The HFR Model Is Not A New Phenomenon In the late 1990s, two hedge fund managers sponsored two reinsurance start-ups: Max Re (sponsored by Moore Capital) and Scottish Re (sponsored by Maverick Capital). In both cases and for different reasons, the HFR model did not survive as the original sponsors originally intended. This doesn’t necessarily mean that the HFR model is unviable, but longevity is unproven.
How two early HFRs fared Max Re
The company started with an alternative investment strategy that evolved into 50% alternative investments and 50% long fixed income. Eventually, Max Re drastically reduced its alternative investments allocation to 5% of its total invested assets by year-end 2009. The substantial reduction in alternative investments and the gradual shift toward fixed-income holdings drastically changed the company’s investment profile and, ultimately, Max Re has come to look more like a traditional reinsurer. In first-quarter 2010, Max Re merged with a Bermudian reinsurer, Harbor Point (formerly Chubb’s reinsurance business), forming a combined company named Alterra Capital Holdings Ltd., which in turn was acquired by Markel Corp. in December 2013.
Scottish Re
In second-quarter 2006, Scottish Re incurred operating losses because of its rapid acquisition pace, which in turn led to operational weaknesses and the need for revision of the assumptions that underlie its financial results. The company had rapidly increased revenues and reinsurance in-force to become the third-largest life reinsurer in the U.S. as of Dec. 31, 2005. Because of the loss and the resulting negative effect on Scottish Re’s financial flexibility, the company needed to raise capital to augment its anticipated liquidity and collateral needs. In early 2008, Scottish Re’s capitalization eroded further because of the declining market value of its subprime and Alt-A investments, along with asset impairments leading to additional collateral-posting requirements. The resultant deterioration in the company’s financial condition severely disrupted Scottish Re’s ability to generate new business and to retain existing business. As a result, Scottish Re ceased writing new business and notified its existing clients
Global Reinsurance Highlights 2014
that it would not be accepting any new reinsurance risks under existing reinsurance treaties, thereby placing its remaining treaties into run-off. Subsequently, Scottish Re was delisted from the NYSE as of April 7, 2008.
Generating The “Float”
Reinsurance premiums fuel the investment engine behind the HFR model. Similar to their traditional reinsurance peers, HFRs receive reinsurance premiums up-front and pay claims later. This collect now and pay later insurance model generates cash flows or “float” that the hedge funds backing these reinsurers invest. Through this scheme, the hedge funds gain access to capital with minimal cost. Economically, this functions similarly to a loan by the cedents (the insurers buying reinsurance), and to the extent underwriting results are break-even or profitable, the HFR may actually be getting paid to borrow rather than pay interest under more traditional borrowing arrangements. However, this neglects the assumed risk from the cedents.
Because these HFRs seek excess investment returns, their reinsurance strategies tend to focus on lower-volatility lines of business because the asset side of the balance sheet generates more risk and reward. HFRs target subsectors of the reinsurance market. In general, they write low margin quota-share reinsurance focused on low volatility and short- to medium-tail insurance risk (four to five year duration) that is mostly exposed to frequency rather than severity-oriented risks (see Table 1). Examples of such lines of business include general liability, homeowner liability, and auto liability. However, there are HFRs, such as PaC Re, that write high-severity and volatile property catastrophe business. In the current low interest rate
“The HFR may actually be getting paid to borrow rather than pay interest under more traditional borrowing arrangements.”
environment, this type (i.e., low margin and low volatility) of business may not be attractive to traditional reinsurers because of their depressed investment returns. Indeed, the traditional Bermudian reinsurers’ invested assets produced an average net yield between 2% and 3% in 2013. On the other hand, presumably the HFRs could take advantage of the fact that the competitors (i.e., traditional reinsurers) structure products and quote prices based on less-esoteric investment strategies or based on a risk-free rate. HFRs assume their invested assets will earn superior returns, which will allow them to structure the reinsurance contracts and prices competitively to win business. The hypothesis that their higher investment returns will offset the reduced profitability from underwriting could, however, be flawed. Additional investment risk inherent in nontraditional investment strategies theoretically generates the excess investment return, so the notion that HFRs can price reinsurance cheaper or require less underwriting income may not necessarily hold in a risk-based analysis. When interest rates start rising, as we expect, the traditional reinsurers will likely become more price competitive in these subsectors as they earn more investment income, possibly undermining the sole value proposition of the HFRs’ model. Also, HFRs may be more likely to experience investment losses under such scenarios if not fully hedged, potentially disrupting their businesses. More importantly, in the current overall crowded reinsurance market, where prices are falling almost universally across the sector, competition is fierce among all market participants (i.e., traditional reinsurers, convergence capacity, and HFRs). Under these circumstances, it will be hard for HFRs to remain opportunistic in finding pockets or subsectors where they can underwrite adequately risk-adjusted priced business. The potential undercutting of reinsurance pricing by HFRs to win business will weaken our view of their competitive position in our credit analysis.
A Multitude Of Asset Strategies; All High Risk Like reinsurance strategies, HFRs’ asset- management strategies are numerous and wide ranging. They include speculative- grade leveraged loans, private equity, long-short equity, fund of hedge funds, and speculative-grade bonds (those we rate
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