Hedge fund reinsurers struggle in the current harsh operating environment

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.

At first glance, the strategy of hedge fund reinsurers may sound promising. Capital initially invested in the reinsurer is invested 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.

Provided the investment returns are positive over the long term, the reinsurer is likely to outperform a fund with an identical investment strategy, EY claimed in a 2014 report titled Leading the Way.

One of the key goals of hedge fund reinsurers is to deliver attractive returns to shareholders, who are primarily high net worth individuals and institutional investors, that exceed those of traditional reinsurers, S&P Global Market Intelligence, explains in a July 2016 report titled Hedge Fund Reinsurers: Dead or Alive?

The premise of the strategy is to target, in general, low margin and low volatility reinsurance business and allocate most of their capital to ‘alpha’-generating hedge fund investments. But these strategies tend to be significantly riskier and consume considerably more capital than those typical of traditional reinsurers and therefore may increase the volatility of earnings and capital over time, according to the analysts.

There is an opportunity for hedge fund reinsurers from a rational point of view, but not so much from an economic point of view, Laurent Rousseau, chief underwriting officer for EMEA P&C Treaties at SCOR, suggests at a Fitch panel discussion. If market volatility similar to the years after the dot.com bubble burst in the year 2000 arises, hedge fund reinsurers are likely to face “very bad surprises”, he says.

Even without an increased market volatility, the 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 a never a good recipe for success, the S&P authors argue.

In 2013, hedge fund reinsurers saw a 52 percent year-on-year rise in gross premiums written (GPW) to $938 million, according to S&P Global. Growth continued in 2014, with $1.38 billion in GPW among hedge fund reinsurers, up 47 percent from 2013. In 2015, the hedge fund reinsurance industry experienced its third straight year of solid top-line increases, with GPW growing 40 percent year-over-year to $1.93 billion. These trends in top-line growth and underwriting performance continued into the start of 2016, according to S&P.

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.

The hedge fund reinsurance industry has yet to generate an underwriting profit, S&P analysts write. They continue to underperform traditional Bermudian reinsurers which include Endurance, Everest, Hiscox or Arch. In addition, the alpha-generating hedge fund strategies have failed to impress as they delivered subpar results, the authors of the S&P report write.

TWO GROUPS

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.

When presenting second quarter results, John Berger, chairman and chief operating officer, says that the performance of Third Point Re’s property and casualty reinsurance segment in the second quarter was disappointing.

“We produced a combined ratio of 119.2 percent due to $12.9 million of adverse reserve development on several contracts. We suffered from both industry-wide loss trends and account specific issues,” he notes.

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 as this article goes to press, 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. Nevertheless, Third Point Re managed to increase net investment income significantly to $86.3 million in the second quarter from $38.6 million in the same period a year ago.

The improved performance is a result of an increased exposure to several high yield energy credits and to equity investments in cyclicals, commodities, industrials, and emerging markets, Daniel Loeb, CEO Third Point LLC, investment manager, explains.

“Our sovereign credit portfolio continued to add value, our Argentinian government bonds have returned 11.7 percent for the quarter and 20.7 percent for the year,” Loeb notes.

In the first quarter, however, Third Point Re reported a net investment loss of $40.1 million.

Hedge fund reinsurers’ asset management strategies vary widely and include speculative-grade leveraged loans, private equity, long-short equity, funds of hedge funds, and speculative-grade bonds, according to S&P. Generally, investment strategies are meaningfully riskier than those of traditional reinsurance companies, making them more capital-intensive, the analysts explain.

FALLING RETURNS

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.

The issue lies in the fact that they deal with long-tail liabilities and that they are using the US regulatory system to operate an aggressive asset management business, he explains.

“That, so far, hasn’t worked out,” not least because clients with long-tail risks are unlikely to select a hedge fund reinsurer as a partner, Mumenthaler said.

“It is really hard to make a case for any company to move long-dated liabilities into a new vehicle which might not be around in 50 years when they have to pay claims.”

AQR Re, which is affiliated with AQR Capital Management LLC, stopped writing new or renewal business after April 1, 2015, because of the soft reinsurance market, S&P notes in the report. In addition, Bermuda-based PacRe—which was launched in 2012 by sponsor Validus Holdings and hedge fund Paulson & Co—entered into run-off in January 2016 because of poor investment returns and minimal premiums. Earlier this year, XL Group dropped its plans to launch its own hedge fund reinsurer, Alloy Re, with alternative fund manager Oaktree, the authors note.

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,” he explains. 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 says.

Convincing primary insurers to make business with a hedge fund reinsurer may indeed be among major challenges for the sector.

“One thing that gets overlooked is that you can take a rating agency with you, you can take the regulators with you, and you can take the brokers, but actually you have to have buyers of your product,” Mike Van Slooten, head of market analysis at Aon Benfield, says during the Fitch panel discussion.

It’s a very discerning market and there are large numbers of strong players, Van Slooten says, suggesting 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?”

S&P believes that the hedge fund reinsurance 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”.

At the same time it will, however, leave some hedge fund reinsurers’ carcasses on the side of the road.