Storm brewing over capacity constraints on reinsurance

With major hurricanes, tropical storms and tropical depressions menacing both the northern Atlantic and Pacific oceans, asset owners might be mulling investment in reinsurance and insurance-linked securities strategies, but capacity constraints mean few managers are accepting new investors.

The capacity issue is the result of difficult investing conditions in the reinsurance markets, driven by the absence of sufficiently destructive natural disasters in recent years.

“Spreads are tight because reinsurance is a cyclical business, dependent as it is on the occurrence of major disasters. There hasn't been a major event since Hurricane Sandy hit the East Coast of the U.S. in 2012,” said Kevin Lenaghan, managing director and a senior analyst on the hedge fund research team at specialist alternative investment consultant Cliffwater LLC, Marina del Rey, Calif.

The current season could spawn a hurricane that would create the level of havoc needed to jolt the reinsurance market into action, Mr. Lenaghan said, given that 2016 is a La Nina year. La Nina winds create a more conducive environment for hurricane formation than in normal atmospheric conditions, making 2016 the most likely year since 2010 for a high hurricane spawn rate, he said.

When natural disasters are large enough to require insurers to pay out a lot of money in claims, the cycle of writing new reinsurance contracts begins, usually at higher premiums, creating investment opportunities for reinsurance money managers. But there hasn't been a large enough disaster recently — a “peak peril” in reinsurance lingo — to shake up the industry, resulting in tight spreads, lower investment returns and few alluring investment opportunities.

“Spreads definitely are tight. There aren't screaming opportunities out there,” said Greg Hagood, co-founder of Nephila Capital Ltd., a reinsurer, and managing principal of Nephila Advisors LLC, its asset management unit. Both firms are based in Hamilton, Bermuda. Mr. Hagood is based in Nashville, Tenn.

The lack of attractive investment deals has led large, established reinsurance managers such as Nephila, which manages about $10 billion for institutional investors, to close its mostly customized investment strategies to new money.

Younger, smaller reinsurance managers such as Elementum Advisors LLC, Chicago, which manages about $2.8 billion, are walking a tightrope when it comes to holding asset owners' interest.

“We are seeing rising interest in reinsurance strategies from institutional investors, but it's challenging because we are very capacity aware,” said John DeCaro, an Elementum founding principal and portfolio manager, noting that present market conditions are not conducive to investment.

Until the investment climate improves, Mr. DeCaro and his colleagues will continue to develop investor relationships, especially with U.S. investors who lag behind their European, Australian, New Zealand and Canadian counterparts in adding reinsurance and ILS allocations to their portfolios.

Tight market conditions for reinsurance managers require “a fine balance from managers when it comes to capacity,” said Todor Todorov, senior investment consultant and an ILS specialist based in the New York office of Willis Towers Watson PLC.

“To compete for the best deals, you must have capital to invest, but you have to be able to invest that capital if you raise it. It's not an easy situation for many managers,” he added.

The lack of investment opportunities and stagnant insurance premium rates also has lowered returns for ILS and reinsurance strategies. “I think when investors compare long-term returns to current returns, it's obvious that insurance premiums have drifted down over the last couple of years because there haven't been major disasters,” said Robert Howie, a principal and Mercer Investments' lead ILS researcher, based in the firm's London office.

“Regardless of where you are on the risk spectrum, returns have progressively come down in the past several years in a somewhat consistent fashion,” said Norman Kilarjian, head of macro and quantitative strategies at hedge fund consultant Aksia LLC, New York, in an e-mail.

Mr. Kilarjian estimated that overall annual returns for reinsurance are about 50% of what they were five or six years ago, with the riskiest strategies, for example, returning about 10% now compared with 20% six years ago. Similarly, a lower-risk catastrophe bond portfolio that previously returned 7% to 8% now would be expected to return 3% to 5%, Mr. Kilarjian said.

Sources generally agree with Mr. Kilarjian's annual return ranges, with the consensus as: cat bond portfolio (passively managed), 3% to 4%; combination reinsurance-cat bond portfolio (actively managed), 5% to 6%; and pure reinsurance portfolio (actively managed), 7% to 8%.

Capacity and lower returns notwithstanding, reinsurance managers reported a recent uptick of interest in reinsurance, ILS and a combination strategy, especially from U.S. asset owners.

Nephila Advisors, for example, opened its closed reinsurance strategies for a total of $750 million earlier this year, and quickly found willing investors, said Mr. Hagood.

Pensions & Investments' reports show some funds have invested in reinsurance this year, including:

c Indiana Public Retirement System, with $29.7 billion in assets, in June invested $40 million in a catastrophe risk strategy managed by Aeolus Capital Management Ltd.;

c Arkansas Teacher Retirement System, with $14.4 billion under management, in April invested $50 million with Nephila and added $37 million to Aeolus, bringing the Aeolus total to $147 million; and

c The $45.5 billion Maryland State Retirement and Pension System invested $100 million in a Nephila strategy in October.

One reason for the rise in interest stems from a search for positive returns not correlated to the market beta produced by traditional equities and bonds, and reinsurance strategies provide that, consultants said.

“We find reinsurance and ILS strategies to be an important portfolio diversifier because the returns are completely uncorrelated to other asset classes and the portfolio risks are fundamentally different,' said Willis Towers Watson's Mr. Todorov, adding that there's been a “significant uptick” in investment by the firm's consulting clients.

“Reinsurance adds a huge amount of portfolio diversification because the returns are genuinely uncorrelated” because they are the result of natural and human-caused devastation rather than market processes, Mr. Todorov added.

The Pennsylvania Public School Employees' Retirement System, Harrisburg, invested a total of $465 million in three reinsurance strategies that fully met plan officials' return and portfolio diversification expectations, said James H. Grossman Jr., chief investment officer.

The $49.8 billion plan's first investment was with Nephila Capital in 2011 and later investments were in 2012 with Aeolus and early 2016 with RenaissanceRe Holdings Ltd.

By way of fulfilling their role in the PennPSERS portfolio, reinsurance investments have produced annualized aggregate returns since inception of 10.8%. And Mr. Grossman confirmed that reinsurance has been “a very good diversifier for the portfolio” because returns are linked to weather and geographical events such as earthquakes rather than stock and bond market movements.

One reason for keeping the size of reinsurance investments lower is to have ready assets on hand after a catastrophe occurs when chances for return spikes are best.

“Existing investors will get the first calls from reinsurance managers post-disaster because timing is crucial. The manager will issue a 10-day capital call,” Mr. Grossman said, stressing returns are dependent on how much money flows back into reinsurance pools after they are drained when insurers have to pay claims.