Hedge fund attraction to the reinsurance sector

Hedge funds are becoming ever more active in the reinsurance space. Initially, the main draw was the ILS space as a source of high yields from an uncorrelated asset class. As the historical returns show (see previous post), this has been a successful strategy over the past 5 to 8 years.

However, as yield seeking investors, particularly from increased pension investment in specialist ILS funds, have flooded the market with supply over the past 12 months with the resulting downward pressure on rates (latest Willis Re report has some Florida rates down 25%), attention may switch towards strategies of getting directly involved in providing capital to the sector. Existing hedge fund backed reinsurers such as Greenlight Re, Third Point, SAC Re and PAC Re have attracted attention, most recently for their tax advantages as per this Bloomberg article in February.

Despite the obvious tax attraction of some hedge fund backed reinsurer strategies (particularly for those focussed on easy to enter commodity markets like property catastrophe), the more solid firms are driven by the leverage that medium to long term insurance float can bring to enhance their investment returns. The daddy of this strategy is of course Warren Buffet. A report entitled “Buffet’s Alpha” from 2012 co-authored by professionals in AQR Capital Management summarises the strategy.  The report concludes that “the secret to Buffett’s success is his preference for cheap, safe, high-quality stocks combined with his consistent use of leverage to magnify returns while surviving the inevitable large absolute and relative drawdowns this entails” and “that Buffett applies about 1.6-to-1 leverage financed partly using insurance float with a low financing rate, and that leveraging safe stocks can largely explain Buffett’s performance.

With current accident year underwriting margins thin and reinsurance pricing increasingly driven by black box quant underwriting, it seems inevitable that naïve newcomers will try to repeat Buffet’s formula for success by aggressively chasing insurance float for leverage. Such new capacity, if substantial, will test the sector’s relatively newfound (and hard fought) reputation for underwriting discipline at a time of building headwinds for the sector.

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