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The plethora of new hedge fund-backed reinsurers that continue to be launched will carve out a niche in the industry—but perhaps not at the expense of the big, global reinsurers, argues Taoufik Gharib from Standard & Poor’s Insurance Ratings.
During the past few years, the hedge fund reinsurer (HFR) model has emerged in Bermuda and the Cayman Islands. HFRs are now competing with traditional reinsurers and alternative capital (also referred to as convergence capacity, third-party capital, and collateralised reinsurance) for business in what is becoming a soft reinsurance market. The multi-billion dollar question is: how viable and sustainable is the new HFR model?
It seems that one of the key aims of HFRs is to deliver attractive returns to shareholders that exceed those of traditional reinsurers. The premise of this strategy is to target, in general, low-volatility reinsurance business and allocate most of their capital to ‘alpha’-generating hedge fund investments (those with returns exceeding a benchmark on a risk-adjusted basis). HFRs’ investment strategies can vary widely but tend to be significantly riskier and consume considerably more capital than those typical of traditional reinsurers, which may increase the volatility of earnings and capital over time.
The emergence of this new HFR model raises a fundamental question: does one plus one equal more than two? In other words, does combining a reinsurer strategy with a hedge fund strategy create higher risk-adjusted returns than they could achieve separately? In Standard & Poor’s Ratings Services’ opinion, this will depend on the extent of risk diversification between a reinsurance underwriting portfolio and a hedge fund asset portfolio and the ability of the divergent risk cultures of reinsurers and hedge fund managers to find common ground. Although we do not rate any of the HFRs, we keep a close eye on them.
The HFR model is not a new phenomenon. In the late 1990s, two hedge fund managers sponsored two reinsurance start-ups: Max Re (sponsored by Moore Capital) and Scottish Re (sponsored by Maverick Capital). In both cases and for different reasons, the HFR model did not survive as the original sponsors originally intended. This doesn’t necessarily mean that the HFR model is unviable, but longevity is unproven.
How the two early HFRs fared
Max Re started with an alternative investment strategy that evolved into 50 percent alternative investments and 50 percent long fixed income. Eventually, Max Re drastically reduced its alternative investments allocation to 5 percent of its total invested assets by year-end 2009. The substantial reduction in alternative investments and the gradual shift toward fixed-income holdings drastically changed the company’s investment profile and, ultimately, Max Re has come to look more like a traditional reinsurer.
In first-quarter 2010, Max Re merged with a Bermudan reinsurer, Harbor Point (formerly Chubb’s reinsurance business), forming a combined company named Alterra Capital Holdings Ltd, which in turn was acquired by Markel Corp in December 2013.
In second-quarter 2006, Scottish Re incurred operating losses because of its rapid acquisition pace, which in turn led to operational weaknesses and the need for revision of the assumptions that underlie its financial results. The company had rapidly increased revenues and reinsurance in-force to become the third-largest life reinsurer in the US as of December 31, 2005.
Because of the loss and the resulting negative effect on Scottish Re’s financial flexibility, the company needed to raise capital to augment its anticipated liquidity and collateral needs.
“THE RAPIDITY IN WHICH THESE PORTFOLIOS MAY TURN OVER AND THE RELATIVELY LOOSE RISK GUIDELINES CALL FOR FREQUENT RISK MONITORING.”
In early 2008, Scottish Re’s capitalisation eroded further because of the declining market value of its subprime and Alt-A investments, along with asset impairments leading to additional collateral-posting requirements. The resultant deterioration in the company’s financial condition severely disrupted Scottish Re’s ability to generate new business and to retain existing business.
As a result, Scottish Re ceased writing new business and notified its existing clients that it would not be accepting any new reinsurance risks under existing reinsurance treaties, thereby placing its remaining treaties into run-off. Subsequently, Scottish Re was delisted from the NYSE as of April 7, 2008.
Generating the ‘float’
Reinsurance premiums fuel the investment engine behind the HFR model. Similar to their traditional reinsurance peers, HFRs receive reinsurance premiums up front and pay claims later. This collect-now-pay-later insurance model generates cash flows or ‘float’ that the hedge funds backing these reinsurers invest. Through this scheme, the hedge funds gain access to capital with minimal cost. Economically, this functions similarly to a loan by the cedants (the insurers buying reinsurance), and to the extent underwriting results are break-even or profitable, the HFR may actually be getting paid to borrow rather than pay interest under more traditional borrowing arrangements. However, this neglects the assumed risk from the cedants.
Because these HFRs seek excess investment returns, their reinsurance strategies tend to focus on lower-volatility lines of business because the asset side of the balance sheet generates more risk and reward. HFRs target subsectors of the reinsurance market. In general, they write low margin quota-share reinsurance focused on low volatility and short- to medium-tail insurance risk (four to five years duration) that is mostly exposed to frequency rather than severity-oriented risks. Examples of such lines of business include general liability, homeowner liability, and auto liability. However, there are HFRs, such as PaC Re, that write high-severity and volatile property catastrophe business.
In the current low interest rate environment, this type (ie, low margin and low volatility) of business may not be attractive to traditional reinsurers because of their depressed investment returns. Indeed, the traditional Bermudan reinsurers’ invested assets produced an average net yield between 2 percent and 3 percent in 2013. On the other hand, presumably the HFRs could take advantage of the fact that the competitors (ie, traditional reinsurers) structure products and quote prices based on less esoteric investment strategies or based on a risk-free rate.
HFRs assume their invested assets will earn superior returns, which will allow them to structure the reinsurance contracts and prices competitively to win business. The hypothesis that their higher investment returns will offset the reduced profitability from underwriting could, however, be flawed. Additional investment risk inherent in non-traditional investment strategies theoretically generates the excess investment return, so the notion that HFRs can price reinsurance more cheaply or require less underwriting income may not necessarily hold in a risk-based analysis.
When interest rates start rising, as we expect, the traditional reinsurers will likely become more price-competitive in these subsectors as they earn more investment income, possibly undermining the sole value proposition of the HFRs’ model. Also, HFRs may be more likely to experience investment losses under such scenarios if not fully hedged, potentially disrupting their businesses.
More importantly, in the current overall crowded reinsurance market, where prices are falling almost universally across the sector, competition is fierce among all market participants (ie, traditional reinsurers, convergence capacity, and HFRs). Under these circumstances, it will be hard for HFRs to remain opportunistic in finding pockets or subsectors where they can underwrite adequately risk-adjusted priced business. The potential undercutting of reinsurance pricing by HFRs to win business will weaken our view of their competitive position in our credit analysis.
A multitude of asset strategies: all high risk
Like reinsurance strategies, HFRs’ asset-management strategies are numerous and wide ranging. They include speculative-grade leveraged loans, private equity, long-short equity, fund of hedge funds, and speculative-grade bonds (those we rate ‘BB+’ or lower). The one common thread is that HFR investment strategies tend to be significantly riskier than those typical of traditional reinsurers. As a result, they are more capital intensive, which may reduce their capital adequacy in our risk-adjusted capitalisation analysis.
Because HFRs introduce significantly more investment risk, they must allocate significantly more capital to buffer this risk, offsetting any increases to returns on capital driven by higher investment returns. However, if the reinsurance liability risk diversifies better with the hedge fund asset risk than is seen with the traditional reinsurance asset/liability mix, the amount of capital allocated may be reduced, providing enhanced capital efficiency and returns on capital. This is a tall order, given that a heavy weighting toward a certain risk (ie, investment risk) limits the ability of diversification from smaller risk (ie, reinsurance liability risk) to reduce the overall risk profile.
Setting aside the tax advantages of placing investments in an offshore reinsurer, true value creation depends on whether risk diversification between reinsurance underwriting and hedge fund investing is greater than the corresponding diversification present in traditional reinsurance models. Given the heightened asset risk HFRs take on, measuring, managing, and controlling these risks is vital. The unique nature of each HFR’s asset strategy requires specified risk functions that can deal with the risks relating to the individual assets held or the underlying assets in each fund within the investment portfolio.
A cultural divide
As hedge funds form reinsurance companies, the contrast in business practices between asset managers and reinsurers is evident. Most notably, traditional reinsurers typically set forth comprehensive risk controls to manage the volatility in their businesses. Although asset managers employed by HFRs also set limits (such as concentration limits in a single issuer or a sector or limits on leverage), they tend not to be as restrictive, comprehensive, or risk-based as traditional reinsurers.
“REINSURANCE STRATEGIES TEND TO FOCUS ON LOWER-VOLATILITY LINES OF BUSINESS BECAUSE THE ASSET SIDE OF THE BALANCE SHEET GENERATES MORE RISK AND REWARD.”
The fluid manner in which hedge funds may reallocate their portfolios and the freedom given to portfolio managers make it more difficult to assess the prospective risk of the organisation. We believe that fund managers are reluctant to relinquish their autonomy to the extent embedded in stronger more traditional reinsurers’ risk controls frameworks. However, asset managers flex their strategies to adjust to HFR profiles, often setting up separate investment vehicles from their main investment funds to facilitate the HFRs’ unique requirements or needs. Nevertheless, we believe that the trade-off between flexibility and adhering to a prudent risk tolerance is a tension that HFRs will struggle to reconcile.
Efforts to bring asset strategies under risk frameworks similar to those of traditional reinsurance companies would go a long way toward bringing a more robust risk construct and risk visibility to HFRs to allow for higher financial strength ratings. Risk visibility speaks to the stability of the investment strategy such that the future risk profile is predictable. Moreover, asset managers will also need to adjust their strategies and asset-liability management to consider the reinsurance liabilities, which could introduce uncertainty in both magnitude and timing of cash needs.
Capital adequacy and liquidity are key
The risks associated with HFRs’ investment strategies are much higher than traditional reinsurers assume. Due to significant investment concentrations in specific strategies, and sometimes specific individual assets, each portfolio requires a bespoke analysis to best understand its risk characteristics. This analysis often requires asset-level detail, but in highly diversified portfolios (such as a fund of funds), the analysis may be possible by analysing the risk characteristics of each individual underlying fund. Furthermore, the rapidity in which these portfolios may turn over and the relatively loose risk guidelines call for frequent risk monitoring.
Heightened market, credit, and liquidity risk are the primary concerns. Alternative portfolios relative to traditional reinsurers’ portfolios hold more assets with greater sensitivity to market movements, such as equities and speculative-grade bonds. In addition, leverage that aims to boost returns also amplifies these risks, thus increasing volatility. Depending on the extent of asset leverage, HFRs will experience higher capital gains when strategies work, but will lose more capital when they don’t.
In fixed-income strategies, the credit risk tends to be higher as well. The fixed-income investments these strategies employ are usually speculative-grade, making them more susceptible to credit losses than the high credit quality portfolios of traditional reinsurers. Once again, leverage often amplifies the risks and rewards. Higher credit and market risk causes these investment strategies to consume significantly more capital than traditional reinsurance investment portfolios.
These considerations also become important when viewing stressed liquidity scenarios. Higher risk and leverage in investment portfolios not only limits the value of assets in times of stress, but these investments may also be hard to liquidate without taking further losses. Borrowing facilities used to employ leverage or derivative contracts may require collateral posting that may capture liquid assets when they are most needed. Some underlying funds may also have ‘gates’ that prevent redemptions in times of stress, and some leverage facilities may require an asset sell-off after losses to maintain leverage requirements. All of these factors may limit the amount of liquidity available in a time of stress.
Our liquidity analysis considers simultaneous assets stresses and underwriting losses and determines whether the company has sufficient liquidity under this scenario to meet its obligations during the course of a year. A lack of liquidity under this analysis significantly detracts from our view of credit quality and could prevent HFRs from receiving ratings similar to those of their more traditional peers.
These risks may be managed, however. For instance, to ensure sufficient liquidity, HFRs could implement proper procedures to monitor cash sources and needs. And specific portfolio guidelines—including prudent limits on position sizes, leverage, and sectors—might prevent large risk accumulations. In addition, risk-based limits might place a ceiling on how much risk an asset portfolio may create. However, these types of risk-based metrics don’t appear prevalent in the investment guidelines of many HFRs. Prudent use of hedging instruments, such as derivatives, are another tool to contain risk. To the extent that these instruments limit risk in the scenarios our capital analysis considers, we adjust our view to incorporate the positive impact to the HFRs’ overall risk position. However, we might consider the credit risk of a derivative counterparty.
Is the new HFR model viable in the long term?
The potential crossover between hedge funds and reinsurers offers compelling possibilities. However, a commensurate focus on additional risks would have to supplement the singular focus on higher investment returns. Considering both is necessary in determining whether one plus one is truly greater than two. This depends on whether combining hedge funds and reinsurers can create additional diversification benefits that don’t occur in these two types of organisations independently, thus creating a more capital-efficient vehicle. We believe it’s possible. However, in our view, closing the gap between reinsurer and hedge fund risk cultures and implementing prudent risk controls is necessary to realise these benefits.
The HFR model will likely carve out a niche market for itself and compete with smaller reinsurers. However, we still believe that the traditional reinsurers will continue to dominate the landscape and provide stable capacity to their cedants.