Hedge fund reinsurers struggle in low interest rate environment

The business model of hedge fund reinsurers is being put to a hard test in the current soft market while sophisticated clients challenge their business model.

In the past few years, hedge funds have been increasingly investing in the reinsurance space in an attempt to diversify the business and boost returns. There are, however, many reasons to believe that the potential for hedge fund reinsurers may be fading.

Hedge fund reinsurers reinvest capital initially pumped into the reinsurer in the asset management strategy. In addition to investment returns, the reinsurer also receives premiums on its underwriting activities, which should generate profits which are also invested into the investment strategy.

Hedge fund reinsurers’ business model shows some flaws as it is being challenged on both the underwriting and the investment sides.

Over the past few years, hedge fund reinsurers have grown their top line aggressively in a soft reinsurance market, which is never a good recipe for success, according to a July 2016  S&P Global Market Intelligence report titled Hedge Fund Reinsurers: Dead or Alive?

The strong top-line growth was, however, largely unprofitable. In 2013, the sector produced a combined ratio of 102.1 percent on a consolidated basis, in 2014 it deteriorated to 105.6 percent, further worsening to 110.2 percent in 2015, according to S&P.

Hedge fund reinsurers are divided into two groups. One is the sponsored type, which generally has a highly rated reinsurer sponsor. This group includes ABR Re, which works with Chubb, Aligned Re, which works with Enstar, and Watford Re cooperating with Arch Capital.

Standalone hedge fund reinsurers, which operate without a sponsor, include Fidelis Insurance and Greenlight Capital Re.

Third Point Re also operates as a standalone reinsurer. In the first half of 2016 it produced a net underwriting loss of $32.2 million, up from $13.2 million in the same period a year ago. At the same time, net investment income declined to $46.2 million from $103.5 million during the period.

Reinsurance prices, particularly in property/casualty, are under pressure. In addition, the first half of 2016 has been a relatively active period for catastrophe events. While the impact from the US hurricane season remains unclear, market observers expect the soft market to remain in place and continue in 2017.

On the asset side, hedge funds have encountered considerable market volatility in the second quarter while low interest rates made it difficult to find high return opportunities.

Investment performance of hedge fund reinsurers has declined recently. While in 2013, the hedge fund reinsurers’ net investment income increased 121 percent year-over-year to $476 million, it plummeted 63 percent year-over-year to $247 million in 2015.

The new Swiss Re CEO is among a number of market observers who question the sustainability of hedge fund reinsurers’ business model.

“We are highly sceptical and don’t believe in the longevity of the hedge fund reinsurance model at all,” said Christian Mumenthaler, Swiss Re CEO, during a presentation at the Rendez-Vous in Monte Carlo.

Arno Junke, CEO of Deutsche Rück, describes the business model of hedge fund reinsurers as “a capital-collecting machine which claims to be able to earn quick money.”

“This is extremely unsexy, because with this statement, they won’t be able to convince their clients,” Junke explained. Their targeted clients are professionals which have understood that hedge fund reinsurers may try to build up something over two years and then they are off again, he said.

It’s a very discerning market and there are large numbers of strong players, said Mike Van Slooten, head of market analysis at Aon Benfield, during a Fitch panel discussion.

He suggested that only a few companies would want to buy cover from a hedge fund reinsurer particularly when targeting medium-term business. “If you want your claims paid in five to 10 years’ time, will you really go to a newly established hedge-fund reinsurer?”

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