Validus expect ILS and third-party capital to play a growing role in reinsurance

Bermuda based insurance and reinsurance group Validus Holdings announced 2012 full year net income of $408.4m and a fourth-quarter 2012 net loss of $90.7m last Thursday. The group held an earnings call and some interesting comments on the growing third-party and institutional capital management side of its business were discussed. It’s clear that Validus see the insurance-linked securities (ILS) sector as an important part of its business and the reinsurance market as a whole.

Validus’ interests in ILS, collateralized reinsurance and third-party capital management have been growing steadily in recent years. The firm operates the AlphaCat sidecars which are collateralized by third-party investors, an AlphaCat ILS fund which was an internal fund but is now taking money from external investors as well and a joint-venture hedge fund style reinsurer PaCRe, Ltd. which it launched in partnership with the Paulson & Co. hedge fund.

At the beginning of January Validus announced it had increased the amount of third-party capital within the AlphaCat sidecars and funds by taking on $404.4m of additional investor contributions. The firm raised $185m of investor capital for its latest AlphaCat 2013 sidecar and also raised $219.4m of third-party capital as subscriptions for its AlphaCat ILS funds. Demonstrating the growing commitment that third-party capital is set to play for Validus, the funds raised for its ILS funds are the first third-party capital contributions the funds have taken. Previously Validus’ ILS funds had been internally funded for the last few years since their launch.

In the last year, Validus’ AlphaCat subsidiary saw managed premiums of $148m for the full year, a 96% increase over 2011, according to CEO Ed Noonan on the call. AlphaCat generated $41m in net income and the funds raised for the sidecars and ILS funds grew the groups assets under management by $404m.

The AlphaCat segment was not immune to hurricane Sandy though, and the fourth-quarter results saw the two sidecars take a hit of which Validus themselves shared $8.4m. Interestingly, Validus revealed its estimate for the impact hurricane Sandy had on the insurance sector when Executive Vice President Jeff Sangster commented that Validus expects hurricane Sandy to cause in excess of $25 billion of losses to the industry. That’s one of the highest estimates we’ve heard and likely includes Validus’ thoughts on how losses could creep upwards slowly over time.

Another interesting point revealed in the call was that Validus have suffered a $31.3m unrealised investment loss due to the PaCRe investment portfolio. That follows on from earlier this year when Validus took a $5m share of PaCRe investment losses. As we’ve written before, the hedge fund backed reinsurer strategy is exposed to asset-side risks and it has been widely discussed that Paulsons hedge fund returns had been affected in 2012.

CEO Ed Noonan discussed how the AlphaCat segment of Validus’ business has been performing. He said that AlphaCat continues to enjoy excellent success and that it is able to attract new capital whenever Validus sees the opportunity to generate acceptable returns for investors. The new AlphaCat 2013 sidecar had a very good January renewals and managed to deploy the vast majority of its capital.

Noonan said that with AlphaCat closely aligned with Validus Re it enables Validus to offer comprehensive solutions to clients, with AlphaCat able to access more, and different, pools of business. At 1st January, AlphaCat’s managed premiums grew 18% over a year earlier.

On the AlphaCat ILS funds, EVP Jeff Sangster said that the infusion of $219m of capital is the first third-party capital Validus has taken into these ILS funds, having funded them internally since launch. He said that they have developed a strong track record with the funds, which helps them to raise external capital, and that they just achieve a management fee for Validus. This shows Validus going down the same route as a number of other large insurance and reinsurance groups, recognising the value in managing third-party capital assets which can be used within its underwriting operations with premiums funding returns to investors.

Noonan said that the managed premium and AlphaCat side of Validus’ business is expected to continue to grow, but they remain mindful that it is a spread business. Right now, he said, it offers institutional investors a cost of capital advantage, noting that they will accept lower returns for higher layers of risk than traditional reinsurers.

However, Noonan said that as interest rates rise and other asset classes become more attractive the spread investors like may reduce or even disappear at times. Noonan said that while he sees long-term growth for the AlphaCat segments of the business, he doesn’t see straight line growth. That’s a very pragmatic approach to the ILS business, as we all know that inflows of capital to the sector do come and go in line with investors appetite for the space and what premiums are achievable.

He added that it may be that the third-party capital part of the business hits a plateau, or slows its growth, but he sees it as a core part of the Validus business and he continues to see opportunities for growth, particularly in the U.S.

Noonan said that Validus are willing to be patient about expanding the breadth of its ILS and third-party capital operations. He said that he suspects that as the ILS sector continues to grow and play a bigger role in the reinsurance industry, some smaller companies may find it hard to sustain themselves in business and Validus would be happy to assist in the process.

On the new inflows of capital Validus has received, Noonan said that it may result in it operating different AlphaCat funds, with differing risk and return profiles. He said that of new premium growth, a lot of the worldwide, fairly high attachment point business ends up in the AlphaCat ILS funds. On the development of AlphaCat over time, Noonan said he expects the sidecars to remain fairly similar and the ILS funds to see more of the high-layer type reinsurance business.

Finally, some comments were made on the Florida insurance and reinsurance market and the potential for increased demand emanating from that market. CEO Noonan said that he sees the area as one where the ILS market will continue to deploy and perhaps grow the amount of capital it deploys and that this has the potential to change the dynamics of the Florida market. He insinuated that Validus will approach opportunities with an open-mind as to where new business fits best in its portfolio, with Validus Re, AlphaCat sidecars, AlphaCat ILS funds or even PaCRe.

Validus has created a platform which allows it to participate in different types of reinsurance business, with differing attachment points, returns and risk profiles, utilising different sources of capital as and when motivations are best suited to the job. This is the future that we are already beginning to see in other re/insurance groups and will increasingly see in years to come, with third-party capital playing an increasingly important role.

You can read a full transcript of the earnings call over at Seeking Alpha.