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?
Thehas developed over the past few years, and fund managers are constantly looking for different ways to raise capital, retain assets, and generate more . 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.