Reinsurers Skeptical of Hedge Fund Investment

Hedge funds have always enjoyed a presence in the insurance sector but Warren Buffet has declared recent hedge fund forays to be a precursor to the decline of major reinsurance companies.

What Has Changed

Hedge funds have invested in catastrophe bonds and other insurance-linked securities for decades. However, Buffett’s concern is the recent phenomenon in which hedge funds are actually establishing captive reinsurance companies, typically in lightly regulated jurisdictions offshore.

This is of significant concern to traditional reinsurers because of the competitive advantage accruing to hedge fund-owned reinsurance entities. Beyond the obvious regulatory advantages, hedge funds are also in a position to leverage with borrowed cash, accept higher risks and invest premium dollars in high yielding strategies. The cumulative effect of these advantages results in lower premiums for potential reinsurance clients and this competitive advantage is what led Buffett to his dire prediction for conventional reinsurers.

Premature Concerns

The nearly $600 billion reinsurance market has substantial room for competition. Thus far, hedge reinsurers have but a fraction of the market at an estimated $5 billion. More to the point, hedge funds face an uphill battle in winning over potential clients. While lower premiums provide hedge fund captives an attractive marketing edge, they must also win the trust of potential clients.

The trust and confidence aspect of the equation does not favor hedge funds. Hedge funds are perceived to be interlopers, as opposed to mainstream reinsurers, which have the advantage of track records spanning generations and impeccable credit ratings. Hedge fund captives have been on the scene for under a decade and many remain unrated by the major agencies. For example, A.M. Best has rated Greenlight Re, Third Point Re, PaCRe, Hamilton Re and Watford Re, but Moody’s has not.

As a result, the playing field is more level than it may appear at first blush.

The Fly in the Ointment

The Internal Revenue Service (IRS) has shown interest in this relatively recent hedge fund ploy and may act to remove loopholes which allow hedge fund managers to reduce tax liabilities by channeling investments to insurance companies in offshore, low tax jurisdictions.  None-the-less, hedge funds continue to surge into the reinsurance business, secure in the knowledge of the difficulties the IRS faces in justifying changes to current tax law.

The Jobs Effect

Many established reinsurers are partnering with hedge funds in an apparent “if you can’t beat them, join them” mindset. These so-called side-car structures allow the hedge fund to focus on investment while the partner manages underwriting risks and business development. This reduces start-up expenses and leverages the management strengths of each partner.

Logically, there will be increased opportunities for employment in the hedge fund industry for anyone with experience in the reinsurance field. Those with the ability to bring clients to alternative reinsurers would be particularly advantaged.

Conversely, those on the investment side of a reinsurance partner may have enhanced opportunities to transition to the partner hedge fund.

These are exciting times for both industries and time will be the judge the success or failure of these strategies.

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