JP Morgan Prime Brokerage Perspectives 4Q 2013

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Prime Brokerage Perspectives Lasting Foundations: Hedge Fund Reinsurance Structures and Permanent Capital Fourth Quarter 2013

In this edition of Prime Brokerage Perspectives, we examine property and casualty reinsurance structures as permanent capital solutions for hedge fund managers seeking to build lasting fund management platforms with diversified investor bases and multiple revenue streams.

Introduction

The traditional hedge fund model has changed relatively little over the years. The basics of the structure are well known: a flow-through vehicle, be it a limited partnership or a limited liability company, which allows for rolling subscriptions and typically provides investors with the ability to redeem capital at regular intervals, most typically on a quarterly basis subsequent to an initial lock-up and subject to certain notice requirements. As the hedge fund industry has matured and evolved over the years, managers have looked to different structural options in order to raise and retain assets, often with the underlying goal of seeking longer-term capital. Leading up to and during the financial crisis, many managers employed private equity-like side pockets or special purpose vehicles (SPVs) as longer-duration mechanisms to invest in illiquid securities. Those structures created difficulties when the financial crisis struck and numerous hedge fund managers found it challenging to satisfy redemption requests given the illiquid nature of the underlying investments. More recently, as a result of regulatory pressures and bank deleveraging, numerous credit-oriented hedge fund managers have sought to raise hybrid vehicles with longer lock-ups to exploit growing opportunities with respect to less liquid assets such as commercial real estate loans, distressed corporate credits, second lien loans and debt instruments of companies in liquidation. Such vehicles include truncated private equity structures with drawdown features, finite subscription periods and terms, and distribution waterfall profit allocations; they also include structures that combine rolling lock-ups and rolling subscriptions with limited liquidity. Vehicles in the latter category typically have initial lock-ups ranging from 1 to 3 years during which redemptions are not permitted followed by a soft lock-up during which redemptions are allowed subject to a penalty. Subsequent to the various lock-ups, investors can redeem capital, usually on a quarterly basis.1

Another more recent trend is the growing interest among hedge fund managers in permanent capital structures – i.e., vehicles that provide a continual source of capital and therefore obviate the prospect of redemptions. While numerous permanent capital options are available for hedge funds, the purpose of this Perspectives piece is to examine property and casualty reinsurance structures that hedge fund managers can use to that end. This report analyzes the economics of those structures and explains the benefits and drawbacks that various hedge fund property and casualty reinsurance models present. The goal of this report is to provide hedge fund executives with an understanding of those vehicles and of whether such structures are suited to their firms and strategies.

1 J.P. Morgan, Prime Brokerage Perspectives, “The New Convergence: Hybrid Hedge Fund Structures and Longer-Biased Strategies,” February 2013.

Prime Brokerage Perspectives – 4Q 2013

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Incentives for Reinsurance Structures and Permanent Capital

Managers

Permanent capital structures, and reinsurance vehicles in particular, are potentially alluring for hedge fund managers because they offer the prospect of a significantly expanded and diversified investor base, including defined contribution plans. Reinsurance vehicles in particular may offer the benefit of tax efficiencies. As “active” businesses, income from insurance companies is tax deferred (until the position is sold) rather than taxed as ordinary income or capital gains on an annual basis. Lastly, structures that offer a continuous source of capital – be they publicly listed reinsurance vehicles or other permanent capital solutions – also eliminate the need to fundraise from limited partners, which, as hedge fund principals know all too well, is a high-touch, often expensive endeavor that is becoming increasingly challenging. By pursuing a publicly listed reinsurance vehicle, hedge fund managers essentially shift the burden of fundraising to a lead underwriter and syndicate in the IPO process. Permanent capital structures also eliminate the potential for limited partner redemptions.

Investors

Such structures also may be compelling for investors. In contrast to the traditional hedge fund model, publicly listed hedge fund reinsurance vehicles can provide investors daily liquidity. Additionally, such structures offer retail investors the ability to invest with best-in-breed alternative asset managers to which such investors ordinarily would not have access. Finally, certain permanent capital structures such as reinsurance vehicles may offer the prospect of returns that are minimally correlated to other risk assets and which can therefore be used as a means of diversification.

With these incentives in mind, we now turn to some of the key structural options along with their attendant benefits and limitations.

Figure 1: Incentives for reinsurance permanent capital vehicles

Manager Perspective Investor Perspective

Perpetual capital source Liquidity

Tax efficiencies Tax efficiencies for investors

Premium income streams + investment income streams Access to asset classes not typically available to retail investors

Access to broader class of potential investors Access to advice of prominent investment managers

Secondary market provides alternative to redemptions Potential for uncorrelated returns

Branding opportunity and elevated profile Diversification

Hedge Fund Reinsurance Vehicles

Economics & Other Key Issues

Reinsurers allow primary insurers to distribute the risks from the policies they underwrite, thereby providing insurance companies with additional capacity to write more policies. In exchange for agreeing to pay a portion of the claims for which an insurer may be liable, reinsurers are entitled to premium payments from the insurers. Reinsurers may become liable on the underlying claims if the originating insurance company either defaults or cannot satisfy its obligations.


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Reinsurance Agreements

Reinsurance contracts can be structured on a percentage basis whereby the reinsurer agrees to pay a percentage of the underlying claim in return for a percentage of the premium. Alternatively, they can be structured based on a loss threshold whereby the reinsurer agrees to pay the share of a claim above a pre-determined amount.

Additionally, reinsurance contracts can be structured on a treaty basis whereby multiple reinsurers share the risk pro rata or according to varying percentages. Reinsurance agreements can also be written on a facultative, i.e., a risk-by-risk, basis.

Revenue Streams

Reinsurance offers two prospective revenue streams: underwriting returns and investment returns. With respect to underwriting returns, reinsurance firms collect premiums from the originating insurers in exchange for sharing the risks from the underlying policies. Reinsurance firms can generate investment returns based on the concept of float. Reinsurers receive premium payments during the life of the underlying policy but are not required to pay out on the related claims until a later date. The premium payments therefore provide reinsurers with a significant time-value-of-money benefit because those premiums can be invested at a potentially high rate of return over time. Because of the considerable lag between the receipt of premium streams and the payout on the underlying claims, the premiums provide reinsurers with investable capital at virtually no cost since that capital does not require interest payments. Hence, the concept of float, which is akin to leverage albeit with no interest payments. (Many conventional reinsurance firms have traditionally invested premium streams in highly liquid, conservative, low-yielding instruments.) Reinsurance therefore offers hedge funds the prospect of management fees and incentive fees based on capital that is essentially free and for which traditional fundraising efforts are not required.

Several hedge fund reinsurance vehicles have come to market in recent years, both as publicly listed and private entities. Such vehicles include Paulson & Co Inc.’s PaCRe Ltd. (“PaCRe”), which is 10% owned by Validus Reinsurance Ltd., Greenlight Capital Re Ltd. (“Greenlight Re”) and, more recently, Third Point Reinsurance Ltd. (“Third Point Re”). Although these entities have several structural distinctions (discussed in greater detail below), it is typical for the reinsurance vehicles themselves to be structured as corporations rather than as flow-through vehicles such as limited liability companies. It also is common to use a holding company with a fund structure such as a master-feeder as the owner. Alternatively, the reinsurance company may be owned by the investment management entity with the master or feeder fund set up as an investor in the company.


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Figure 2: Overview of publicly listed alternative reinsurers

Greenlight Re Third Point Re

• Established in 2004, Greenlight Re (NASDAQ: GLRE) is a specialist property and casualty reinsurance company based in the Cayman Islands

• Initial capitalization of $300 million • Current market capitalization of $1.2 billion • Greenlight Re writes a combination of global property,

casualty and specialty reinsurance distributed primarily through the broker market. The company writes worldwide with concentration of cedants in the U.S., U.K. and Europe

• Rated “A” by A.M. Best

• Established in 2011 as a private entity, Third Point Re is a property and casualty reinsurer domiciled in Bermuda, which went public in August 2013

• Initial capitalization of $750 million • Current market capitalization of $1.7 billion • Third Point Re writes a combination of personal and commercial

lines, both short and medium tails, and distributes primarily through the broker market. The majority of business is generated from the U.S., but the company expects to increase its presence in Europe, Asia and South America

• Rated “A-” by A.M. Best

Sources: J.P. Morgan Financial Institutions Group, company websites, A.M. Best reports and news filings

Jurisdictional Issues

Hedge fund managers contemplating reinsurance vehicles must make a determination as to the domicile of the reinsurance company. The Cayman Islands, Ireland and Bermuda are favorable jurisdictions for reinsurance vehicles. The Cayman Islands, where Greenlight Re is domiciled, and Ireland offer beneficial tax regimes for reinsurance businesses. Both jurisdictions also offer a broad array of experienced service providers.

Bermuda is nonetheless the jurisdiction to which most hedge funds have looked to launch reinsurance vehicles. Bermuda is particularly attractive for reinsurance companies for several reasons. First, from a purely commercial perspective, Bermuda has evolved into an epicenter for the industry. Accordingly, firms that are based in Bermuda will tend to have access to the most deal flow. Bermuda is also a hub for much of the top talent in the industry. Second, from a business infrastructure perspective, Bermuda has an especially deep well of service providers such as law firms, which are intimately versed in the industry’s best practices and precedent. Third, from a balance sheet perspective, Bermuda law stipulates only minimal capital requirements for reinsurance companies. Finally, Bermuda law does not impose onerous requirements as to how reinsurance companies should invest the capital they generate from premium payments. Reinsurance firms therefore have considerable flexibility in how they invest and manage premium-generated capital. Several of the existing hedge fund reinsurance vehicles are domiciled in Bermuda, including PaCRe and Third Point Re.

Structural Options

Hedge fund managers that decide to enter the reinsurance business have several models available to structure their reinsurance firms. As a threshold issue, hedge fund managers must choose between launching a new, independent reinsurance entity versus entering into a partnership or joint venture with a third-party reinsurer.

For hedge fund managers who opt to establish stand-alone reinsurance platforms, there are several permutations from which to choose. Here, however, we focus on two key models, which we refer to as “Hedge Fund Re 1.0” and “Hedge Fund Re 2.0.” A third option discussed here – “Hedge Fund Re 3.0” – entails partnering with an existing reinsurance company. There are not yet any publicly listed precedents for the 3.0 model.


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1. Hedge Fund Re 1.0

The first option, based on existing precedent, entails launching a stand-alone reinsurance company. The property and casualty reinsurance policies that the company writes are distributed primarily through a network of brokers, which are not affiliated with the company. The capital generated from the premium streams is invested exclusively by a fund run by the manager that owns the reinsurance vehicle. A fund could be formed specifically to manage the reinsurance company float. Alternatively, the float could be invested in an existing fund or a parallel vehicle pari passu with the manager’s other investors. An important feature of this option is that policies, including property and casualty as well as catastrophe risk, are written, and coverage is provided by, the reinsurance subsidiary directly. The reinsurance company is therefore exposed directly to the risk of payouts from losses on the underlying policies, including those related to catastrophe risk.

Figure 3: Stand-alone hedge fund reinsurance operating company structure

Founding investors DebtFollow-on investors

Hold Co.

Bermuda class IV reinsurer Hedge fund

(Full operating company with independent management

team)

Asset Management

Fee

Operating Company Structure

InvestmentFees

Source: J.P. Morgan Financial Institutions Group

Benefits

A key benefit of this option for hedge fund managers is that by forming a new, stand-alone reinsurance company, a manager has direct control and oversight of the underwriting operation, including the ability to cherry pick talent to run the business. Additionally, depending on the quality of the management team hired to run the reinsurer and the corresponding quality of its underwriting, this model has the potential to generate attractive returns from both underwriting, which is not correlated to other risk assets, and from investments.

Drawbacks

There are several possible disadvantages to this model. First, the reinsurance company is exposed directly to catastrophe risk on the underlying policies, which can be especially volatile. Accordingly, if the coverage being provided includes high-risk catastrophe reinsurance, the performance of the company has the potential to be somewhat volatile (although a company may limit the amount of catastrophe risk it underwrites). Prospective volatility may, in turn, exert a drag on the price-to-book multiple of the reinsurance company over time.


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Another disadvantage is the time, effort and expense of forming a new reinsurance company. It will take some time for the reinsurer to build up a book of underwritten policies, which means that the premium base will initially be limited. Concomitantly, the amount of float available for the manager to invest will be limited until the book of underwritten policies achieves scale. High overhead from the start-up costs of launching an independent reinsurer and a small initial premium base may result in an elevated expense ratio. A high expense ratio could in turn exert pressure on the company’s valuation.


The second model is similar to the first option, as it entails the formation of a stand-alone entity. Additionally, the premium income that the reinsurer generates is invested in a fund overseen by the manager that owns the reinsurer. A key structural distinction with the second model is its use of a separately capitalized “cat” fund, in which the reinsurance company is an investor, to provide higher risk property catastrophe and excess of loss coverage. As in the 1.0 model, the reinsurance company itself will still underwrite lower-risk property and casualty policies. By using a separately capitalized entity to provide higher risk property catastrophe coverage, the reinsurer can limit its exposure to losses on the underlying policies and thereby insulate its balance sheet from the associated risks. The cat fund can be structured to sit above a special purpose reinsurer that underwrites collateralized property catastrophe reinsurance contracts.

Third Point Re, which went public on August 14, 2013, is the template for the 2.0 model. Based in Bermuda, Third Point Re is a specialty property and casualty reinsurer. A distinctive feature of Third Point Re is its use of a separately capitalized cat fund, Third Point Reinsurance Opportunities Fund (the “Cat Fund”), to provide catastrophe and excess of loss reinsurance rather than doing so through the company itself. (Third Point Re still underwrites property and casualty reinsurance directly.) Third Point Re formed the Cat Fund in conjunction with Hiscox Ltd., a Bermuda-based reinsurer.2

The Cat Fund and the special purpose reinsurer are controlled by a management company (the “Cat Fund Manager”) of which Third Point Re owns 85%. Hiscox owns the remaining 15%. The Cat Fund Manager charges a management fee equal to 1% per annum of assets under management (“AUM”) for investors with a two-year lock-up and 1.5% for investors with no lock-up. It also charges an incentive fee equal to 10% of the profits for investors with the lock-up or 15% for those without it.

Third Point Re has a 53% interest in the Cat Fund, Hiscox has a 32% interest and Dan Loeb and other investors share the remainder. The Cat Fund provides catastrophe and excess of loss coverage in the U.S., Europe and Japan through catastrophe insurance and collateralized products such as cat bonds, insurance-linked securities and industry loss warrants. A special purpose catastrophe reinsurer, which the Cat Fund owns, underwrites the collateralized products.

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2 J.P. Morgan North America Equity Research, Third Point Reinsurance Ltd., September 9, 2013, available at

These fee streams have the potential to grow as AUM in the Cat Fund scales over time through commitments from outside investors.

https://jpmm.com/research/content/GPS-1205541-0. 3 Ibid.

https://jpmm.com/research/content/GPS-1205541-0�


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Figure 4: Third Point Re

Hiscox New Investors

Cat Fund

Third Point Re.

Cat Fund Manager

85% Ownership

15% Ownership

Third Point LLC Employees$50 Million Investment

$30 Million Investment

$10 Million Investment

Cat Reinsurer Individual Securities

Investment Management Agreement

Sources: J.P. Morgan Equity Research, public company filings

Benefits

The downside protection that this structure affords enables the reinsurer to offer higher risk, but potentially lucrative, catastrophe reinsurance with limited exposure to its balance sheet and therefore minimal impact on its rating. The net result may be higher profitability on the company’s underwriting returns and limited volatility for the reinsurance company’s performance.

Because many clients require catastrophe protection as part of a reinsurance package, Third Point Re’s catastrophe insurance offering enables it to target a larger pool of customers than if it did not do so. Third Point Re’s ability to provide such coverage stems directly from its use of the Cat Fund feature. Moreover, because Third Point Re provides catastrophe coverage through a separate entity, the company’s exposure to related losses is limited to its investment in the Cat Fund – approximately $50 million.4

Drawbacks

Consequently, the company’s balance sheet is shielded from catastrophe risk but Third Point Re benefits from the ability to provide such coverage.

This model shares some of the drawbacks of the first option, the most obvious of which is the time and expense associated with building out an independent reinsurance platform, including the recruitment and hiring of a team. Concomitantly, as with option 1, there will be a lag as the reinsurer builds its underwriting book, which initially will limit the premium income that the reinsurer can generate and the float that it has available to invest. Before the underwriting portfolio achieves critical mass, the reinsurer’s expense ratio may therefore be elevated.

4 Ibid.


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While options 1 and 2 are based on publicly listed precedents, option 3 is not. The key difference between this option and the preceding models is that the third structure does not entail the formation of a full-fledged, stand-alone reinsurance company. Rather, option 3 entails the hedge fund manager partnering with an established reinsurer through a joint venture so that the hedge fund essentially outsources the underwriting function to a third-party reinsurance firm. (The joint venture unit, a separate legal entity, will require the hiring of a magagement team, but primarily for purposes of administration and corporate governance.) The hedge fund will in turn contract with the reinsurer to manage an agreed-upon percentage of the float generated from the premium streams. Accordingly, the hedge fund is able to concentrate on its core competency of generating investment returns on the float.

This arrangement is symbiotic for both the third-party reinsurer and the hedge fund. The reinsurer is able to diversify its investment portfolio and, hopefully, earn attractive risk-adjusted returns with some downside protection given hedge funds’ asymmetric return profile.5

Benefits

Additionally, because the reinsurance company is providing the hedge fund with a stable capital base without the typical risk of redemptions, it may be able to negotiate favorable terms on fees.

The primary benefits of this model for the hedge fund are three-fold.

• First, the hedge fund gains access to a permanent capital source. The cost of that capital, i.e., the float, is de minimus.

• Second, the hedge fund can diversify its revenue streams by sharing in the underwriting profits at an agreed-upon percentage.

• Third, by outsourcing the actual reinsurance business, this model negates the main drawbacks of forming a ful-fledged, stand-alone entity, including time, cost and an elevated expense ratio as the reinsurer builds its underwriting portfolio. By contracting with an established reinsurance firm, the hedge fund can garner immediate access to a well-developed underwriting portfolio, which is the product of superior risk analytics and that has already achieved scale. Accordingly, there will be no lag time as the portfolio is developed.

Drawbacks

The primary disadvantage of this model is the added expense since there will be a revenue sharing arrangement with the third party reinsurer with respect to both the underwriting returns and the investment returns. However, the benefits of access to a well developed, large-scale underwriting portfolio – and the immediate availability of investable float – may outweigh that disadvantage.

5 J.P. Morgan, Prime Brokerage Perspectives, “Defined Benefit Plans and Hedge Funds: Enhancing Returns and Managing Volatility,” Second Quarter 2013.


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Figure 5: Illustrative example of option 3

Investors Debt

JV Hedge fund

Fees for underwriting on

behalf of reinsurance company JV

Third party reinsurer

Asset Management

Fee

Partnership or JV Structure

InvestmentFees

Source: J.P. Morgan Financial Institutions Group

Conclusion: Overall Benefits and Drawbacks

While the reinsurance business is potentially alluring for hedge fund firms, it also carries risks for new investment management entrants. First, and most obviously, reinsurance underwriting and coverage is far afield from the core competencies of most hedge fund executives, be they portfolio managers or chief operating officers. There is a high degree of execution risk in hiring, overseeing and retaining a team that has the experience and rolodex to do so. Second, new entrants in the industry must contend with origination risk because reinsurers provide coverage on policies underwritten by insurance firms that they do not control. It is therefore paramount that any new entrant structure its coverage to minimize the degree of origination risk whether through an outsourced model, a separately capitalized entity such as a cat fund or otherwise. Finally, there is of course payout risk on claims to the underlying insureds. While such risk can be mitigated to a degree via skilled underwriting, the risk of having to make substantial payouts cannot be minimized entirely. Because of the payout risk, reinsurance vehicles are more appropriate for hedge funds that run liquid strategies where the assets are capable of real time valuation and which can generate cash to satisfy imminent liquidity needs. By contrast, managers that oversee less liquid strategies and funds with longer lock-ups will not align well with reinsurance businesses. Reinsurance companies also must secure ratings from A.M. Best. If the premium income is not invested in liquid assets, it will be difficult to secure an A or A- rating, which any reinsurer would need. This is another reason why managers that oversee liquid strategies align well with reinsurance businesses whereas hedge funds that invest in less liquid assets do not. Another issue that prospective entrants should consider – though not a risk factor per se – is that significant capital has flowed into the reinsurance industry in recent years, partly as a result of investors straining for yield amidst today’s low rate environment. Consequently, there is significant downward pressure on premium prices. Reinsurers in today’s market are therefore price takers. Accordingly, hedge fund managers seeking to access permanent capital through reinsurance vehicles should balance such considerations against the benefits that the structures discussed herein can provide, including a long-term asset base, low cost of capital and diversified revenue streams that are less correlated. We welcome inquiries from managers interested in discussing such solutions in more detail.


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Important Information and Disclosures

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Economy & Finance

JP Morgan Prime Brokerage Perspectives 4Q 2013