14 April 2014ILS

A deeper, broader footprint

William Pollett, president and CEO of Blue Capital Management, talks to Bermuda:Re about cedant appetite and investor interest in the asset management company’s burgeoning collateralised reinsurance offering.

Having managed third party capital in a variety of guises for the past ten years—from sidecars and closed end cat bond funds, through to third party trades and retro vehicles—Montpelier Re upped its game in the third party space in 2012 with the launch of its Blue Capital asset management arm. As William Pollett, president and CEO of Blue Capital Management Ltd, explained, the reinsurer decided that it was well-positioned to establish a brand and expand its supporting infrastructure to further develop its third party business, which has expanded apace over the past decade.

Pollett explained that Blue Capital forms part of a wider reinsurance strategy to “develop a collateralised platform which will complement Montpelier’s traditional rated product.” Increasing appetite among reinsurance buyers for collateralised capacity and a push to develop interest among a new investor set have been behind the formation of Blue Capital. The successful IPO of Blue Capital’s sponsored UK fund in December 2012, including two follow-on offerings in May and November 2013, coupled with the IPO of a sponsored NYSE-listed vehicle in November 2013 have been indicative of rising appetite in the convergence space.

As Pollett explained, while re/insurers “at the larger end of the food chain have been trading with capital markets for some time”, smaller re/insurance companies have been more reticent. Change is underway, however, as these companies increasingly recognise the stabilisation and diversification benefits collateralised products can provide both to them and to the market as a whole. Pollett highlighted those systemic risks that are a threat to all rated reinsurers as being a key driver of the search for collateralised alternatives—“way out at the tail, what’s bad for one reinsurer is bad for all reinsurers. But if you can introduce some collateralised protection, it can help you diversify away from that risk.” Blue Capital’s collateralised capacity represents an attractive proposition to smaller and mid-sized insurers considering an increasingly diverse range of reinsurance options that complement the traditional offering.

And this is how Pollett views Blue Capital: not as a competitor to its parent, Montpelier Re, but as a complement to Montpelier’s existing capacity and rated offering. There is considerable synergy, said Pollett, with Blue Capital able to leverage the platform and capabilities that Montpelier Re has nurtured since 2004, while the Montpelier Group can deepen and expand its footprint through Blue Capital. “Clients know that Montpelier is dedicated to the space, and is committed long-term to providing property catastrophe protection to its clients and, importantly, has a long track record of paying claims promptly.”

Pollett explained that Blue Capital is using the same pricing infrastructure as Montpelier Re to deliver bespoke collateralised programmes to insurance clients. He noted, “Not many collateralised markets have the ability to provide quotes to traditional reinsurance programmes on a timely basis.” Being able to do so is a distinct advantage in the market.

The Montpelier Group now boasts two pockets of permanent capital that it can extend to the market, meaning there isn’t the kind of redemption risk usually associated with typical ILS funds. “We sell our capacity under the slogan ‘Collateral is great, but not all collateral is created equal’—ours will be there ear after year,” explained Pollett. “The same cannot be said for some of the new convergence capacity that has entered the market recently. It is this longevity and choice that makes our offering so compelling.” [At the 1-in-100 year return period loss event, arguably traditional reinsurers are better positioned to replenish their capital base than an ILS fund with finite capital from a limited universe of investors.]

A targeted approach

Pollett said that Blue Capital is targeting Montpelier Re’s premier clients and looking to expand and deepen the footprint with those clients through the addition of collateralised protection. He explained that while there is a high degree of overlap in terms of the clients that Blue Capital is targeting, there is typically a very low level of overlap regarding the reinsurance layers they are writing. “Montpelier typically writes the 1 in 100 reinstatable limit covers, whereas Blue Capital is writing the reinstatement premium protections or the single shot top and drop covers. It’s the same client, but it’s a different piece of their programme.” He added that it’s not a question of whether Blue Capital might cannibalise Montpelier Re’s existing book of business, but rather how distinct sources of capital can co-exist to direct risk and reward from clients’ programmes to the most appropriate balance sheets for such risk and reward. The intention is to grow the total share of existing client programmes vertically and horizontally.

Montpelier Re’s typical client-base—smaller regional and country-specific insurers—will typically cede a maximum of 10 to 15 percent of their programme to any specific reinsurer. “These clients are looking for counterparty diversification,” explains Pollett, and this is where Blue Capital comes in, offering complementary capacity to Montpelier Re’s traditional offering. “Blue Capital is a core part of Montpelier Re and is 100 percent owned. This means that the two companies walk in lock-step, eliminating conflicts interests and ensuring synergies are properly mined.”

Pollett explained that while larger insurers typically enjoy strong capital positions, smaller players simply cannot trade forward if they do not have the appropriate reinsurance in place post event—“if they didn’t, they would simply lose their ratings and customers”.

“Smaller, regional insurers value long-term relationships such as those they’ve had with Montpelier because they can be confident we will pay claims following an event. Thus, they are willing to sacrifice some price for certainty and quality of cover,” he said. It is in building these relationships and by offering clients greater diversity of choice and collateralised capacity that Blue Capital is looking to build its presence in the market.

Permanence the differentiator

Addressing Blue Capital’s decision to take two of its sponsored companies public, Pollett explained that the firm had sought to establish a position in the market that would both differentiate it within an increasingly crowded convergence field and champion the robust, permanent capital it extends to clients. He said that the two IPOs—in the UK and then the US—had enabled the company to access a broad base of investors who had previously been restricted to investing in open-ended, hedge-fund type ILS structures.

Blue Capital is different—even complementary—to the two other existing UK-listed catastrophe reinsurance products, he said, because those funds focus on the cat bond and retro market, respectively. Blue Capital brings a rather different proposition to the traditional market—the permanence of its capital while offering its investors access to a broader range of risk premia.

“If you are looking to participate in the highly trade-orientated side of the market—where you’re doing retrocessional covers or industry loss warranties, where it’s really an annual trade and there’s no expectation that that trade will be renewed the following year—a hedge-fund type structure where your investors can redeem their funds after a year works quite well. But where you’re looking to deploy capital long term, to insurance companies that view their reinsurance purchase more as a permanent part of their capital structure and a multi-year commitment, having the permanency of capital is a valuable differentiator.” Recent years have illustrated clearly that more opportunistic capital is, by its very nature, short term and its departure has left some clients with gaps in their reinsurance placements.

Citing the financial crisis of 2008, Pollett said that a number of ILS funds faced significant redemptions, which led to a shortfall in client capacity. This had been “nothing to do with their underwriting performance”, said Pollett, rather their investors needed cash quickly, raiding the ILS funds in the process. Blue Capital provides additional security, but in the form of alternative capacity.

A diverse offering

Not that Montpelier Group’s collateralised offering is limited to its publicly traded Blue Capital sponsored vehicles. Montpelier also has the option to offer clients open-ended fund type structures, but as yet these are not open to public investment, said Pollett. He said that these facilities serve a purpose for institutional investors who specifically want to participate via an open-ended fund platform,

“We have a number of products that can fit the needs of a broad range of potential investors. We certainly wouldn’t want to narrow our focus to a particular subsector, but the reality is that the listed fund in the UK (LSE:BCGR), is targeted more at the UK institutional multi-strategy and high net worth investor. In the US (NYSE:BCRH), the typical investor is a smaller institutional or retail investor, largely because of the size of the fund, at $175 million.” Pollett said that the fund would be a natural fit for smaller institutional investors, looking to invest $5-10 million, rather than those looking for larger allocations.

Nevertheless, there are opportunities for bigger players to become involved, particularly as the fund builds momentum. Positioned as it is, it would be a natural complement to investment plays in more than one catastrophe fund, said Pollett. “We market our product not as the only way to participate in catastrophe risk, but as an attractive complement to other investments in the space. Due to our focus first on traditional reinsurance, and second on smaller regional or state-specific insurance companies that don’t otherwise participate in the alternatives markets, we provide our investors with a nice diversifier of risk, return and liquidity, even within their catastrophe allocation.”

Pollett said that it was important to be clear with investors about the risk profile of the vehicles. While current conditions were creating challenges, considerable opportunities to attract investor interest remain.  “Even though we are seeing some pressure on rates as a result of the lack of significant catastrophe losses and competition from new capital, we still see plenty of opportunities to deploy capital at what we think are attractive returns, and we continue to see interest from investors who recognise the relative value of ILS versus other traditional and alternative offerings in the capital markets.”

Managing expectations

Pollett said that investors in Blue Capital’s three vehicles benefit from the superior risk selection capabilities of the underwriting team, which filters hundreds of submissions in order to “pick the programmes with the best margins and strongest risk-adjusted returns that fit the specified strategies”. He said that Blue Capital will turn down programmes with insufficient margins but noted they had not yet reached a point where they have been unable to deploy capital due to pressure on rates.

Pollett explained that the weighting of the portfolio emphasises peak peril risks that deliver the best returns, but that Blue Capital is still able to achieve diversification across companies in a particular state or region. “We have insurance companies that have concentration over zip codes rather than continents. Although we have a fair amount of exposure to US wind, we can diversify that exposure quite effectively by allocating that capital across a number of discrete, smaller entities that have geographical dispersion, even if it’s in the state of Florida and up the eastern seaboard.

“If on the other hand you’re writing an ILW or an ultimate net loss retro-type policy, then your emphasis is more on writing the industry loss than on building a portfolio of discrete risks. We view ourselves as a stock-picker rather than a ‘warts and all’ index fund.”

This approach represents a competitive advantage, said Pollett. “We’re looking to build a portfolio which will generate alpha over the industry average by being selective. Blue Capital’s underwriting approach consists of two key components. One is quantitative, in that we leverage all the granular data we collect from our cedants, and then apply Montpelier Group’s data scrubbing and modelling capabilities to select risks that we think have the best margin.

“We then overlay that with a highly qualitative approach that entails a deep understanding of our clients developed over many years.” He added that Blue Capital aims to visit each insurance client personally and meets their management teams in order to understand their philosophy, and score their data position based on qualitative factors. “These two approaches drive an ability to outperform, particularly in major market loss scenarios,” he said.

“The type of client that we target might have a 10 percent market share over three zip codes in New Jersey, but when a big event comes through, their loss might be 3 to 5 percent of the industry loss over those three zip codes because they’re better underwriters, they’re more selective in terms of which properties they will insure. That’s how we add value.” Pollett admitted that it isn’t always easy to demonstrate that kind of track record, but said that Blue Capital constantly works to optimise its portfolio and selection process.

Market dynamics

Turning to conditions in the wider market, Pollett said that the influx of convergence capital was due to “recognition that margins, relative to other capital markets alternatives, are very attractive in the catastrophe space right now”. He added that there is perhaps a little too much capital coming into the market at this point, arguing that a slowdown driven by wider economic changes will help the pricing cycle become more manageable. “Our products return a risk-free rate plus a spread, so if short term rates increase from 30 basis points to 200 basis points at a given point in the future, our products would generate a spread above that 200 basis point level.”

Pollett admitted that as the interest rate curve steepens the attractions of catastrophe risk as an asset class may decline, but added “We still believe that our products have merit as long as the expected margin is attractive—the asset class is for the most part uncorrelated to traditional risk factors, so it’s always going to be an attractive addition to any long-term investor’s portfolio.” He concluded that while some of the ‘hot money’ might disappear in response to interest rate rises, longer term investors would probably remain, helping to stabilise levels of capital in the market.