Capital Adequacy And Liquidity Are Key The risks associated with HFRs’ investment strategies are much higher than traditional reinsurers assume. Due to significant investment concentrations in specific strategies, and sometimes specific individual assets, each portfolio requires a bespoke analysis to best understand its risk characteristics. This analysis often requires asset-level detail, but in highly diversified portfolios (such as a fund of funds), the analysis may be possible by analyzing the risk characteristics of each individual underlying fund. Furthermore, the rapidity in which these portfolios may turn over and the relatively loose risk guidelines call for frequent risk monitoring.
Heightened market, credit, and liquidity risk are the primary concerns. Alternative portfolios relative to traditional reinsurers’ portfolios hold more assets with greater sensitivity to market movements, such as equities and speculative-grade bonds. In addition, leverage that aims to boost returns also amplifies these risks, thus increasing volatility. Depending on the extent of asset leverage, HFRs will experience higher capital gains when strategies work, but will lose more capital when they don’t. In fixed-income strategies, the credit risk tends to be higher as well. The fixed- income investments these strategies employ are usually speculative-grade, making them more susceptible to credit losses than the high credit quality portfolios of traditional reinsurers. Once again, leverage often amplifies the risks and rewards. Higher credit and market risk causes these investment strategies to consume significantly more capital than traditional reinsurance investment portfolios. These considerations also become important when viewing stressed liquidity scenarios. Higher risk and leverage in investment portfolios not only limits the value of assets in times of stress, but these investments may also be hard to liquidate without taking further losses. Borrowing facilities used to employ leverage or derivative contracts may require collateral posting that may capture liquid assets when they are most needed. Some underlying funds may also have “gates” that prevent redemptions in times of stress, and some leverage facilities may require an asset sell-off after losses to maintain leverage requirements. All of these factors may limit the amount of liquidity available in a time of stress.
Global Reinsurance Highlights 2014
For instance, to ensure sufficient liquidity, HFRs could implement proper procedures to monitor cash sources and needs. And specific portfolio guidelines—including prudent limits on position sizes, leverage, and sectors—might prevent large risk accumulations. In addition, risk-based limits might place a ceiling on how much risk an asset portfolio may create. However, these types of risk-based metrics don’t appear prevalent in the investment guidelines of many HFRs. Prudent use of hedging instruments, such as derivatives, are another tool to contain risk. To the extent that these instruments limit risk in the scenarios our capital analysis considers, we adjust our view to incorporate the positive impact to the HFRs’ overall risk position. However, we might consider the credit risk of a derivative counterparty.
Is The New HFR Model Viable In The Long Term?
“We still believe that the traditional reinsurers will continue to dominate the landscape and provide stable capacity to their cedents.”
The potential crossover between hedge funds and reinsurers offers compelling possibilities. However, a commensurate focus on additional risks would have to supplement the singular focus on higher investment returns. Considering both is necessary in determining whether one plus one is truly greater than two. This depends on whether combining hedge funds and reinsurers can create additional diversification benefits that don’t occur in these two types of organizations independently, thus creating a more capital efficient vehicle. We believe it’s possible. However, in our view, closing the gap between reinsurer and hedge fund risk cultures and implementing prudent risk controls is necessary to realize these benefits.
The HFR model will likely carve out a niche market for itself and compete with smaller reinsurers. However, we still believe that the traditional reinsurers will continue to dominate the landscape and provide stable capacity to their cedents.
Our liquidity analysis considers simultaneous assets stresses and underwriting losses and determines whether the company has sufficient liquidity under this scenario to meet its obligations during the course of a year. A lack of liquidity under this analysis significantly detracts from our view of credit quality and could prevent HFRs from receiving ratings similar to those of their more traditional peers. These risks may be managed, however.
Taoufik Gharib
New York, (1) 212-438-7253
taoufik.gharib@
standardandpoors.com
Jason S Porter, CFA New York, (1) 212-438-3348
jason.porter@standardandpoors.com
Robert N Roseman
New York, (1) 212-438-7236
robert.roseman@
standardandpoors.com
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