New hedge fund reinsurers are struggling to get the necessary rating to make their business model work, according to Aon Benfield and Willis Re.
An excess of asset risk and a reluctance to back untested management teams are the main reasons why rating agencies have been reluctant to award the A- ratings that insurers are looking for, the brokers said in their 1 January market review reports.
Hedge fund insurers have been a minor contributor to the flood of 'alternative' capital flowing into the reinsurance sector to date, mobilising just over $5bn. But more such operations were expected to launch as US hedge fund managers saw an opportunity to create tax-efficient Bermudian investment vehicles and lock-up their investors for a longer period of time.
These vehicles make their returns by accepting insurance premiums and using their investment skills to take more asset risk than a traditional reinsurer would. They tend to underwrite low volatility, medium to long-tail casualty lines but some do go for property catastrophe risk.
In order to win business in the US, an A- rating from agency AM Best is the minimum rating that clients will accept, said Bryon Ehrhart, CEO of Aon Benfield Americas.
Some start-ups have struggled to convince AM Best that their management teams have a strong enough track record to pull off their business plans. The higher asset risk is also a problem, since the rating agencies are reluctant to give credit to hedge fund managers' claims of superior portfolio management.
For example, Fitch Ratings said it "looks more at performance under downside scenarios, or tail risks. We tend to look at the nature of the underlying investment positions, which often include use of leverage or short sales."
"I don't think the rating agencies have an issue per se with taking more investment risk," said James Vickers, chairman of Willis Re International. "The problem is when you put it into the agency's [economic capital] model it takes a lot of capital, so you have less capital for underwriting."
Among the pioneers of this model is Greenlight Re and there were some successful launches last year, such as Watford Re. But others have failed to get off the ground, such as Golub Capital Re and Pine River Re, after failing to obtain the required rating. Both of these firms had top quality management teams, Vickers noted.
Can future start-ups do a better job of convincing the rating agencies? "There will be more of them. It will just be a higher hurdle," said Aon Benfield's Ehrhart.
Vickers said it will not be easy, as agencies are unlikely to budge from the capital loading they put on the investment side. Start-ups could try to develop structures to reduce volatility, but hedging may reduce the potential returns to a level where investors are no longer interested. "You get into a circular argument," he said. "And without a rating beginning with an 'A', you will not get anywhere."