There seemed to be some interest in my previous article, where I gave a very basic outline of what the New York Department of Insurance calls ‘Shadow Insurance’ transactions via the use of captives. Given the interest in insurance as a topic, I have decided to test the waters again write about another topic in the insurance universe: hedge fund backed reinsurers.
What does a hedge fund have to do with reinsurance?
The hedge fund industry has developed over the past few years, and fund managers are constantly looking for different ways to raise capital, retain assets, and generate more alpha. One approach that they have taken is to enter the business of reinsurance, a process whereby one entity takes on all or part of the risk covered under a policy issued by an insurance company in consideration of a premium payment. Hedge funds have typically invested in reinsurers through sidecars or buying an equity stake in a reinsurance company, but now hedge funds are beginning to launch their own reinsurance businesses. It just so happens that setting up a reinsurance company is one structure that ticks all of the boxes for hedge funds.
How does it work?
It is actually surprisingly simple. The reinsurance company that is set up by the hedge fund focuses on a line of business from an underwriting perspective. Then, the investible assets are managed by the sponsoring asset manager (i.e. the hedge fund). Bermuda is a great place to domicile the reinsurer, as there are minimal capital requirements and the government generally does not dictate how reinsurers must invest their assets. All in all, the tax benefits to hedge funds are huge
How else is it beneficial?
This type of structure essentially provides a ‘new product’ for an asset manager. There are now TWO revenue streams: underwriting AND investment returns. With the addition of a reinsurance vehicle, funds can appeal to investors that they would not traditionally attract. More investors = more AUM = more $$$! Additionally, publicly listed hedge fund reinsurers can provide general liquidity to investors (your capital isn’t locked-in because you have the ability to trade the stock).
The reinsurance company is generally levered using reinsurance premiums. By selling reinsurance contracts, the collected premiums are then reinvested by the fund. The ultimate goal of the reinsurance entity is to generate ‘float’ for the fund to invest. They receive the reinsurance premiums up front and pay claims later.
How viable and sustainable is this model?
Running this kind of operation takes a lot of time and initial capital to set-up, so not every asset manager is going to set up a Bermuda domiciled reinsurer and have a field day. Hedge fund backed reinsurers investment strategies are far more risky than those of traditional reinsurers. And generally, riskier entities are more capital intensive.
At the end of the day, the question is the following: Can combining hedge funds and reinsurers create additional diversification benefits that don’t occur in either structure independently?
Will do my best to answer any questions.
Great write up.
Do you see the HF reinsurers getting into the long-tail casualty lines of business anytime soon (E&O/D&O/WC etc...) ? With the huge increase in reinsurers capital base over the past few years leading to drastic rate reductions on property business, competition has put serious pressure on the amount of capital the HF reinsurers can deploy in their "traditional" property catastrophe space.
double post
A lot of the rating agencies have fairly negative views on the viability of this business model. There has been a lot of discussion around HF reinusrers, but, truth be told, not many of them have materialized. I know of at least one start up that completely scrapped its plans due to rate pressure in the space, coupled with projected difficulty in the alternative asset class. I think a lot of issues need to be shaken out if this model is to become common.
While that it's true that the rating agencies have had negative views lately, it's only important if the HF is seeking a rating. Many of the true HF players don't use one, nor do they need one - i.e. Fermat, Nephila, Aeolus etc... As long as the cedant is comfortable with using a trust, then rating is not a factor. In fact, many cedants think (and I tend to agree) that utilizing a trust is better security than any A+ paper can provide. Also, if the cedant isn't comfortable using a trust, many of the large players can use fronts such as Hannover Re.
On your last comment "I think a lot of issues need to be shaken out if this model is to become common" - I think that it depends on which side of the aisle your looking at it from. From the reinsurance standpoint, utilizing the FH model has become very common. I do not know of many programs that do not have some sort collateralized reinsurance. I'm not sure about the other way - from the investor standpoint - as I'm on the reinsurance side of the aisle.
@"MikeB0351" - I can see funds getting into those lines of business, but I'm not sure when. I think they'll have to come around eventually because if they don't...then they basically have an entity that's housing all low risk/volatility instruments. That completely undermines the entire hedge fund reinsurer model (as they effectively become a traditional reinsurer at that point and will get crushed by the likes of RGA, Swiss Re, and the other big players), so for this structure to remain profitable they will need to be able to take on more risk.
It's not hard to see why fund managers are attracted to this model. Everyone looks at Buffett and sees how much he has benefited from having (a) permanent capital plus (b) negative-cost float to invest. Under that structure you turn a great investor into a legendary investor. And then there are the tax benefits.
But the key problem is that these funds (the ones I know of) do not have good insurance people. They aren't making a profit on underwriting, and I would wonder about their risk management practices. Berkshire, Fairfax, Markel have achieved amazing returns out of a combo of profitable underwriting and good capital allocation. Right now I'm not sure why you would want to invest in one of these hedge fund reinsurers over any of those three, particularly Fairfax and Markel given their size and room to grow.
Not many people realize that this is basically Warren Buffett's model (via investing GEICO's float). There are also a couple of big hedge funds with publicly traded reinsurance vehicles out there (Greenlight and Third Point come to mind).
It is a good way to access "permanent capital" because once you have a diverse insurance portfolio, your float is fairly safe from large redemptions. Invest it just like your other funds, and collect that fee.
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