculation in the market (which we won’t go into here). It is however a sign that in a pressured reinsurance market environment no player is safe and simply being lower-cost or more efficient is no guarantee of longevity and a profitable business model for any player right now.

Moody’s acknowledges that, despite market conditions, more alternative capital is expected to enter the reinsurance market.

“The relative returns of reinsurance as an asset class and the diversification benefits will remain attractive for some investors. However, AQR’s exit shows the limits to the ILS business model and argues for consolidation among ILS funds,” Lee concludes.

Given some of the market discussion around other underlying reasons for AQR’s exit, we’re not in total agreement with Moody’s here. The firm’s exit does show the limitations of bringing ILS into a large, $130 billion+ asset managers world, where ILS is a tiny piece of its operations.

However we agree that consolidation among some ILS players is likely and some of the reasoning behind AQR’s move points to that as one of the drivers for its exit from the space. As reinsurance conditions get tougher we will see more consolidation trends emerging in the space, as well as partnerships between capital, reinsurers and ILS managers.

But if ILS players grow through consolidation they are likely to attract additional capital. Plus the capital that AQR had invested in the space will likely find its way back in through other avenues, if the third-party investors have the appetite.

And while reinsurers may partner with ILS players, that has no guarantee of improving their credit outlook. As reinsurers attract increasing amounts of third-party or ILS capital into their business models, they may simply be replacing balance sheet capital underwriting with off-balance sheet underwriting, resulting in a lower return on the business shared with investors.

Unless reinsurers that embrace third-party capital and ILS are using it wisely to grow and acquire new business, the end result could be a reduction of profit margin, with less of the risk premium earned out of the business they are underwriting. Is that model credit positive for reinsurers over the longer term?