Assessing The New Breed Of Hedge Fund-Backed Reinsurance Companies

Hedge fund-backed reinsurance (HFR) isn’t a brand new business model, but with only a couple of previous examples to point to (neither very promising) and the current crop having only been open for a couple of years it’s not completely obvious how to gauge their potential.

“Does combining a reinsurer strategy with a hedge fund strategy create higher risk-adjusted returns than they could achieve separately?” asks Taoufik Gharib for Standard & Poor’s Ratings Services in an August 11 white paper. “This will depend on the extent of risk diversification between a reinsurance underwriting portfolio and a hedge fund asset portfolio and the ability of the divergent risk cultures of reinsurers and hedge fund managers to find common ground.”

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Late 90s hedge fund-backed reinsurance don’t bode well

With only two prior examples, Max Re backed by Moore Capital and Scottish Re backed by Maverick Capital, it’s important not to draw overly broad conclusions, but neither hedge fund-backed reinsurance was really a success. Scottish Re expanded rapidly to become the third-largest reinsurer in the US by 2005, but operating losses that began in 2006 were exacerbated by the financial crisis and in 2008 it ceased writing new business and told existing clients that it wouldn’t take on any new reinsurance risks. It was delisted later that year. Max Re has had more success, but it also shifted its asset mix from 50/50 long fixed income and alternatives in the late 90s to 95/5 in favor of fixed income by 2009. By the time it merged with Harbor Point in 2010, it looked an awful lot like a traditional reinsurance company.

Reducing overall risk profile ‘a tall order’

Even with this uninspiring history, the appeal of Hedge fund-backed reinsurance is easy to see. If the strategy works it allows companies to bid on low volatility, medium-term reinsurance policies like home and auto liabilities and then invest the float for superior returns, essentially giving hedge funds another way to find returns in a low yield environment.

But the central question is how well the hedge fund-backed reinsurances will be able to diversify risk between the two sides of their business. Gharib argues that there is a deep cultural divide between hedge funds, where portfolio managers are given a great deal of flexibility and autonomy as long as they can produce good results, and the traditional reinsurance industry where managers have to work within stringent risk control frameworks.

He doesn’t think it’s impossible for an hedge fund-backed reinsurance to improve its overall risk/reward by coordinating between the two sides of the business, but says that, “This is a tall order, given that a heavy weighting toward a certain risk (i.e., investment risk) limits the ability of diversification from smaller risk (i.e., reinsurance liability risk) to reduce the overall risk profile.”

So is will  Bill Ackman’s IPO be a good buy? Only time will tell.