The Emergence Of Hedge-Fund Backed Reinsurers In Bermuda

Hedge funds have cottoned onto the benefits of Bermuda's reinsurance market, with many establishing their own start-ups

Described as the 'Little Wall Street of the World', Bermuda is one of the largest jurisdictions for insurance and reinsur­ance. More significantly, it is the rein­surance capital of the world, with a substantial number of insurance-related entities calling the island home. This insurance gem boasts an aggregate capital and surplus valued at $185bn, with total assets calculated at $524.7bn in 2011.

Recently, a new phenomenon has been taking the Bermuda reinsurance market by storm. Hedge funds, which until now have mostly chosen to invest indirectly into the insurance and rein­surance markets through insurance-linked securities structures or by investing in the equity of holding com­panies operating reinsurance business, have been establishing their own rein­surance companies. As a result, start-ups such as Third Point Re and PaCRe emerged in 2012 as competitors to the more traditional insurance models.

The insurance model is being reconstructed to fulfil the needs of the investment community. SAC Re chief executive Simon Burton acknowl­edged this, saying: "The investment community is clearly sending us a message that they are dissatisfied with the packaging of reinsurers."

The rise of hedge fund reinsurers

Why is now an opportune time for hedge funds to set up their own com­panies to underwrite reinsurance directly? Ultimately, hedge funds are searching to raise and retain assets and to achieve substantial returns.

Traditional asset classes are not producing the high double-digit returns that were prevalent pre-2008. In addi­tion, fund managers now have access to more cash from large institutional investors (pension funds and endow­ments), who are allocating a greater proportion of their portfolio to the reinsurance arena in search of uncor­related returns and higher yields (look­ing to generate gains irrespective of how stock and bond prices are moving). Becoming an asset manager for an insurance company provides a ready source of capital that mitigates the need to raise additional cash.

Funds such as George Soros, HBK Investments (Glacier Re) and Citadel (CIG Reinsurance) have realised that a hedge fund can set up a reinsurer in, for example, Bermuda and can use the premiums it collects to invest with the hedge fund itself. This has the added benefit of having access to permanent capital ('sticky' assets) that is not likely to be withdrawn by a fickle investor who wants to withdraw its money at the first sign of deteriorating results. In addition, hedge fund managers can generate revenues by charging man­agement and performance fees on the assets they manage.

In 2012, four hedge fund reinsur­ance start-ups were established: Third Point Re was set up in January under former Harbour Point chief executive John Berger, with $780m of capital, targeting auto and other casualty; AQR Re was also formed in January with $260m of capital, focusing on col­lateralised catastrophe; in April, PaCRe was founded and capitalised as a joint venture between Paulson & Co and Validus, with $500m of capital targeting catastrophe risk; and, in July, SACRe was formed as a reinsur­ance vehicle of Steven Cohen's SAC Capital Advisors with $500m of capital that focuses on US catastrophe/low-severity casualty.

The advantage of Bermuda

The incorporation of hedge fund-backed reinsurers was described by Stone Point Capital chief executive Charles (Chuck) Davis as a "win-win" for hedge funds. He says: "You get permanent capital, it's tax-advanta­geous, it's leveraged, and if it's pre­mium to book you share in it and you get ownership."

In addition, fund managers are pro­vided with an opportunity to enhance their hedge fund's portfolio by diversi­fying its risk. For this strategy to be efficient, the various securities within a portfolio cannot be perfectly corre­lated. Incorporating a start-up provides hedge fund managers to do exactly this, as reinsurance offers little, if any, correlation with the traditional equity and bond markets. Moreover, it enables funds to hold long-term capital.

It is not enough to incorporate a start-up, however, as the governing law of the jurisdiction will play a major role in determining not only the initial prof­itability of the company, but also the extent to which the start-up will be able to retain that capital. Under Bermuda law, the tax benefits to hedge funds are substantial. Currently, there are no taxes on profits, incomes or dividends, nor is there any capital gains tax.

In addition, Bermuda imposes mini­mum capital requirements and gener­ally does not dictate how reinsurers must invest their assets, making it easier for hedge fund managers to execute their investment strategies with reinsurance premiums.

Will the phenomenon continue?

As attractive as the hedge fund-backed reinsurer model may sound, there are risks associated with their ability to continue generating high investment returns, and the potential for unex­pected payouts. Premium income can be put to work within hedge fund strate­gies, aiming to profit both from premi­ums as well as the investment strategy on the other end. This introduces a greater element of investment risk and reintroduces a correlation risk. A recent example of this is PaCRe whose Advantage Plus hedge fund suffered a 50% decline in 2011 versus a 17% rise in 2010 (and a loss of 19% at the end of 2012). The flip side, of course, is that seasoned investors can recoup losses by alternating between underwriting and investment opportunities when the market is hard or soft. This allows them to make the vehicle profitable from both the returns from writing reinsurance business as well as from the supporting hedge fund investment portfolio.

A special report from ratings com­pany AM Best, Amid Tepid Returns, Bermuda Insurers Discover That It Is All Relative, suggests that Bermudian reinsurers are set to put in a solid year of underwriting performance. The com­pany predicts the market to post a return on equity of better than 10%, which, in a post-financial crisis world, is relatively attractive compared with the yield available in other asset classes.

AM Best vice-president Robert Derose says that while it is too early to determine the longevity of hedge fund-backed reinsurers, the Bermuda market remained "fundamentally resil­ient". And, given that 2012 was the third costliest year in history (after 2011 and 2005) for the insurance industry, with $160bn paid out for insured losses, Derose's favourable description of the Bermuda market cannot be ignored.

Appropriate exit strategies

In this recovering economy, efficient risk management is viewed as a competitive business advantage. Ernst & Young partner Michael Lee says investors are now prioritising man­agement and initial investment phi­losophy over performance as factors that influence investment.

For this reason, having an exit strat­egy is crucial. Hedge fund managers that wish to exit the reinsurance busi­ness can do so in a relatively short time frame thanks to the portfolio containing relatively short-tail risks. If all claims are paid and the manager wants to with­draw, the mechanism to exit is usually fairly straightforward.

It will be interesting to see how this newer strategy of hedge fund-backed reinsurance will compare to traditional reinsurance over time. While this sector is currently attractive for hedge fund managers, only those who know when to focus on premiums and when to focus on deploying capital into assets are likely to succeed.

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