The hedge fund reinsurer was the next logical progression for alternative capital into the market, but as their performance has failed to meet expectations, where does that leave the future of this business model? Bermuda:Re+ILS reports.
Bermuda-based hedge fund-backed reinsurers have emerged as an increasingly popular business model in the past decade. For hedge funds, such ventures represent an uncorrelated investment, a source of permanent capital to invest in, and they can offer significant tax advantages.
From a reinsurance perspective, the lucrative investment returns hedge funds can generate on the asset side of the balance sheet can represent a complementary income stream to underwriting profits and give them an edge over their mainstream competitors.
There is no doubt the appetite among investors from this sector to invest in risk transfer vehicles remains strong. Capital continues to chase the prospect of better returns through investment in the reinsurance sector. According to Aon Benfield, the June 2015 Aon Benfield Aggregate alternative capital rose by 6 percent during the first half of 2015 to $68 billion, while traditional capacity fell by 3 percent.
This capital is manifesting itself in a number of ways including the near-record issuance levels of catastrophe bonds, the expansion of fully collateralised placements and growing utilisation of ‘sidecar’ vehicles, Aon Benfield says.
More and more have also launched their own reinsurance businesses in recent years—and most have chosen Bermuda as their jurisdiction of choice.
The Island is a great place to domicile a reinsurer for several reasons, including its flexible yet world class regulatory regime, manageable capital requirements and lack of strict requirements on how assets might be invested.
But just how successful have these players really been so far?
Tried and tested?
It’s a question that is often asked but surprisingly difficult to answer. The opaque nature of hedge fund investments serves as just one barrier to knowledge. Even their claim to produce high yield returns with limited market correlation has been dismissed by one industry commentator as an “untested hypothesis”.
Part of the problem stems from the fact that most are relatively new and, even those that have been around for a few years are, as yet, untested by either a significant catastrophe loss event or a sizable investment market stress environment. This is an area of concern because any huge fall in asset values by a hedge fund could deplete a reinsurers’ capital, putting potential strain on a company—especially if it coincided with unusually high claims.
“Reinsurance buyers are sceptical about the model and it is not obvious to them why they should embrace it when there is plenty of choice out there.” MIke Van Slooten
One company that has been tested perhaps more than most is Greenlight Capital Re, which was formed by David Einhorn’s hedge fund Greenlight Capital. The company is domiciled in the Cayman Islands and it is also listed, having completed an initial public offering in 2007, making its performance more transparent.
As a result of its longer history, Greenlight Capital Re has endured more claims than many newer players and withstood the financial crisis. However, it has come under shareholder pressure recently with its share price dropping by almost 25 percent in the past 12 months from around $32 per share to around $22 at the time of going to press.
The decline in its share price has been driven by less than inspiring results, largely because of losses on the investment side of the business—perhaps a warning of the pitfalls of relying on the promises of higher returns thanks to the hedge fund model.
Greenlight Re made a net loss of $39.6 million for the second quarter of 2015, compared with a net profit of $109.6 million for the same period in 2014. If the company’s performance in the first six months of the year is examined, challenges can be seen on both sides of the business.
The company’s combined ratio for the six months ending June 30, 2015 was 109.2 percent compared with 99.8 percent for the prior year period. Meanwhile, it made a net investment loss of $45.1 million in the first six months of 2015, representing a loss of 3.2 percent, compared to net investment income of $103.8 million during the comparable period in 2014 when Greenlight Re reported a 7.3 percent return.
“Our investment portfolio continues to be defensively positioned as we remain cautious due to an uncertain investment environment,” stated Einhorn, chairman of the board of directors.
“While we are disappointed with the underwriting loss from legacy business this quarter, we remain encouraged by the current portfolio and new relationships.”
Meanwhile, Third Point Re, a Bermuda-based property/casualty reinsurer, also listed, has fared better but has also seen a dip in performance. It reported a net income of $15.7 million for the second quarter of 2015, compared with net income of $31.3 million for the second quarter of 2014, a decrease of 49.9 percent.
For the three months ended June 30, 2015, Third Point Re recorded net investment income of $38.6 million, compared to $40.5 million for the three months ended June 30, 2014. The return on investments managed by the company’s investment manager, Third Point, was 1.7 percent for the three months ended June 30, 2015 compared to 2.3 percent for the three months ended June 30, 2014.
“Although our combined ratio was elevated in the quarter due to $3.2 million of losses from weather activity in Texas and $2 million of adverse reserve development, we remain committed to our goal of underwriting profitability,” said John Berger, chief executive.
“In the second quarter, we generated premiums written of $184.3 million, an increase of 26.7 percent, and we continued to develop a strong pipeline of new business.
“Our investment manager, Third Point, continued to outperform the broader market indices this year producing a 1.7 percent return on our investment portfolio for the quarter and 4.8 percent for the year.”
The markets were not impressed by recent results. Third Point’s share price has dropped by around 14 percent since June and analysts have expressed some concerns.
Zacks Investment Research commented that surging claims associated with windstorms and weather-related incidents in the state of Texas affected the firm’s underwriting results, inducing wider underwriting loss and the combined ratio deteriorating 510 basis points to 107.8 percent.
“Third Point Re was also burdened with significant debt levels at the end of the quarter. This is a cause for concern as high debt levels might dampen the balance sheet strength and also make future borrowing expensive,” said Zacks, which also downgraded Third Point to “strong sell” status as of September 4, 2015.
These are just two examples of hedge fund reinsurers operating in the public realm. Others, which are not listed and thus less transparent, jealously guard their investment strategies and performance. Ultimately, the long-term future of the hedge fund approach depends on its success in generating superior risk-adjusted returns over the market cycle compared with other alternative and more traditional reinsurance market structures.
Some seasoned market practitioners are sceptical. Industry veteran Don Kramer, the founder and chairman of ILS Capital Management, is one such executive. One of the many challenges the ventures face, he notes, is a legitimate exit strategy given their poor performance of late.
“The concept of the hedge fund reinsurer was to write low risk reinsurance, generate additional investment assets beyond surplus, and manage those assets for a premium return thereby generating double digit returns on equity. The next step was to go public with the shares priced at a high premium to book value,” he says.
Great idea, but as of July 31 the publicly traded hedge fund reinsurers were faring badly in comparison with their traditional reinsurer counterparts. Kramer makes the point that since December 31, 2013 two publicly traded hedge fund reinsurers declined 20.9 percent and 22.9 percent respectively, while the S&P Reinsurance Subindustry index rose 21.1 percent.
Indeed, data examining stock price and asset returns of 33 Bermuda reinsurers from 2000 through 2012 in The Synergies of Hedge Funds and Reinsurance by Eric Andersen shows that, despite a positive relationship between firms’ gross returns and alternative asset management domiciled on the Island, exposure to alternative investments not only “fails to mitigate market risk, but also may actually eliminate any exceptional returns asset managers would have otherwise produced by maintaining a traditional investment strategy”.
The 2012 Andersen report was written a time when rating agencies were being bombarded by requests from prospective hedge fund reinsurance start-ups. Things have changed since then with equity market volatility taking its toll on portfolio investment strategy.
The first signs of difficulty in this sector were signalled around a year ago when Golub Capital Re decided to put its launch on hold indefinitely because of the deteriorating conditions in the market. The Bermuda-based hedge fund reinsurer start-up was planning to go live with an AM Best A- rating and $750 million in capital. Requests by hedge fund reinsurers for an industry rating have now all but dried up.
The agency’s view
Mike Van Slooten, head of market analysis with Aon Benfield, says not to expect hedge funds to be hammering at the reinsurance ratings door any time soon.
“There is a market acceptance issue with these vehicles,” he says. “Reinsurance buyers are sceptical about the model and it is not obvious to them why they should embrace it when there is plenty of choice out there.”
On top of this, he believes that rating agencies remain to be convinced about the veracity of the business model.
“AM Best is sceptical about the model. It sets the bar high here and it’s got to the point where some of the firms that were interested in doing it have decided it wasn’t in their interests to go ahead,” says Van Slooten.
He notes that PaCRe, the joint venture between US hedge fund Paulson & Co and Bermuda-based Validus Re, represents another hedge fund reinsurer that has struggled to meet its investment targets.
“Here an agency (AM Best) was prepared to back the model, but only two years down the line they have been unable to pull together enough investment and have asked for their rating to be withdrawn,” he adds.
Since the August 11, 2015 withdrawal of PaCRe’s financial strength rating and issuer credit rating at the company’s request, there has been considerable speculation in the market as to the rating agency’s view on hedge fund-sponsored reinsurers.
While admitting that the current market is “challenging” for hedge fund reinsurers, Greg Reisner, managing senior financial analyst, AM Best, believes the model is indeed sustainable.
“AM Best is not sceptical of the hedge fund reinsurer model. We believe it is a viable model as evidenced by the fact that we rate several hedge fund reinsurers,” he says.
“In our analysis, we evaluate business plans and the strength of management to execute those business plans in the market. Currently, the market environment is very challenging and that is factored into the overall equation, among other things.
“Generally speaking, time will tell how committed hedge funds are to the reinsurance sector. Convergence capital has steadily increased its participation to the reinsurance sector over the past few years. If that is any indication, there will likely be a solid degree of interest in the near/intermediate term.”
AM Best currently maintains interactive ratings with six hedge fund reinsurers and the rating process for these structures remains in accordance with its credit rating methodology.
An August statement from the firm around PaCRe offers an insight into the challenges the hedge fund reinsurer model faces, generally.
It states: “The company has not achieved its projected premium volume, due to the current competitive market environment in property catastrophe reinsurance. However, it has produced positive underwriting results since inception, despite a few significant loss events, which is a testament to the solid underwriting and strong cycle management capabilities of the underwriting manager.
“Additionally, the alternative asset strategy has not performed as expected during PaCRe’s operating history producing unrealised investment losses. Although management has made changes to the investment strategy in an effort to reduce the volatility, it will take time for these changes to inure to the benefit of PaCRe.”
It goes on to highlight the start-up nature of PaCRe along with the “greater investment risk that is associated with this type of investment strategy” as destabilising factors. In addition the “business plan will be challenged by established reinsurers as well as other alternative investment reinsurers entering the market”.
There seems to be enough cause for concern for prospective investors to be wary. However Ken Billingsley, a senior vice president research analyst at Compass Point Research, sees a positive future for hedge fund reinsurers—if not on the scale of the firms we have previously seen coming to market.
“Smaller hedge funds, looking at the asset side of their business, will be willing to go into this market. Most hedge fund reinsurers take on a lot less leverage than their peers because they are taking on lots of excess risk on the investment side and can’t take leverage on their underwriting side,” Billingsley says.
Van Slooten adds that hedge fund investment is “really permanent capital—it’s quite hard for the investors to get their money out”
It remains the case that only two hedge fund-backed reinsurers have effectively pulled out of the market recently. AQR Re, launched in 2012, ceased to write any new or renewal business effective April 1, 2015. And the aforementioned PaCRe, also formed in 2012, moved to being an unrated company and is expected to write very limited business fronted by Validus.
At the same time, this market segment is not looking as attractive as it once was with Fidelis Insurance Holdings, launched in June, the only major new player entering the market this year. The Bermuda-based company is led by former Lancashire Holdings executives Richard Brindle and Neil McConachie, with investments managed by several hedge fund managers.
ABR Reinsurance was launched in April 2015 by ACE and investment bank BlackRock as a joint reinsurance and investment venture. However, it is solely for reinsurance use by ACE with no external risk assumed.
As Fitch notes in its 2016 Global Reinsurance Guide: “The hedge fund-backed reinsurance market lost some of its momentum in 2015 and does not appear likely to regain it in 2016. This is partly because of the continued competitive reinsurance market conditions that are making it more challenging to write business that meets return expectations.”
It’s fair to say that equity returns for hedge fund reinsurers are generally disappointing as they struggle to create above-average returns in a volatile equities market.
Threat from the IRS
The sector is facing increased scrutiny in the US from the IRS/US Treasury and Congress on the potential for abuse by hedge funds that set up reinsurance companies primarily to achieve an exemption from passive foreign investment company regulations and thus avoid taxes.
There are real fears that any proposed clampdown by the US Treasury on what it sees as hedge funds masquerading as reinsurance companies in a deliberate tax dodge could “force the restructuring of business operations in Bermuda”.
So says PwC’s Richard Irvine in a 20-page document submitted by the Association of Bermuda Insurers and Reinsurers (ABIR) detailing its own proposals for deciding what constitutes a reinsurer.
The treasury’s intention, contained in the Exception from Passive Income for Certain Foreign Insurance Companies regulations, is to focus on a firm’s headcount as the prime delineator of what constitutes an insurance company. The ABIR has countered saying the central element is whether the entity assumes any insurance risk.
US authorities are also considering whether to impose minimum standards for reserves or premiums in an attempt to differentiate between those companies that rely on underwriting or from investing.
ABIR suggests ‘a bright line safe harbour test’ of 15 percent reserves-to-asset ratio as an alternative guideline. Four Bermuda-based re/insurers would fail this test—PaCRe (0.4 percent reserves-to-asset ratio), Hamilton Re (9 per cent), MS Frontier Re (11.9 per cent) and Da Vinci Re (14.7 percent). It wants to introduce a ‘facts and circumstances’ test for those failing the ‘bright line’ test.
Meanwhile captives on the Island would suffer a “devastating” impact from the US proposals, says the Bermuda Insurance Managers Association.
Aon Benfield, Greenlight Capital Re, Third Point Re, John Berger, Mike Van Slooten, Bermuda