Tag Archives: diversification benefits

When does one plus one equal more than two?

S&P released a thoughtful piece on Monday called “Hedge Fund Reinsurers: Are The Potential Rewards Worth The Added Risk?” I couldn’t find a direct link to the article but Artemis has a good summary here. They start by asking whether combining a reinsurer strategy with a hedge fund strategy can create higher risk adjusted returns than the two approaches could achieve separately. They conclude with the following:

“The potential crossover between hedge funds and reinsurers offers compelling possibilities. However, a commensurate focus on additional risks would have to supplement the singular focus on higher investment returns. Considering both is necessary in determining whether one plus one is truly greater than two. This depends on whether combining hedge funds and reinsurers can create additional diversification benefits that don’t occur in these two types of organisations independently, thus creating a more capital efficient vehicle. We believe it’s possible. However, in our view, closing the gap between reinsurer and hedge fund risk cultures and implementing prudent risk controls is necessary to realize these benefits.”

I have posted on this topic before. One of the hedge fund reinsurer strategies is to combine low volatility P&C business (primarily as a source of cheap “float”)with the alpha seeking asset business. My problem with this strategy is that every reinsurer is looking out for low volatility/stable return (re)insurance business (its the holy grail after all!), even more so in today’s highly efficient and competitive market. So what can clever chino wearing quants living on a tropical island offer that every other established reinsurer can’t? I suspect that the answer is to price the business with a higher discount rate based upon their higher expected return. S&P point out that this may create increased risks elsewhere such as liquidity risk in stress scenarios. Another strategy is to combine volatile property catastrophe risk with higher asset risk, essentially combining two tail risk strategies. This pushes the business model more towards the highly leveraged model as per that used by the monoline insurer, the ultimate “picking up pennies in front of a stream-roller” play.

To get an idea of the theory behind the various strategies, the graph below illustrates the diversification of each using the calculation in the Solvency II standard formula, with different concentrations for market, counterparty, life, health and non-life risks (selected for illustration purposes only).

click to enlargeHedge Fund Reinsurer Diversification

The graph shows that a hedge fund reinsurer with a low volatility liability strategy shows the least amount of diversification compared to a composite, non-life or a property cat reinsurer due to the dominance of market risk. Interesting, the high risk strategy of combining a hedge fund strategy on assets with property cat on the liability side shows diversification at a similar level (i.e. 78%) to that of a non-life reinsurer where non-life risk dominates.

Hedge fund reinsurers would no doubt argue that, through their alpha creating ability, the 25% correlation between market and non-life risk is too high for them. Reducing that correlation to 0% for the hedge fund reinsurers gives the diversification above, as per “Diversification 1” above. Some may even argue that the 25% correlation in the standard formula is too low for traditional players, as this post on Munich Re’s results excluding catastrophic losses illustrates, so I have shown the diversification for an illustrative composite, non-life or a property cat reinsurer with a 75% correlation between market and non-life risks, as per “Diversification 2” above.

In my opinion, one plus one is always two and under-priced risk cannot be justified by combining risk strategies. Risk is risk and combining two risks doesn’t change the fundamentals of each. One strategy that hasn’t re-emerged as yet is what I call the hedging reinsurer whereby liabilities are specifically hedged by asset strategies. Initially, the property cat reinsurers tried to use weather derivatives to hedge their risk but an illiquid market for weather derivatives and the considerable amount of basis risk resulted in difficulties with the strategy. The strategy is commonly used on the life side of the business with investment type business, particularly business with guarantees and options. Also the appetite for longevity risk by those reinsurers with significant mortality exposure that can significantly hedge the longevity risk is a major developing market trend. I do not see why the strategy could not be used more on the non-life side for economic related exposures such as mortgage indemnity or other credit type exposures.

In the immediate term, the best strategy that I see is the arbitrage one that those who have survived a few underwriting cycles are following, as per this post. On that point, I noticed that BRIT, in their results today, stated they have “taken advantage of current market conditions in reinsurance to significantly strengthen group wide catastrophe cover. These additional protections include a property aggregate catastrophe cover and some additional variable quota share protection”. When risk is cheap, arbitrating it makes the most sense to me as a strategy, not doubling up on risks.

Uncorrelated CaT capital “is the cheapest”

One of the reasons given by market participants for competitive pricing in the ILS markets is the lower cost of capital required by such instruments due to the uncorrelated nature of the underlying exposure with other classes. I previously posted on the lower risk return for an ILS fully collaterised portfolio against a similar portfolio written by a mono-line property catastrophe reinsurer. The ILS investor may be prepared to accept a lower return due to the uncorrelated nature of the exposure. It is nonetheless resulting in lower prices for risk which has always ended badly in the past.

Twelve Capital are a well known ILS investment manager and recently published a white paper on the impact of ILS capital on the reinsurance industry. I liked the way they described the lower cost of capital issue, as below:

“Equity is the most expensive form of capital for the (re)insurance industry. Thanks to its diversification benefits, ILS is the cheapest. The most popular form of investment for those looking to enter the reinsurance market was, prior to the birth of ILS, equity offered by traditional reinsurers. However, returns on equity are eroded by company management costs and the tendency of reinsurers to diversify into less profitable lines of business. In addition, financial market investments on the asset side of the balance sheet expose reinsurance shareholders to additional financial market risks. A listed reinsurance stock thus has the disadvantage of being highly correlated to equity markets in general.

So, what ought to be a fundamentally uncorrelated investment gets transformed into a correlated investment, and the diversification benefit is lost. The investor is also exposed to the risk that the management of reinsurance companies might not always act in the best interests of shareholders.

As insurance investors focus on those lines of business that are favourably priced and soundly modelled, reinsurance companies might end up losing their most profitable lines to the ILS market. And it is this source of profit that reinsurers have traditionally relied upon to support and cross-subsidise substantial volumes of business that generally only break even. With profitable lines taken away by more efficient investors, reinsurance companies are left with business models that cannot sustain conventional cross-subsidisation.”

The comment on reinsurer’s management is a bit below the belt! The impact of the loss of the low frequency/high severity business to the traditional market is a valid one though. However, the long histories of the largest tier 1 reinsurers with large diverse portfolios and the ability to provide products and services across most business lines and jurisdictions indicate more robust business models than the commentary suggests in my opinion.

My previous post looked at the capital return of a fully collaterised provider such as an ILS fund against a mono-line catastrophe provider such as a property cat reinsurer. To see if the commentary above on a correlated investment is reflective of actual experience, the graph below shows the S&P500 against the share prices of the property catastrophe reinsurers Renaissance Re, Validus Re, Montpelier Re and Platinum Re since late 2002. Excluding Montpelier Re, which obviously had some company specific issues after the 2005 wind losses, the R2 for the other firms is remarkably similar around 65%. This suggests investing in the equity of these firms has indeed been a correlated investment in the past.

click to enlargePropCaT Reinsurers correlated to SP500

It emphasises that the traditional reinsurance market needs to focus on reducing such correlation, whether real or wrongly perceived, to compete better for this cheap capital.

Computer says yes

Amlin reported their Q1 figures today and had some interesting comments on their reinsurance and retrocession spend that was down £50 million on the quarter (from 23% of gross premiums to 18%). Approx £20 million was due to a business line withdrawal with the remainder due to “lower rates and improved cover available on attractive terms”.

Amlin also stated “with the assistance of more sophisticated modelling, we have taken the decision to internalise a proportion of a number of programmes. Given the diversifying nature of many of our insurance classes, this has the effect of increasing mean expected profitability whilst only modestly increasing extreme tail risk.

The use by insurers of their economic capital models for reinsurance/retrocession purchases is a trend that is only going to increase as we enter into the risk based solvency world under Solvency II. Current market conditions have resulted in reinsurers being more open to offering multi-line aggregate coverage which protect against both frequency and severity with generous exposure inclusions.

It will only be a matter of time, in my opinion, before reinsurers underwrite coverage directly based upon a insurer’s own capital model, particularly when such a model has been approved by a firm’s regulator or been given the blessing of a rating agency.

Also in the future I expect that firms will more openly disclose their operating risk profiles. There was a trend a few years ago whereby firms such as Endurance (pre- Charman) and Aspen did include net risk profiles, such as those in the graphs below, in their investor presentations and supplements (despite the bad blood in the current Endurance-Aspen hostile take-over bid, at least it’s one thing they can say they have in common!).

click to enlargeOperating Risk Distributions

Unfortunately, it was a trend that did not catch on and was quickly discontinued by those firms. If insurers and reinsurers are increasingly using their internal capital models in key decision making, investors will need to insist on understanding them in more detail. A first step would be more public disclosure of the results, the assumptions, and their strengths and weaknesses.