Two of the three listed total return reinsurers are shifting their strategies amid generally weaker performance than their more traditional peers.

The most drastic move may be Greenlight Capital Re Ltd.'s decision to conduct a strategic review and derisk its investment portfolio. The actions come after rating agency A.M. Best changed its outlook on the A- financial strength ratings of the company's subsidiaries to negative from stable due to negative underwriting performance and a material decrease in surplus.

Third Point Reinsurance Ltd. is taking on more underwriting risk. It started writing property-catastrophe business, which it had previously eschewed, in January and brought in a new specialty underwriting team over the first and second quarters of 2019. The company expects to write between $20 million and $25 million of new specialty business in 2020.

In response to the underwriting shifts, Third Point Re is also changing its investment strategy. The company has been moving some of its investments in the Third Point Enhanced Fund to fixed-income investments managed by Third Point LLC. It made an initial $350 million redemption from the fund in May, and submitted a redemption notice for a further $400 million.

Lagging behind

Total return reinsurers aim to take more risk on the investment side of their balance sheets, giving a portion of their investment portfolios over to affiliated hedge fund managers, or in Watford Holdings Ltd.'s case high-yield debt investor HPS Investment Partners, and match this with a consistent underwriting performance. More traditional reinsurers deliberately take more underwriting risk but little investment risk, focusing their portfolios mainly on government securities and highly rated corporate bonds.

But the hedge fund reinsurers' strategy has generally produced worse returns for shareholders than the more traditional model over the past five years, S&P Global Market Intelligence data shows. The return on average equity for Greenlight Capital Re has underperformed the collective return of the SNL Global Reinsurance index for all of the past five years. Third Point Re beat traditional reinsurers only in 2017. The return on average equity of Watford Re, launched by Arch Capital Group in 2014 and listed on the Nasdaq stock exchange in 2019, underperformed the SNL Reinsurance Index in three out of the four years for which return on average equity figures are available.

Hedge fund reinsurers have been underperforming traditional reinsurers on both underwriting and investment returns. The three publicly listed hedge fund reinsurers' combined ratios have been consistently above 100% for the past five years, denoting underwriting losses. On the other hand, the world's largest reinsurers only recorded underwriting losses in 2017, which was a record year for catastrophe claims. The exception is Swiss Re AG, which reported a combined ratio of 106.6%, driven by a combination of catastrophe losses and lower releases from prior-year reserves.

Hedge fund reinsurers' investment returns have been volatile. Greenlight Capital Re made investment losses in 2015 and 2018, as did Third Point Re. Watford Re fared better, only producing investment losses in 2014. Swiss Re, Hannover Re, and Scor SE all produced positive investment returns over the past five years.

Greenlight Capital Re, Third Point Re and Watford are trading below book value, suggesting that investors still need convincing of the merits of their strategy.

The financial performance challenges continued for some in the first half of 2019. Greenlight Re reported a combined ratio of 108.3% for the half, compared with 97.3% for the same period of 2018, and total investment income fell to $51.1 million from $185.9 million.

Watford Re's combined ratio worsened to 103.8% from 100.7% in the first half, although its net investment income improved to $82.1 million from $33.4 million.

Third Point Re was showing signs of improvement across the board. Its combined ratio improved to 102.5% from 104%, and net investment income grew to $224.1 million from $29 million. Third Point Re CEO Dan Malloy said on an Aug. 8 earnings call that the company is "on track" to achieving underwriting profitability "later in the year."

Challenges ahead

There are also tax regulation challenges to come for the hedge fund reinsurers under proposed new U.S. passive foreign investment company, or PFIC, rules. If a non-U.S. investment firm is classified as a qualified insurance company, it does not have to pay tax under PFIC rules. But the new rules, if passed as proposed, will toughen qualified insurance company tests.

Hedge fund reinsurers noted in their second-quarter earnings calls that the situation was uncertain. "At this point, it is really too early to tell exactly how it'll affect the broader industry, including us, but we're certainly paying close attention to it," Malloy told analysts.

But Watford Re CEO John Rathgeber was slightly more upbeat, telling analysts on a July 30 earnings call that the regulations apply the year after they are finalized, so the industry would have advanced warning of the final rules. He also said the U.S. Department of Treasury seems open to modifying some proposals "if reasonable considerations are presented."

Rathgeber also said that Watford believes its insurance business is "actively conducted" and would expect to pass "any reasonable test that may be adopted."

The companies are also expecting to benefit from the general upward trend in insurance and reinsurance pricing. Rathgeber said one of the reasons for his confidence in Watford Re's continuing book value growth was improving conditions.

"There's a growing consensus that we've entered, if not a hard market, a seller's market," the Watford Re CEO said.