Where do hedge fund reinsurers turn next?
By: Bermuda Re
Despite challenges on several fronts, the number of newly formed hedge fund reinsurers is predicted to rise. But the real question could be how they evolve and whether some need an exit strategy to move on, as Tom Kelly, managing director, KPMG in Bermuda explains to Bermuda:Re+ILS.
In April, 2015 the US Treasury’s Internal Revenue Service (IRS) released guidelines for proposed regulations designed to address perceived tax issues associated with the income of offshore reinsurers operated by onshore hedge funds.
There are concerns on Bermuda, however, that the proposed legislation could impact many legitimate re/insurers and that the guidelines misunderstand the nature of many reinsurers’ business models. The Association of Bermuda Insurers and Reinsurers has written to the IRS outlining some of these concerns and offering suggestions for how the guidelines may be modified.
Several months on from the announcement of these regulations, the situation remains unclear and unresolved, and Tom Kelly, managing director, KPMG in Bermuda, says that changes to the tax circumstances of these players could put the brakes on both their growth and new formations.
“Bermuda is a great location to establish these entities because the regulation is practical without being onerous and has a high focus on solvency and liquidity, which allows them to establish themselves rather quickly,” he explains.
“However, if something changed the regulation in Bermuda, the US or Europe, particularly in respect of how these entities are viewed, this could have a significant bearing on their operating model.”
Eyeing up an exit
The threat of the IRS may not be the biggest challenge facing these players. Kelly claims that a bigger issue could be their potential exit strategies.
“One critical thing for these entities that are not public is, what is the path to a successful initial public offering (IPO) and how that may differ for the various types of structures that are being created,” he says.
“Can we draw a comparison against what we’re seeing in the tech sector? There’s money coming in for start-ups, but the success of the IPOs may not quite mirror what we’ve seen in the past—that’s something for everyone to focus on.”
Kelly also identifies other challenges facing these players, some of which, he says, could cause them to reconsider their strategy.
“The rating agencies—most recently Standard & Poor’s (S&P)—have been vocal in commenting on the cheaper forms of reinsurance within the property-catastrophe sector. For many of the recent structures, a minimum A- rating is still a pre-requisite and therefore any views from the rating agencies that significantly constrain future capital use could be a serious roadblock to success,” he says.
“The agencies could have an impact on how far these reinsurers go, although this will be based on the ceding enterprise and how it views the use of these vehicles as part of its programme.”
It is not easy to predict how the companies will react to changing market conditions, however. Because they make money on both sides of the balance sheet, in theory, their business model is designed to endure the volatility in both capital and reinsurance markets.
There are circumstances under which they could exit the market but there is no obvious easy option available, Kelly says.
“Due to the nature of their capital structure, these entities are supposedly perpetual, so they don’t have a set life span, which means you’d expect that they’re in for the long haul,” explains Kelly.
“Closing them down would require either a sale, which relies on their finding a buyer, or running them off, which can be timely and costly.”
Kelly says that any liquidation would likely be driven by shareholder influence over the sponsors.
“The whole model is based on a permanent capital idea for the hedge fund sponsor, so it would unlikely be the hedge fund sponsors that would want to liquidate the reinsurer as they have the assets under management. It would be more a case of shareholders not being happy with the way that the overall entity was performing, or an inability to attract a sufficient level of interest in a proposed IPO,” he says.
Different business models
Kelly describes such entities as the result of the coming together of the capital markets with the reinsurance industry—in many ways mirroring the type of partnerships that have emerged in the insurance-linked securities (ILS) market.
However, there is great variation in the operational objectives of different players.
“While these reinsurers should be viewed as normal reinsurers to a certain extent, there is a real variety of operation models,” he says.
“Starting with Third Point, it is a reinsurance company looking for third party reinsurance business, and has an investment strategy that is managed and run by a hedge fund.
“Then you have companies such as Fidelis, which from a reinsurance point of view, writes third party reinsurance, looking to offer a variable investment and underwriting strategy—so using a platform of investment managers.
“Then you have Watford Re which has a mixture of premium coming from the reinsurance sponsor, independent business and a single hedge fund sponsor.”
As a global hub for risk transfer, Bermuda has facilitated many forms of innovation over the years and was thus a natural place of establishment for hedge fund reinsurers.
“Bermuda has a tremendous track record of growing and incubating fully fledged reinsurance entities. It’s been very successful in regulating them too, so Bermuda has had a huge success story in this area,” says Kelly.
There are fewer than 10 of these structures currently in the market but Kelly says that he expects the numbers to grow over the next six to 18 months.
“The real question is how many are coming to market?” he says. “If everything remains consistent, then it would appear there are more willing hedge funds than there are willing re/insurers.
“However, consolidation in the market place could limit the number of re/insurers that are available to set up these kinds of structures but could also incentivise others that haven’t previously considered a structure like this as appealing. The number may also be limited by the size of the high net worth market place that has been the primary source of initial capital to date.”
Despite the recent entrants having capital at their disposal, they are entering the market at a particularly challenging time.
“They might have a bigger war chest to make acquisitions and they won’t suffer the drag of legacy business, but they are also entering the market during a softer period, and that will be a challenge in itself,” he says.