While an attractive investment proposition, hedge funds can throw up a number of challenges for reinsurers, as Richard Major explains

Hedge funds, long a favoured asset class among pensions, endowments, and the very rich, are attracting increasing interest from reinsurers. Over the last several years, investment returns have suffered under low interest rates and erratic equity returns. Softening premium rates in the property/casualty sector are heightening the significance of reinsurers' investment income. Reduced rates tend to reduce earnings and, consequently, capital generation and reinsurers' stock prices.

One might therefore expect a return to greater allocations to common stock, traditionally a popular source of returns that exceed those from core fixed income investments. In years 2000 through 2003, however, a number of insurers learned well publicised lessons about the volatility of equity prices and the consequences of excessive reliance upon realised gains to support earnings.

All these factors make attractive an investment proposition that offers equity-like returns (at least, those from good years) and bears little correlation with bonds or stocks. These are, of course, the central premisses of hedge funds. Although the correlation between any particular hedge fund and the broader financial markets can be high, many seek positive returns regardless of market behaviour, that is, "absolute" returns. Hedge fund managers seek to be relatively less dependent than traditional investment managers on the direction of the market for their results.

Estimates of the number of hedge funds are only that, though more than 6,000 is a frequently cited number. Although each manager may pursue multiple investment strategies, industry observers classify them into ten or so categories, such as global macro, convertible debt arbitrage, and commodities trading. Although a manager might offer its fund as following a particular strategy, the fund's governing agreements generally accord it discretion in how to execute that strategy or even whether to follow it at all.

Conversation on hedge funds rarely omits mention of the collapse in 1998 of Long Term Capital Management. Despite the apparent lessons of that experience, most hedge funds do not "blow up", but quietly emerge and then wind down. Beyond that, most hedge funds that accept new investors are either new or young, with managers recently departed from financial institutions or other hedge funds and without meaningful track records on their own or with their fund. Funds require redemption notices of up to three months and even then may redeem only quarterly or annually. This is a risky and illiquid class of investments.

An ironic situation

In an ironic development, reinsurers compete increasingly with hedge funds for insurance risk. Attracted by harder premium rates in property/casualty since early 2001, and what they see as inefficient price discovery in re/insurance, hedge funds are selling re/insurance, primarily high attachment property cover. Some funds have organised and capitalised their own reinsurers. Others are utilising a fronting company that transfers its insurance liabilities to the hedge funds via derivatives. The relationship among insurers and the hedge funds in which they invest is taking on the slight appearance of a spiral.

Assessing an investment in a particular fund presents the empirical challenge of having to do so on highly imperfect information and information that may have limited relevance to future investment performance. Similarly, a particular strategy that has performed well in the recent past may not continue to perform well. There is a considerable body of publicly available data on hedge fund performance, though it is self-reported and suffers from survivorship bias (bad funds cease reporting their data). Finally, returns are not distributed normally, but can demonstrate "fat tails" on the downside. All these considerations highlight the importance of diversification in an institution's allocation to hedge funds.

Spreading the risk

Investing in one fund can bring stellar returns or the loss of the original investment. Given the difficulty of predicting which will occur has motivated insurers to invest in funds of hedge funds. Absolute returns from this strategy tend to fall short of those from well performing hedge funds. Many of those are, in any case, turning away new investors. The benefits are however several, including lower volatility, less dependency on individual strategies, and reduced exposure to an individual manager's poor performance.

Some larger insurers manage their own diversified fund of hedge funds, though often with outside advice. As discussed further below, the resources required to conduct such a program are significant. A manager of a fund of hedge funds offers investors the opportunity to participate in a diversified portfolio of investments in individual hedge funds. Such a manager may have better access to attractive funds, have experience in evaluating funds, and can offer better liquidity direct investments in the underlying funds. It should also offer a portfolio of relatively uncorrelated fund investments. With more capital invested in a greater number of funds than can an individual reinsurer, the manager can more easily rebalance the portfolio as correlations change.

The cost to the investor is a second layer of fees over the hedge funds' fees. Thus, the investor may be paying the manager a 1% or 2% annual fee as well as 10% of gains. The manager, in turn, is paying from its investors' funds the underlying hedge fund fees, which can also be 2% plus 10% to 20%. Even so, the risk-adjusted net performance of a fund of funds can be attractive. It may, however, be difficult to persuade the investment committee of the board that the economics are attractive. To some, this double layering is simply unreasonable.

Academic literature has addressed the question of when adding additional funds to a portfolio ceases materially to reduce portfolio risk and only adds complexity. The number varies, but generally between ten and twenty. The degree of diversification actually achieved depends on the correlations among the specific funds.

Reinsurers that invest in hedge funds generally limit their allocations to less than 5% of invested assets. Hedge funds and other "risky" assets as a percentage of surplus is also a measure that rating agencies examine closely.

PXRE and Max Re are two notable exceptions to the 5% target. According to PXRE's 2004 10-K, at year end 2004, the company had 11.8% of its portfolio invested in 23 "different hedge funds and other limited partnerships." Max Re's 2004 annual report notes it had 31.8% of its portfolio in a fund of approximately 50 hedge funds. That percentage also included reinsurance private equity investments; so backing out the figure for private equity indicates a 30% allocation. Max Re is one of the active reinsurers that has made alternative investments a central aspect of its larger strategy. It is instructive that a company with a highly disciplined program has diversified to 50 funds.

The illiquid and potentially volatile nature of hedge funds makes them suitable for securely capitalised reinsurers that are unlikely to face a need to monetize the investments unexpectedly or suddenly. This suggests as well that they are suitable for reinsurers with highly diversified liability profiles. They are appropriate for the risk or capital portfolio where one might also find, say, venture capital or real estate. An important consideration in contemplating hedge fund investments are the views of regulators, equity analysts, and rating agencies.

The regulator's view

Reinsurers most visibly investing in hedge funds have been domiciled in Bermuda, which views its insurance industry as self regulating and has no limits specific to hedge funds as insurance investments. It, and most likely all insurance regulators, in the consultative aspect of its supervision would take a dim view of a thinly capitalised or otherwise unstable insurer's investing in hedge funds. The National Association of Insurance Commissioners (NAIC) in the US applies a 20% to 30% capital charge to "other invested assets", which include hedge funds. It is instructive to contrast this, which contemplates a sudden 20% loss of value, to Max Re's returns on alternative assets, which have been consistently positive since its organisation in 2000 and greater than that of the S&P 500 in four years out of five.

Equity analysts are skeptical of capital gains and, regardless of whether they have been appearing regularly, view them as capable of ceasing unexpectedly. Further, as the reinsurer decides when and if to realise a gain, analysts recognise gains are managed to impress them. Consequently, the quality of earnings diminishes as capital gains become more significant to earnings and as a company's record in generating them turns uneven. Still, despite the significant role of gains in hedge fund returns, companies have found that adding a well diversified and managed portfolio of hedge funds can help reduce portfolio risk. A modest allocation to them can bring this benefit without creating a difficult "story" for management to persuade the analysts to accept.

It reassures both equity and ratings analysts when management demonstrates a clear understanding of their company's business. This is certainly true for a reinsurer's investment program. While at a prior firm, an insurer asked for our view of its investing with a fund manager that would pursue an innovative strategy that sounded difficult to evaluate, execute, and control. Asked to explain it, the treasurer said they would be hiring a group of real "rocket scientists" who would know everything on their behalf. Regardless of the validity of the investment strategy, this was sufficient to elicit an unfavourable response. It is therefore essential to demonstrate sufficient familiarity with the hedge funds, their surveillance, and their risks to be able to make an informed decision to buy, hold, or redeem. Although to a lesser extent than securities analysts, ratings analysts can and do include their qualitative views in assessing a company. A significant, if inchoate, qualitative consideration is of simple comfort or discomfort, trust or mistrust, with management and their company. If management disclose both good and bad news, do what they say they will, and clearly understand their business, they will get a better hearing from their rating agencies.

As does the NAIC, rating agencies apply capital charges that indicate they have yet to accept the "bond-like volatility" of hedge funds. AM Best, for example, applies a 20% charge for property/casualty insurers' "other investments", such as hedge funds. The benchmark for life insurers' other invested assets is 3.6% to 100%. Although conversations have started at 100%, one might expect the opening bid to be closer to 30%.

As a result, hiring a selection advisor or fund of funds manager should be viewed as a decision to retain expert advice and not a delegation of responsibility. There should be a consistent pattern of management's involvement in selecting the manager, monitoring the due diligence on potential investments, evaluating performance reports, and monitoring the appropriateness of the hedge fund allocation.

William Donaldson, chairman of the Securities and Exchange Commission in the US recently referred to a "gold rush mentality" in the largely regulated hedge fund industry. The challenges of investing effectively in hedge funds are many. Still, an increasing number of insurance enterprises are finding them an attractive diversification for their portfolios.

Richard Major is director and insurance strategist with Insurance Advisory Services at Deutsche Asset Management.

- The opinions reflect those of Mr Richard Major as of April 2005 and do not necessarily reflect the opinions of Deutsche Asset Management and are subject to change without notice. This article is intended for informational purposes only and does not constitute investment advise or a recommendation or an offer or solicitation, and is not the basis for any contract to purchase or sell any security or other instrument, or for Deutsche Bank or its affiliates to enter into or arrange any type of transaction as a consequence of any information contained herein.