In recent years, Hedge Fund Reinsurers (HFRs) have emerged in Bermuda and the Cayman Islands to compete with traditional reinsurers and alternative capital for business. Their goal is to deliver returns to shareholders that exceed those of traditional reinsurers. Let’s look at how they achieve this, as well as some of the pros and cons of the HFR business model…

How they generate investment capital

The investment engine of HFRs is fuelled by reinsurance premium. As with traditional reinsurers, HFRs receive premiums up front and pay out later on insurance claims made.

This generates a pool of cash that hedge funds use to make their investments; in this way, they gain access to capital at minimal cost. And to the extent that underwriting results are break-even or profitable, the HFR may be getting paid to use these funds to invest, rather than paying interest to borrow the funds to invest in the normal way.

Insurance risk

Importantly, however, we also have to factor in the insurance risk assumed by HFRs in accepting the reinsurance premium.

Because the asset side of their balance sheet is designed to generate more reward (and risk), HFRs’ reinsurance strategies often focus on lower-volatility lines of insurance business.

They therefore target sub-sectors where they can focus on low volatility and short- to medium-tail insurance (such as GL and AL), where they are exposed to frequency- rather than severity-oriented risks.

Investments risk

The asset-management strategies of HFRs are wide ranging and include speculative-grade leveraged loans, private equity, long-short equity, fund of hedge funds and speculative-grade bonds.

Their investment strategies tend to be significantly riskier than those associated with traditional reinsurers. This means they must allocate significantly more capital to buffer this risk, offsetting any increases to returns on capital driven by the higher investment returns.

When assessing their overall investment risk, heightened market, credit and liquidity risk are primary concerns:

a) Alternative portfolios relative to traditional reinsurers’ portfolios hold more assets (such as equities and speculative-grade bonds) that have greater sensitivity to market movements

b) Credit risk tends to be higher because as 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

c) Leverage aimed at boosting returns also amplifies risk, thereby increasing volatility: HFRs experience higher capital gains when strategies work but lose more when they fail

These risks can be managed, however.

For example, to ensure sufficient liquidity, HFRs could implement rigorous procedures to monitor cash sources and needs. And strict portfolio guidelines regulating position sizes, leverage and sectors can mitigate large risk accumulations. Using derivatives to hedge against risks is another option.

Comparing the old and the new

Worth noting is that the contrast in business practices between asset managers and reinsurers is there to be seen. Traditional reinsurers typically set forth comprehensive risk controls to manage the volatility in their businesses; HFRs tend not to be as restrictive, comprehensive or risk-based in their approach.

This has led some industry insiders to argue that the trade-off between flexibility and adherence to a prudent risk tolerance is something that HFRs find difficult to balance.

And in times when interest rates start to rise, it is expected that traditional reinsurers may become more price-competitive in those sub-sectors where they compete as they earn more investment income, thereby potentially undermining the USP of the HFR business model.

Additionally, HFRs may also be more likely to experience investment losses under such scenarios, if not fully hedged, causing disruption to their businesses.

At the end of the day and tax advantages aside, true value creation in the use of HFRs ultimately depends on whether risk diversification between reinsurance underwriting and hedge fund investing is greater than the corresponding diversification present in traditional reinsurance models. Time will tell.

See also: How You Can Benefit From Going Offshore

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