Steinbrugge: Is It Time to Consider Reinsurance for a Diversified Hedge Fund Portfolio?

Oct 4 2017 | 6:29pm ET

Is This the Time to Consider Reinsurance for a Diversified Hedge Fund Portfolio?
By Don Steinbrugge

Most institutional investors understand the uncorrelated, diversification benefits of property catastrophe reinsurance. Many have been waiting on the sidelines for a large event to happen that would drive up pricing before allocating to the strategy.  The two big questions these investors ask are, “Is pricing going up?” and “Has the probability of hurricanes increased?”

Will pricing on property catastrophe reinsurance increase?

2017 has the potential to be the costliest year for the reinsurance industry on record, even worse than 2005 when the reinsurance industry was impacted by hurricanes Katrina, Rita and Wilma.  Applied Insurance Research (AIR) Worldwide estimates that losses from Hurricane Maria could add between $40 billion and $85 billion to the insurance industry losses from recent catastrophes. When added to the devastation of Hurricane Harvey and Irma along with recent earthquakes in Mexico, losses could be as high as $165 billion based on AIR estimates of all events.

Insurance companies typically assume the initial losses from major events and purchase reinsurance to cover losses above a threshold. The most recent events will likely have a disproportionately large impact on reinsurance, compared to others in the insurance industry, as they trigger aggregate losses which exceed those thresholds.

Prices for reinsurance are impacted by supply and demand. The potential $165 billion of lost capital will need to be replaced and will subsequently put upward pressure on pricing. In addition to the immediate material loss, a significant amount of capital will be locked up for accruals of potential claims at the end of 2017. This capital will be unavailable during the forthcoming January reinsurance renewal season. 

Fitch Ratings noted “Given the magnitude of the Maria-estimated losses, we now believe that 2017 catastrophe losses will constitute a capital event for a number of (re)insurance companies as opposed to just an earnings event.”  Companies faced with a potential downgrade will either have to raise capital or reduce their balance sheets, thereby putting further pressure on pricing. Price increases will be moderated by new capital coming into the industry but also enhanced by investors withdrawing capital from underperforming funds.

As a result, property catastrophe reinsurance rates may increase to the highest level seen in years, especially in regions affected by the 2017 hurricanes and in the Retro (reinsurance of reinsurance companies) market. For example, before the most recent events, but after Hurricane Harvey and Irma, some reinsurance deals were completed with premiums 25% to 50% higher than deals earlier in the year.

Has the probability of future hurricanes increased?

There has been a lot of debate on the impact of global warming on weather patterns. However, there is no clear evidence supporting the theory that global warming is impacting property damage from hurricanes over the short term. The short term (one year or less) maturities of most reinsurance deals allow models to remain accurately applied in the face of gradually shifting weather patterns. As a matter of fact, over the previous decade and before the third quarter of 2017, the industry experienced below-average losses from hurricane-related catastrophes.

What is reinsurance?

Reinsurance is one of the few hedge fund strategies that has almost no correlation to the stock or bond markets. The strategy has the potential to generate high single-digit to low double-digit returns on average over the next five to ten years, regardless of the direction of the capital markets. One way to understand the asset class of reinsurance is to compare it to structured credit. Lending institutions can either hold various loans they have made on their books, or they can sell the loans to other institutions and keep a small transaction fee. Insurance companies can do the same thing with property insurance policies they underwrite. 

When a bank sells their loans to a third party, often the interest and principal payments are broken out into various structured credit tranches offering different expected risk-versus-reward levels.  This concept of slicing up risk is similar to how insurance companies carve up a basket of insurance policies. Typically the insurance company assumes most of the initial risk and then sells off tranches of risk to reinsurance providers. The most conservative way to participate in the reinsurance market is through catastrophe bonds (CAT bonds). These securities trade on exchanges and can easily be purchased by institutions. They generally cover the highest tranches of risk and tend to have the lowest probability of loss. They also offer the lowest yields and expected returns. Most of these securities are only yielding approximately 5% before loss and gross of fees and expenses. Traditional reinsurance tends to focus on the middle layers of risk offering yields significantly higher than CAT bonds and is the area that most institutional investors are focused.

What are some of the things to consider before investing in a property catastrophe reinsurance fund?

It’s not easy to differentiate between reinsurance funds during long periods without a major event. The third quarter of 2017 will cause the relative performance between funds to widen out dramatically and provide a good stress test to determine which reinsurance funds actually have good risk controls. How funds performed during this period relative to expectations will be important to consider when determining the potential funds to which one should allocate. We expect to see some firms with single digit losses while others may be down over 50%.  Firms with draw-downs of this magnitude will either go out of business or require many years to move back to their high-water mark. 

Other evaluation factors on which to focus were included in the previous paper we wrote on the industry titled,“Reinsurance: the Perfect Hedge Fund Strategy to Enhance a Portfolio’s Sharpe Ratio?” In addition to those, we believe the best way to maximize future returns is by focusing on mid-sized reinsurance organizations with between $500 million and $2 billion in assets. As a firm’s assets grow above $2 billion, their ability to generate alpha through deal selection is slowly reduced as alpha is diluted across a larger asset base.

Other ways of differentiating reinsurance funds are:

1.  Volume of deal flow: It is very difficult to generate a large amount of deal flow in the reinsurance space.  To access the deal flow, firms must have relationships with regional insurance brokerage offices. Developing relationships across the extensive geographical landscape of the reinsurance industry takes an enormous amount of time and effort. However, the more regional relationships a firm is able to develop and, subsequently, the more deals they are able to see, the more inefficiencies in the market they can potentially identify.  

2.  Focus on small, regional companies: By focusing on smaller insurance companies that typically primarily focus on single-family residences within a single state, reinsurers face less competition and can receive more accurate information to precisely identify and price risk. This information advantage allows reinsurers to diversify risk and isolate deals in certain geographic areas.  This geographic isolation is important.  When events occur, all the positions are not impacted - only the ones in the immediate area of the catastrophe event.

3.  Proprietary analytics: Most reinsurance firms use the same weather models and datasets that can be purchased from the scientific community. To develop an edge, reinsurance firms must develop proprietary overlays to refine and enhance the models as they pertain to specific perils and/or geographies. A large portion of alpha can be generated through improved accuracy of the risk assessment compared to the off-the-shelf models.

4.  Risk control: Risk control is extremely important in any reinsurance portfolio. One way to implement this control is to build a portfolio that maximizes the Omega Score. While Sharpe Ratio can be appropriately applied to outcomes with normal or near-normal distributions, Omega Score is a more effective way to evaluate risk for the ‘fat-tail’ return distributions found in reinsurance.

Don Steinbrugge, CFA, is the founder and managing partner of Agecroft Partners, a global hedge fund consulting and marketing firm. He frequently writes white papers on trends he sees in the hedge fund industry, is an active speaker at industry conferences, and is a regular guest on business television.

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