January 22, 2020
Viewing Management Fees on Reinsurance Interval Funds Through the Correct Lens
The reinsurance industry’s existence presents an opportunity for investors to add an asset, through participation in its business, with “equitylike” expected returns that are uncorrelated with the risks and returns of other assets in their portfolios (stocks, bonds and other alternative investments)—there is no logical reason to believe that losses from earthquakes, hurricanes, floods and fires should generally be correlated with returns to stocks, bonds, commodities or currencies, or any factor in which you can invest (such as momentum or the carry trade). The combination of the lack of correlation and equitylike expected returns (most financial economists project U.S. equities to provide long-term, real returns in the 4 to 5 percent range) results in a more efficient portfolio, specifically one with a higher Sharpe ratio (a higher return for each unit of risk).
It’s important to understand that the equitylike expected returns associated with accepting the risks of investment in reinsurance are not a “free lunch”—they are compensation for the risk of occasional large losses. This is true of all risk assets, whether U.S. stocks, international stocks, emerging market stocks, small stocks, value stocks, high yield bonds, etc. As is the case with equities, writing insurance against extreme but rare events comes with accepting the negative skewness of returns. Because investors dislike negative skewness, they demand a large premium for accepting such risks (resulting in a high expected, but not guaranteed, return). A well-structured reinsurance fund can minimize the risk of negative skewness by diversifying across many different types of risk and across the globe.
It is also important to understand that just as when bear markets lower equity valuations, which raises future expected returns, when insurers and reinsurers incur losses (as has been the case over the past three years), they raise premiums. Thus, the highest expected return to insurers and reinsurers, as it is with equities, tends to be after catastrophic losses. Patience and disciplined rebalancing are keys to successfully harvesting the reinsurance premium over time.
Summarizing, adding exposure to reinsurance risks helps to diversify the risks of a traditional stock and fixed income portfolio. Reinsurance also offers the potential for equitylike returns but with less volatility and less downside risk than equities. My firm, Buckingham Strategic Wealth, believes the most effective method to gain exposure to the reinsurance premium is to partner with large reinsurance firms through the purchase of quota shares. In a quota share arrangement, which transfers risk from the reinsurance company to the buyer, investors receive a specified percentage of the premium of a defined book of reinsurance business (e.g., 5 percent of a reinsurer’s global natural catastrophe business) and also pay the very same percentage of the losses (5 percent in our example). Such an arrangement eliminates the risk of “cherry-picking” (the reinsurer selling off what it believes to be the worst risks). Note that while most “vanilla” quota shares are a pro-rata slice of a large book of business, there are more exotic varieties. For example, you could have a quota share of just a specific territory rather than a whole book, or even just a few contracts. This is why it’s important to understand the nature of the contracts an interval fund invests in, as you want to avoid the risk of cherry-picking by the selling reinsurer.
Quota shares also eliminate market beta risk that would be incurred if an investor owned the stocks of reinsurers. They also minimize the concentration risk associated with catastrophe (CAT) bonds (which tend to be highly concentrated in U.S. hurricane risk). It’s also important to note that part of the excess expected return is compensation for investing in an illiquid investment. Quota shares typically involve purchasing one-year contracts and thus are not like daily liquid mutual funds. In other words, the liquidity risk is not due to the limited liquidity available from the interval fund, but from the illiquidity of the investments it makes.
Reinsurance Risk Interval Funds
To access the reinsurance risk premium in a highly diversified way (both from a risk variety and geographic perspective), my firm recommends using interval funds that invest in quota shares that purchase broad spectrums of a reinsurer’s catastrophe risk (to avoid the aforementioned risk of cherry-picking). A benefit of doing so is that it provides broad diversification and accesses the reinsurance premium beta, and does not seek alpha (as most hedge funds do).
A concern, or objection, to the use of such funds is that, compared to other passive investment strategies we recommend, the expense ratios are much higher. While the expense ratio is relatively high, a reinsurance interval fund doesn’t operate like the typical stock fund we recommend. One needs to have the proper perspective to evaluate the fee.
The equity funds we recommend all buy and hold publicly traded, liquid investments. And they are passively managed, resulting in low expense ratios, though typically higher than those of similar index funds. We are willing to pay a higher fee because we believe the funds we recommend add more value through deeper exposure to factors (such as size, value, profitability, and momentum), patient trading, and fund construction rules that eliminate securities from their eligible universe that have had historically poor risk-return characteristics). In other words, we don’t just consider the expense ratio, but the value added relative to the expense ratio.
Reinsurance interval funds are a very different type of fund. They don’t invest in publicly traded, highly liquid securities. Instead, in effect, reinsurance interval funds are running a business that negotiates quota sharing agreements with other reinsurers, a more expensive alternative. Thus, the right way to think about this is that the fund is the equivalent of a private equity investment in one line of business (catastrophe risk) of a reinsurance company. With that in mind, one question for investors should be: Is this a good alternative? Another would be: What are the economics of the fund compared to that of the reinsurers themselves?
The following analysis will demonstrate why we believe that reinsurance interval funds can be a good alternative, explaining why investors are receiving value for the fee paid.
Why Reinsurance Quota Share Management Fees Make Sense
When you compare management fees for investing directly in reinsurance, they seem high compared to listed equities. That raises the question: Why would it make sense for a value-conscious investor to pay these fees to invest directly in reinsurance through quota shares?
As we discussed, reinsurance is valuable in large part because it is intuitively uncorrelated with traditional asset classes (stocks and bonds). It is a highly specialized asset class that requires a significant investment in expertise and technology (e.g., catastrophe models). There are no computers to choose which securities to select, as is the case with passively managed equity funds. Funds that specialize in reinsurance investments tend to have higher fees because each quota share arrangement is negotiated and structured with each individual reinsurer, similar to private transactions (such as those entered into by hedge funds operating in this space). In exchange for higher fees (and less liquidity), investor benefits include higher return potential and broader access to the universe of reinsurance risk (versus what is available from CAT bonds). In the past, investors who wanted this exposure had to invest with hedge funds that charged typical hedge fund fees (e.g., a 2 percent management fee plus a 15- to 20-percent performance fee, and also pass-through expenses). However, today there are interval funds that offer this type of exposure without performance fees or other pass-through expenses.
Reinsurers Also Have Expenses
While the typical management fee charged by interval funds operating today is relatively high (2 percent or higher), what many investors fail to consider is that, as discussed above, the reinsurers who are selling the quota shares also have expenses. It’s just that you don’t see the bill for those expenses in the form of a management fee. To understand this, we’ll walk through a hypothetical but realistic example, one that demonstrates that a quota share investor can actually be on the same profitability basis as the reinsurance company itself.
Suppose that the typical reinsurance company has an operating expense ratio of 30 percent to originate business. Again, those expenses include the costs of underwriters, risk models, office overhead, etc. However, because a significant portion of their expenses are fixed, the marginal cost of origination is much less than the average cost. Thus, it can be attractive for a reinsurer to grow its business even if its negotiations with an interval fund results in its not being fully reimbursed for its average costs. On the other side of the trade is the interval fund. If it can acquire the quota shares without ceding back the full 30 percent operating expense ratio, it can benefit as well because it shares in the risks in the exact same proportion as it shares in the premium. The interval fund agrees to share in the expenses at a rate that is attractive to both sides.
How much of the premium the interval fund will have to cede back to the reinsurance company will depend on such factors as the “quality” of its capital. The percentage might range from as low as about 21 percent to as high as about 30 percent. A fund that is viewed as a long-term strategic partner should be able to negotiate a lower percentage to cede back than a single transaction-oriented partner could. The interval fund structure enables the fund to position itself as a strategic provider of long-term capital. Another factor is scale. A larger player might be able to negotiate better terms. And finally, market conditions matter—the scarcer the capital, the smaller the percentage the interval fund will have to cede back to the selling reinsurer. Note that capital tends to be most scarce after periods of losses. Thus, expected returns are highest at such times. The bottom line is that the amount of the premium ceded back will depend on several factors. Thus, it’s important to perform due diligence in choosing an interval fund.
Returning to our hypothetical example, assume an interval fund has an expense ratio of 2.3 percent. Because the premiums it purchases (before consideration of the ceding amount) are equal to about 36 percent of the capital it deploys, a 2.3 percent expense ratio is the equivalent of ceding back about 6 percent (2.3/36) of the premium. If the interval fund was able to negotiate ceding back 24 percent of the premium, the total costs to the investor in the interval fund would be equal to 30 percent of the premium—putting it in the same position as the reinsurance company before it enters into the quota share arrangement. (As noted above, the amount it will have to cede back will depend on market conditions and the strength of its position as a permanent capital partner.) And the interval fund has the very same risks as the reinsurer. As you can see, in this hypothetical example, the interval fund investor is in the same position in terms of expected returns as the reinsurance company, even though the investor is paying that “high” expense ratio. In other words, whether the fund’s expense ratio is high is dependent on how much it cedes back in the negotiations with the reinsurer.
Another important point to keep in mind is that investing in quota shares and CAT bonds is the only way to isolate the uncorrelated catastrophe risks.
Reinsurance Equities Have Additional Risks
When you invest directly in the shares of reinsurers, the current market price reflects the forward-looking expectations for the industry. Today, reinsurers are typically trading above book value, which must reflect a positive outlook. On the other hand, investors in quota shares bear none of the risks related to the equity market—they are always buying shares at book value, not above. That has implications for expected returns on investment, as the price you pay matters.
Another important point is that by isolating the catastrophe risks, the interval fund avoids the other balance sheet risks typically held by most insurance and reinsurance companies in the form of their stock and bond portfolios (as well as the risks of other insurance businesses they may be in, such as life insurance, annuities, disability and auto, as well as the investment management business). These differences explain why the performance of reinsurance interval funds and that of insurers and reinsurers can be very different. For example, in 2008 the stocks of most insurers and reinsurers experienced significant losses. On the other hand, it was a good year for those who invested directly in catastrophe risks because there were no major earthquakes or any major hurricane landings that year. The reverse can also be true, as has been the case in recent years. This illustrates the uncorrelated nature of investing directly in catastrophe risks.
The bottom line is that the cost of investing in a reinsurance interval fund should be viewed in terms of the expected return on investment and whether one is being compensated for taking the risks. The expense ratio is not the only thing one should consider.
Reinsurers are willing to cede business to reinsurance interval funds because their marginal costs are lower than their average costs. The extra capacity gained by ceding premium to investors allows reinsurers to underwrite more protection for their insurance company clients without straining their capital. That leads to increased profits and a higher return on equity. In return, interval fund investors in quota shares get access to an aligned, diversified pool of risk that has equitylike expected returns.
There’s a cliché about individuals who know the price of everything and the value of nothing. That applies to investors who focus solely on the expense ratio to judge the worthiness of an investment. The right way to think about the expense ratio is whether the return expected after all costs compensates the investor for the risks taken, and how the addition of that investment impacts the overall risk and return of the portfolio. It’s also important to carefully look “under the hood” of an interval fund to determine if fair value is being received.
I hope the example demonstrates that, when viewed through the proper lens, investors are receiving good value for their investment in a reinsurance interval fund. It’s why my firm recommends considering investing in them. The equitylike expected returns are compensation for the risks of occasional large losses as well as the illiquidity created by the interval structure, which limits the maximum liquidity the fund must provide to 5 percent per quarter and 20 percent per year.
The same logic regarding how to think about expenses applies to interval funds that invest in consumer, student and business loans. While interval fund fees may seem high, here too one cannot purchase publicly available liquid investments in such loans. Thus, an investment in such a fund should be viewed as an investment in a private equity fund running a bank. And banks, of course, have expense ratios. Thus, one should consider the expected return, net of expenses, not just the expense ratio.
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The opinions expressed by featured authors are their own and may not accurately reflect those of Buckingham Strategic Wealth®. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
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