Total return re: adjusting to the new abnormal
Total return reinsurers emerged as a response to the low interest rate environment, and with little sign of an imminent rise, these flexible structures have evolved and gained in popularity, say Steven Chirico and Dan Hofmeister of AM Best.
“Large amounts of excess capital are a positive in the total return model.”
A total return reinsurer contemplates risk and returns from both sides of the balance sheet, by deploying risk capital where the best opportunities present themselves, whether as investments or reinsurance contracts.
These opportunity sets are analysed in tandem, under the common assumption of low correlation between investment returns and reinsurance results for most lines of business.
AM Best views the total return reinsurer as a relatively recent manifestation of the alternative capital concept, which started with the first issuance of catastrophe bonds in the mid-1990s, following the Northridge earthquake and Hurricane Andrew. Most of the total return reinsurers formed in 2012, in a deteriorating reinsurance rate environment.
Market dynamics drive the concept
In some ways, the reinsurance and investment market dynamics following the financial crisis led to the total return reinsurer concept. Reinsurance pricing had softened from the hard market after hurricanes Katrina, Rita, and Wilma in 2005, with pricing on almost all lines of business having declined below technical adequacy by 2012.
Exacerbating the situation were low investment yields, with 10-year US Treasury bond rates near 200 basis points, a level not seen since before 1950.
These market dynamics in effect halved the return on equity for reinsurers as a group, from the mid-teens to the high single digits. Developed economies have been in an anaemic nominal and risk-adjusted interest rate environment for almost a dozen years now. The rise in interest rates that many have predicted for several years has failed to manifest, and the COVID-19 economic shutdown will very likely prolong the low rate environment—the “new abnormal”.
The insurance industry relies heavily on investment income to drive operating results. For the five-year period that ended December 31, 2019, investment income for this cohort accounted for 98.5 percent of net income. Long-term fixed-income securities constituted 57 percent of the industry’s invested assets and 48.7 percent of admitted assets. This asset allocation is essentially prescribed by regulators for insurers and reinsurers licensed in the US.
Offshore reinsurers are also exposed to the low rate environment, but they generally have more investment flexibility. The total return reinsurer emerged out of this environment. Traditionally, reinsurers take a significant majority of enterprise risk on the liability side of their balance sheets by deploying risk capital for reinsurance business and parking most of the float in highly rated, relatively short-duration fixed-income investments.
However, hedge fund managers questioned why reinsurers would deploy capital writing underpriced reinsurance business just to sustain market share and invest the float in low-yielding fixed-income instruments—and how they could make money in such an environment.
“The potential third generation of the total return model takes the form of a special purpose vehicle.”
The solution they developed was to find adequately priced, longer-tail, low-volatility reinsurance business to generate float, to invest for higher risk-adjusted asset returns. This business has been overweight on standard casualty lines of business such as general liability, auto, accident and health, and workers’ compensation, which are generally written on a quota share basis, compared with a more traditional reinsurer.
Large amounts of excess capital are a positive in the total return model because that capital can be invested to earn a higher return while simultaneously being available to ensure policyholder security.
Since 2015, the capital markets have experienced an increased level of volatility, especially in 2018 and 2019. Value equity investing in particular has generated some rocky results, as equity pricing has seemed to deviate materially from intrinsic value (as calculated by fundamental techniques).
Additionally, the rise of algorithmic program trading, where speed is almost as essential as identifying mispriced securities, has quickly absorbed any alpha that emerges. At the same time, reinsurance pricing is starting to see positive momentum, after the heavy property catastrophe loss activity in 2017 and 2018.
In response to these changes in investment market and reinsurance pricing dynamics, all of the total return companies rated by AM Best (Figure 1) have decreased their risk asset allocations materially and are deploying the newly freed excess capital to write reinsurance business, which has experienced recent significant price increases and improved terms and conditions. The change in risk allocation can be viewed as evidence that the total return reinsurer concept does have the flexibility contemplated in the model.
Total return reinsurers–net P/C premiums earned as a percentage of the market, 2019 (%)
Source: AM Best data and research
Emergence of several total return reinsurer models
Initially, a “hedge fund re” was a configuration in which money was raised from private investors who were known to a prominent hedge fund manager—the first generation of the model. A chief executive officer from the reinsurance industry was named as well as a chief financial officer and a chief underwriting officer. The investments were run by the hedge fund manager, with a separately managed account or a fund of one.
Local management was charged with finding low volatility standard casualty quota share reinsurance business (characterised by low premium and reserve leverage) based on an investment strategy designed to go further out on the risk/reward continuum and incorporate publicly traded securities to provide liquidity.
These entities were named so that they could be easily identified with the hedge fund manager. Greenlight Re and Third Point Re are examples of the first generation.
The second generation can be thought of as the partnership model, which used outside expertise for investments and underwriting. This model sourced almost all reinsurance business from underwriting partners, which have been large, highly rated reinsurers. The investment side of these entities is managed by large, multi-strategy investment firms that design investment portfolios with varying risk/reward and liquidity characteristics.
Partnership total return companies execute long-term partnership agreements with the investment manager and the reinsurance partner. These partners also have material investments in their “customer”. Harrington Re and Watford Re are examples of the second generation.
The potential third generation of the total return model takes the form of a special purpose vehicle (SPV) designed to aggregate several unrelated alternative asset strategies with a common source of reinsurance business. The SPV can be an “incorporated cell captive” in which asset managers “own” a cell capitalised by investors who are clients of the investment manager. The underwriting entity may be from a rated reinsurer or from a managing general agent or managing general underwriter.
This third generation of the model has the advantage of allowing the entity to match reinsurance business with multiple asset managers and strategies, thus increasing diversification and limiting the influence of a dominant asset manager.
AM Best is aware of marketplace discussions on this third generation of total return company, but none of these has been assigned a rating as of this writing.
Thus far, the total return companies rated by AM Best have been limited to primarily casualty reinsurance lines of business. Regulated primary insurers have not embraced the total return concept, possibly because of regulatory constraints, which can discourage material amounts of risk asset investment allocations.
Theoretical advantages and disadvantages
The advantages and disadvantages of a total return reinsurer depend on one’s perspective. From a reinsurer’s perspective, the potential for significantly higher investment returns (say, 6 percent versus 3 percent over the long term) can allow the deployment of capital to diversify the reinsurer’s earnings sources, which can have particular advantages during a prolonged soft reinsurance pricing cycle.
The total return reinsurer has the opportunity to toggle its risk capital allocation between a risk asset portfolio and a portfolio of reinsurance opportunities. These opportunities can be managed to maximise the return on equity compared to more traditional reinsurers, by pushing the boundaries of the efficient frontier.
Entities with more traditional, lower-yielding investment strategies can be forced into deploying a much greater percentage of capital into writing underpriced reinsurance business or shrinking their way into oblivion by decreasing their writings and returning capital. In essence, the total return model allows greater optionality.
From an asset manager’s perspective, a common assumption of a low correlation of reinsurance to the capital markets, tax advantages, and a fee income stream on permanent capital all represent significant advantages over other investment opportunities. The correlation of reinsurance results with risk asset returns is relatively low, depending on the line of business.
Property catastrophe reinsurance has the lowest correlation to asset returns, while workers’ compensation has a higher correlation. The sweet spot seems to be the general casualty lines of business, which have a relatively low correlation to asset returns and a claim tail that creates float with which investment income can be earned for multiple years.
All but one of the total return reinsurers are domiciled in tax-advantaged countries, mostly Bermuda, which allow a reinsurers’ investment returns and reinsurance profits to accumulate tax-free, further enhancing the return on equity. Passive foreign investment corporation rules ensure that these entities are “real” reinsurers instead of a tax dodge.
In fact, total return reinsurers generally have less premium leverage than traditional reinsurers do. Risk modelling tends to limit the premium and exposure levels driven by the risks taken on the asset portfolios of total return reinsurers.
From an investor’s perspective, the low correlation of reinsurance to other investment opportunities, coupled with tax advantages, can represent an accretive opportunity for long-term investors such as pension funds, mutual funds, and family offices. Notably, smaller investors can avail themselves of the expert investment management they would otherwise be excluded from due to closed funds and buy-in minimums.
By investing in shares of a publicly traded total return reinsurer, smaller investors can also benefit from the significant long-term outperformance of these investment managers.
The total return reinsurer model has two main disadvantages: operating performance volatility and market acceptance. A total return reinsurer’s net income, operating ratio, and return on equity will experience higher volatility (Figure 2).
To offset this volatility, a total return reinsurer retains excess capital in the form of less operational leverage, to absorb adverse earnings and capital events that can be generated by risk asset portfolios. Although most of the total return reinsurers secure known underwriting talent and chief executive officer personalities, market acceptance is a disadvantage. Due to operational volatility, relatively high investment manager fees, and relatively small size and short tenure, market acceptance requires that a ceding company or insured understands the value of placing business with a total return reinsurer.
Adverse operational volatility in 2015, 2018, and the first quarter of 2020, coupled with the total return reinsurers’ relatively short tenure and relatively small balance sheets, can make reinsurance panel acceptance challenging.
Total return reinsurers–return on equity, 2014–2019 (%)
Source: AM Best data and research NB: 5-year average ROE = -0.3%
Viability of the total return model
Whether the total return reinsurer model in its initial iteration is viable is questionable. The reinsurer model has struggled in the recent environment. Recent investment return volatility, coupled with the soft reinsurance pricing environment that lasted from 2012 until 2018—the first years of most of these entities’ existence—has resulted in volatile and muted operating results.
These dynamics were a challenge to market acceptance, affecting the entities’ ability to consistently write profitable reinsurance business, which was exacerbated by struggling value investing opportunities and followed by a near-complete shutdown of global economies in the first quarter of 2020, which punished almost all investors.
The long-term viability of the total return reinsurer model hinges primarily on management’s ability to realise the theoretical returns that can be generated by effectively deploying capital and taking risk on both sides of the balance sheet.
This article is an excerpt from the Best’s Special Report “Emergence of “Total Return Reinsurers”.