Don Steinbrugge Explains Reinsurance: A Strategy That Helps Hedge Funds Remain Safe From Market Volatility

Back in January, Benzinga published a series of articles where Don Steinbrugge, one of the top experts in the hedge fund industry, shared a preview of the top trends he expects to see among hedge funds in 2017. The specialist talked about the evolution in fees, the impact of the Trump administration, money flows, shifting strategies, manager selection and many other topics.

In this occasion, Seinbrugge is back to educate us about another very interesting strategy that some hedge funds are using: reinsurance. Similar to relative value fixed income, market neutral long/short equity, commodity trading advisors (CTAs)-based, direct lending and volatility arbitrage strategies, reinsurance has a low correlation with capital markets.

RE-Insurance? What’s That?

Hedge Funds & Reinsurance

Choosing Your Kind Of Exposure

Most Benzinga readers are quite familiar with insurance companies like Allstate Corp ALL, Chubb Ltd CB, American International Group Inc AIG, Metlife Inc MET or Prudential Public Limited Company (ADR) PUK. However, many of these firms, and some others like Everest Re Group Ltd RE, Reinsurance Group of America Inc RGA and RenaissanceRe Holdings Ltd. RNR, offer a related product: reinsurance.

Javier Hasse: What is reinsurance?

Don Steinbrugge: Reinsurance is either a company or a fund that basically assumes insurance liabilities from traditional insurance companies.

Basically it is very similar to the mortgage market. Banks lend money to people to buy a house; banks can either keep those loans on their books or they can sell their loans to Wall Street and keep a transaction fee. [And], most loans are sold.

Insurance companies can do the same thing. They can hold the insurance on their books or they can basically sell it to a reinsurance company or a reinsurance fund, and they make a transaction fee for doing that.

So, often what insurance companies will do is they will sell a lot more insurance than they want to keep on their books, or they’ll have too much insurance in a specific peril or geographical area. And, in order to reduce the risk in their portfolio they will sell off part of that portfolio to a reinsurance company [that starts collecting premiums and becomes liable for the policies].

Hasse: What do hedge funds have to do with this?

Steinbrugge: The concept of reinsurance in a hedge fund structure is to build out a portfolio that is diversified by both peril and geographically.

When you have a portfolio of insurance you collect premiums, and the return of the reinsurance fund is the premiums you collect minus the claims you pay out. And, the way you reduce risk in reinsurance funds is to be broadly diversified, because, for instance, hurricanes don’t hit the entire world at once.

[Opposite to a traditional reinsurance company, some hedge funds investing in reinsurance are creating their own reinsurance companies. However, instead of putting the money in their reserves in low-yield, very-high-quality bonds that pay less than 1 percent interest], they are putting the money in their hedge fund. What they are trying to do is generate returns in their hedge fund that are tax deferred and get the tax benefit of a reinsurance company. So, on the insurance side, they are taking the least amount of risk they possibly can because they don’t want to generate their returns through the insurance. They want to generate returns through their fund.

Hasse: So, why invest in a reinsurance fund?

Steinbrugge: The reason an investor would want to invest in a reinsurance fund is because the return stream is not correlated or does not move in the same direction as the stock and bond markets. The returns are completely independent of the capital markets, and are instead based on claims versus premium collected.”

Investors usually get about 85 percent of (premiums collected – claims – management fee of about 1.5 percent).

[So, in general, the chance for a reinsurance fund to boast positive returns is quite high. However, there is a small chance that, once every 20 or 30 years, they experience a large negative return]

So, the downside volatility of the reinsurance fund would be similar to investing in the stock market, but the stock market has a lot more negative years that what you will get in a reinsurance fund.

Hasse: Who is the ideal investor for these kinds of funds?

Steinbrugge: You have to be a qualified investor. You have got to have at least $1 million in net assets or make over $200,000 a year. It would be the same requirements of any other hedge fund to allocate to a reinsurance fund.

The interesting thing about reinsurance funds is that the earnings are deferred until you take your money out of the fund. If you keep your money in the fund for more than 12 months, then all the earnings currently are taxed at the long-term capital gains rates.

The type of investors that allocate to reinsurance include pension funds, endowments, family offices, high net worth individuals. It’s all the people that would normally invest in a hedge fund that would consider reinsurance; it is just one of a lot of different hedge fund strategies that hedge fund investors look at.

Hasse: So, how does an investor decide between a reinsurance company and a reinsurance fund?

Steinbrugge: The difference between investing in a reinsurance company and investing in a reinsurance fund is that, if you invest in a fund, you are getting more of a pure return on reinsurance; if you invest in a company, part of the returns are going to be dividends, which are going to be taxed at a higher rate for U.S. investors. The second thing is that your performance is going to be driven by the profitability of the company, and by changes in the price/earnings ratio of the stock. So, your returns are going to be more correlated with the S&P 500, because if the stock market sells off what typically happens is the price/earnings ratios of stocks across the board all go down. So, investing directly in a reinsurance company will cause you have more correlated returns in the stock market than if you invest in a reinsurance fund.

[Having said this, buying insurance policies from insurers is similar to a regular equity investment]. You have to analyze what the value of the liabilities that the insurance company is offloading and whether you are able to get a good deal on it or not [...] It’s important that, when you invest in a reinsurance fund or company, you are doing it with a management team that is very experienced. And, ultimately that should show up in the performance of the fund over time.

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