Will reinsurers catch a cold? Hedge funds experienced their first negative quarter on record in Q1. That could have dire consequences for the insurance companies and products they invest in, explains Lindsey Rogerson.
Questions are being asked about the stability of some of the newer entrants into the reinsurance market. There have been several high profile hedge fund collapses since the subprime bubble popped and with global debt markets choked, private equity has been feeling the pinch too. But do these industry issues really mean the end of the happy marriage between hedge funds, private equity and reinsurance?
“My understanding is that the majority of hedge fund/private equity capital have largely exited the Bermuda classes of 2001 and 2005,” explains Nick Martin, a director at HIM Capital Management. “This has been helped by the companies, such as Lancashire, buying back shares from founders. In addition many hedge funds/private equity were funding sidecars that did not get renewed for 2008. I am not aware of any distressed sales in the market.
“As to whether it may affect start-ups in future it probably will. I suspect that hedge funds/private equity will be looking at asset classes that are more their core competence than (re)insurance, which of course is an inherently risky business. In addition, next time around I expect there to be more sidecar type deals than pure start-ups.”
The sidecars (or special purpose vehicles) in 2006 and 2007 proved their worth and have produced better returns on capital than the recent start-ups, which are now mostly trading at or below book value, continues Martin. “The model of starting a new company, having a couple of good years, and selling it at a nice premium to book value has not worked this time.”
Capital raising hindered
The crunch has affected the ability of investors to raise large amounts of debt quickly. “That means that larger deals that are dependent on debt in large volumes are on hold or not happening,” explains Andrew Lebus, managing partner at Pantheon Ventures. “I think that periods of market closure are almost inevitable after the cycle turns, so this is nothing particularly unexpected. Deals are still happening down the scale.”
It is also important to remember that while the credit crunch may have triggered a rethink on the way deals are structured, a lot of private equity funds are sitting on pots of cash. Hamish Mair, head of Private Equity Fund at F&C Asset Management, believes that the heady ratios of 80% debt to equity will be replaced by something like 50% to 60% in future.
This will have implications for price exits according to Mair, who says it will mean more trade sales and possibly listings, as opposed to private equity groups selling businesses to other private equity groups. This fact alone could make reinsurance an attractive proposition to private equity. Century Capital used trade sales to offload Faraday and Tempest Reinsurance and it took Montpellier Re public. As long as private equity can see a healthy return and a clear exit, it will continue to invest.
The same applies to hedge funds. Yes some funds have tanked in the last 12 months, but there are still a healthy number of long-established funds out there that did not get burned by the subprime-triggered events. Many of those in good shape are those who have a track record of using reinsurance to generate alpha for their funds.
In fact it is not out of the question that hedge funds and private equity groups could be running the slide rule over insurance groups who have subprime issues. Royal bank of Scotland has already put its UK insurance business up for sale. Other opportunities could present themselves in due course.
Those who think the love affair between hedge funds, private equity and reinsurance could be cooling permanently may have misread the signals and underestimated the mutual benefits of such marriages. Admittedly, with rates now softening in US hurricane-exposed catastrophe and property lines it will probably take a major event – such as the likes of Hurricane Katrina – to bring a new wave of hedge fund money into the market.
But hedge funds, and to lesser extent private equity, are all about exploiting distortions for profit. Just because the most recognised avenue for hedge funds – namely US hurricanes and other catastrophes – is not enticing at the moment in financial terms, does not mean other areas are not ripe for “distortion” exploration.
Witness the recent entry of Warren Buffet into underwriting the US municipal bond market. 3i’s 2006 backing of a start-up reinsurer Asia Capital Re (ACR) in Sinapore also fits into this category, although admittedly the “distortion” here is an emerging need for insurance.
This deal also highlights a popular misconception about existing forays into reinsurance. The perception is that all the deals done to date have been start-up reinsurers, cat bonds or sidecars in Bermuda. This is just not true. Stone Point Capital bought out the reinsurance business of French insurance giant AXA with its Paris Re venture and that of UK group Chubb.
Wake up call in China
As unpalatable as it might be to mention, with search teams – at the time of writing – still sifting through the debris in China’s Sichuan Province, nothing crystallises the need for insurance quite like a catastrophe on your doorstep. The emerging Chinese middle class and the government are likely to have an increased appetite for insurance (and someone will have to reinsure these policies) after the events of this May. The possibility of a Chinese catastrophe pool could also mean opportunities for reinsurers and capital market investors.
Granted the majority of private equity money that has flowed into reinsurance in the past has gone to property and casualty, but not all of it. Private equity groups Vestar Capital Partners, MMC Capital and Blackstone have all invested in health or life reinsurance deals in the recent past. It is likely that opportunities presented by the Middle Eastern, Indian and Chinese markets may tempt them into further insurance deals in these markets in the future.
Ironically, the subprime collapse presents opportunities as well. It is highly likely that all the lawsuits with regards to directors’ and officers’ policies will boast the need for primary insurance. A survey by First Flight, a UK executive recruitment group, found that only around 40% of non-executive directors have D&O insurance. The flood of anticipated claims is also likely to highlight the need for reinsurance, as those insurers facing hefty payouts reassess their own needs.
As the 3i deal backing ACR proves, there is a new kid on the block when it comes to backing ambitious underwriters in their own businesses, namely sovereign wealth funds. 3i’s partner, Khazanah Nasional Berhad, is the Malaysian Government’s sovereign wealth fund. A convergence of interests makes it highly unlikely this type of partnership will be the last between the reinsurance, private equity and sovereign wealth sectors.
Why? With debt markets still frozen-ish, private equity/hedge fund managers are looking around for co-investors with deep pockets. Sovereign wealth funds, especially those of the Middle East whose pockets are only getting deeper with oil passing $135 a barrel, are looking around for groups with a track record of building successful businesses. And lastly, the burgeoning economies of the developing world need insurance and reinsurance in order to drive growth.
So, in retrospect, perhaps going forward it will be less of a marriage and more of a ménage à trois!
Lindsey Rogerson is a freelance journalist.