Several well-known hedge fund managers have backed new reinsurance vehicles, with the aim of using stable premium flows in lower-risk underwriting business to support higher returns on the companies' asset portfolios.
The business model sounds simple, but achieving these goals may prove to be challenging, according to Fitch Ratings.
Making money on the asset portfolio has always been a fundamental part of the (re)insurance business model, although the protracted low-yielding environment has significantly reduced this source of earnings for most players, making it harder to offset technical losses.
One difficulty for reinsurers that are reliant on hedge fund returns will be on generating double-digit returns year after year. The investment portfolio for one such company, PaCRE, set up in April 2012 and managed by the hedge fund Paulson & Co. Paulson's Advantage Plus fund, highlights the volatility of earnings: it experienced a 50 per cent decline in 2011 and a 17 per cent rise in 2010, according to press reports.
A huge fall in asset values like that experienced by the Advantage Plus fund in 2011 would deplete a reinsurers capital, putting the company at risk of a default if it coincided with unusually high claims payouts.
This topic is being hotly debated at the reinsurance industry's annual gathering in Monte Carlo, where some believe the presence of hedge-fund-backed reinsurers will serve to promote underwriting discipline as well as providing an alternative choice to reinsurance purchasers.
Fitch believes hedge funds could contribute to a more competitive pricing environment in certain sectors. In years when the funds are able to generate high returns, the demand for income through reinsurance premiums means that reinsurance prices could drop below their sustainable level. The hedge-fund-backed reinsurers will remain profitable (unless there are losses on the policies or assets), but insurers only generating single-digit investment returns would find it harder to post a profitable business.