Hedge fund re’s struggle to beat the competition
Reinsurers, for the most part, have been struggling to optimise one side of the balance sheet and its ability to contribute to the return measures and competitiveness of the organisation. This is evident by declining investment yields that are due in part to artificially depressed yields on fixed income securities, which may prove to be anaemic compared to their inherent risk.
Over the last decade, the global reinsurance industry has been losing a significant amount of surplus growth opportunity from much lower than historic fixed income investment yields. Whether you are a proponent or not, convergence capital is most likely here to stay. One manifestation of this convergence capital is the hedge fund-sponsored reinsurer. In an environment where rate-on-line has become much more competitive and the peaks of the underwriting cycle have softened in recent history, reinsurers are looking for strategies to optimise the risk-reward balance.
There are many ways to accomplish this, one of which is the hedge fund-sponsored reinsurer model, of which most are still in the start-up phase. To that end, it is uncertain what the specific long-term results will be compared to more traditional reinsurers.
The hedge fund model
2015 represented a challenging year for all reinsurers and hedge fund-sponsored reinsurers were not immune to the adverse market trends. On the underwriting side of the risk and reward continuum, the soft pricing environment in almost all lines of business and geographies has led to shrinking premium volumes or at least lacklustre growth for those companies that are exercising underwriting discipline. Premium growth and underwriting performance has been disappointing across the ‘hedge fund re’ composite with a combined ratio of 111.5 percent, a loss ratio of 70 percent, and an underwriting expense ratio of 41 percent for 2015 (see Table 1).
Of course, the start-up nature of most of these entities and related costs coupled with less than optimal premium volumes compared to fixed expenses has led to an inflated expense ratio. A normalised expense ratio would produce a combined ratio more in the 100 to 105 percent range, which is still high by about 10 points compared to the US and Bermuda reinsurance composite. It should also be noted that none of the companies in this hedge fund re composite was able to avail itself of prior year reserve takedowns that have been heavily utilised by companies in the US and Bermuda composite that for 2015 represented a 6-point benefit to the loss and combined ratios.
The more important question yet to be answered is how reliable are the current loss picks for these companies. Future adverse reserve development would certainly not bode well against the current backdrop of underwriting performance and lacklustre investment returns. Time will tell.
Investment results for 2015 for the hedge fund-sponsored composite were similarly disappointing, with a 0.9 percent investment yield, with the most adverse performance in the composite being down 22.2 percent and the most beneficial in the composite being up 25.9 percent. It is apparent that in an investment climate characterised by significant volatility and a very high P/E ratio compared to historical averages, some investment styles can suffer compared to strategies that have significant diversification assistance from other non-correlated strategies.
The $279 million net loss realised by the hedge fund-sponsored composite for 2015 was equally disappointing. Return on equity measures were adverse by 4.7 percent for 2015. While investment and overall performance has been disappointing, it is too early to jump to the conclusion that the hedge fund re model does not work. The level of investment volatility experienced is not unexpected and is contemplated in our various stress tests. The success of these strategies has to be evaluated over the long term and through various market cycles. The robust capitalisation of these companies provides the bandwidth to achieve success.
The ability to absorb investment volatility is apparent in view of underwriting leverage. Net premium to surplus for the hedge fund-sponsored composite was approximately 33 percent for 2015, compared to approximately 60 percent for the US and Bermuda composite. Likewise, net reserves to surplus for the hedge fund-sponsored composite was approximately 20 percent for 2015 compared to approximately 121 percent for the US and Bermuda composite. The hedge fund-sponsored reinsurers that have been operating longer had higher leverage measures than the newer entities but none had higher operational leverage than the average of the US and Bermuda composite. In general, this model mandates a lower level of underwriting leverage given the greater asset risk employed.
The hedge fund-sponsored composite, both in aggregate and for each company individually, exhibited strong risk-adjusted capitalisation at year-end 2015 despite some of the recent operational challenges. AM Best’s rating approach contemplates stress scenarios on both sides of the balance sheet with simultaneous volatility in the investment markets and a prolonged reinsurance pricing environment.
Overall operating performance in general for the reinsurance market has been characterised by mediocre operating and return measures for the last several years. New entrants in this market have been struggling in this challenging environment and hedge fund-sponsored reinsurers, taken as a group, experienced adverse results from both sides of the balance sheet in 2015. While this level of performance is not what one would hope for, this level of volatility has been anticipated and accounted for by AM Best’s stringent start-up requirements. As with any start-up, it generally takes several years for a strategy to take hold and reach adequate economies of scale.
Hedge fund re models
AM Best has been rating hedge fund-sponsored reinsurers for approximately 10 years. During that time, several iterations of the model have developed.
Model 1: AM Best refers to this as the ‘build’ model and it represents the initial type of hedge fund-sponsored reinsurer. The build model is characterised by a standalone underwriting platform that is built from scratch by hiring individuals for underwriting, risk management, claims, etc. These individuals are meant to form a team that develops their own view of risk and seeks to underwrite business through the broker market, Lloyd’s, and through existing relationships.
The investment platform of the build model can be either a single alternative asset manager like Greenlight Capital or Third Point Capital, or it may be a mosaic of hedge funds assembled by the management team, usually with the help of a third party advisor like Goldman Sachs or The Blackstone Group. Currently rated examples of the build model are Greenlight Re, Third Point Re, Hamilton, and Fidelis.
Model 2: This is referred to as the ‘partnership’ model and represents the next phase on the timeline of hedge fund-sponsored reinsurers. The partnership model is characterised by reinsurance business generation from an existing underwriter. Basically, the business is priced, written, and risk-managed by an entity utilising established platforms to source business from tested distribution channels. The investment platform of the partnership model options is the same as for the build model. Both Watford and Harrington are examples of the partnership model.
Model 3: This is referred to as the ‘segregated portfolio’ model, which represents the next phase on the timeline of hedge fund-sponsored reinsurers. The segregated portfolio model is characterised by a cell captive type special purpose vehicle (SPV), either a segregated portfolio company or an incorporated cell company, where several different owners and hedge funds come together in a single SPV to match different alternative investment strategies with a source of reinsurance business from a common source.
In some ways, the segregated portfolio model is a cooperative of sorts, where a smaller allocation of unrelated investment strategies can be matched against a reinsurance business flow from an established underwriter or a panel of such entities. The cell owners would participate on the results of their own investment performance and their pro-rata share of the performance of the reinsurance business assumed. To our knowledge, there are currently no rated segregated portfolio model entities.
Footnote: This article was excerpted from AM Best’s annual special report on the global reinsurance industry: Innovation: The Race to Remain Relevant.
Steve Chirico is assistant vice president of AM Best. He can be contacted at: steven.chirico@ambest.com
