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Reinsurance: the perfect hedge fund strategy to enhance a portfolio’s Sharpe ratio?

Reinsurance: the perfect hedge fund strategy to enhance a portfolio’s Sharpe ratio? By Donald A. Steinbrugge, CFA

Reinsurance is one of the few hedge fund strategies that has almost no correlation to the stock or bond markets and has the potential to generate high single digit to low double digit returns on average over the next 5 to 10 years, regardless of the direction of the capital markets. It is important for investors to stress test their overall portfolio for major market selloffs, because most hedge fund strategies’ correlations to the capital markets are dynamic and rise dramatically during market selloffs as we saw in the 4th quarter of 2008. Reinsurance funds provided valuable diversifications benefits during that period. This brings us to the question: what is reinsurance and how should an investor evaluate managers in this strategy?

What is reinsurance? It is important to differentiate between the asset class and the legal structure of reinsurance. This paper will be focusing on the asset class of reinsurance and not the legal structure. A number of Hedge Funds have created a reinsurance structure for their hedge fund strategy, creating a more tax efficient fund for their investment strategy. The current tax benefits are that taxes are deferred as long as they stay in the fund and gains are primarily long term capital gains. The objective is to generate returns from their core strategy, and have as little risk exposure to insurance as possible, but still keep the tax benefits. These are not the type of investments we are referring to in this paper.

The best way to understand the asset class of reinsurance is to compare it to structured credit. Lending institutions can either hold various loans they have made on their books, such as residential and commercial mortgages, credit card receivables or bank loans, or they can sell the loans to other institutions and keep a small transaction fee for sourcing the deal. Insurance companies can do the same thing with insurance policies they underwrite. The insurance market is made up of 2 major risks which include life with approximately $2.5 billion annual premium per year and non-life $1.8 billion premium based on a Swiss Re/Sigma Global 2012 report. Non-life can further be divided into casualty and property. This paper will focus on the property reinsurance market.

When a bank sells their loans to a third party, often the interest and principal payments are broken out into various structured credit tranches, where a purchaser can elect to only purchase the specific cash flows that meet their needs. This carving up of a security concept is similar to how insurance companies carve up a basket of insurance policies. Reinsurers can elect which liabilities on which they would like to bid. For example, they might bid on a bundle of earth quake policies heavily weighted to Southern CA, where they would only be responsible for the liability after a certain dollar amount was paid out first. They could also size the risk to less than 3% of their portfolio.

How do reinsurance firms build out a portfolio? A reinsurance fund is heavily regulated and is limited to how much insurance risk they can assume based on the assets of the fund. Most of these property risk policies have relatively short lives of 1 year or less, but can range up to 2 years. The objective of any good reinsurance fund is to maximize the risk adjusted returns for their investors by...