Wednesday, October 29, 2008

Why Reinsurers Should Be Boring

There is nothing conceptually wrong with reinsurance. And there is nothing conceptually wrong with aggressive investment management, provided the pursuer is willing to take their lumps like a man, and doesn't need the capital for anything so pedestrian as paying claims, or providing one's family with sustenance on a proverbially rainy day. But just as aggressive investment managers might be ill-advised to play around and get too cute with reinsurance (lest they hubristically overlook the obvious or fine print), so too might reinsurers be better served by eschewing aggressive investment management. "Too clever by half" goes the old saw, the most recent casualty which is GreenlightRe, though XL, Max Re, and even primary insurer Aetna all have been left with egg on their respective corporate facades.

Pity David Einhorn (corrected - tnx Theodore)! He wasn't the first onshore investor stretching the limits of risk-transfer by employing smoke-and-mirrors in order to try to save a few tax dollars to [hopefullly] allow investors to roll-up their (and his) investment gains offshore - in the process self-servingly securing locked-in capital for his hedge fund. And Pity David (oops again - tnx GN) Einhorn's insurance investors! Many of whom paid above book and subsequently ate double-expenses just to access the fabled wunder-trader, only to discover that what they thought was bona-fide alpha was in fact little different and just a fallible as a fake Rolex bought curbside.

MaxRe, ill-fated tax-dodge of Moore Capital scion Louis Bacon (the III or is the IV???!)too has never failed "to miss an opportunity to miss an opportunity". Or said another way for the sake of clarity, there is no pothole they've failed to hit - whether in underwriting, investment management, or regulatory. Perhaps this is kharmic payback for one's inherent intentions, scupppered much as Commodities Corp/Orix's Stockton Re was. The chart right shows Max Capitals relative performance against a "real" reinsurer, AXS. And as for XL Capital - now less than ten cents on the dollar - one seriously must ask the question whether or not their eyes were ever on the ball, or whether they had eyes at all, so spectacularly poor was their sub-prime market-timing, investment allocation (to Credit and hedge funds), and insurance risk-management.

Yes, I think the message is that there is something to be said for business focus. "Core competency" or sticking to one's knitting. Boring, steady focus, and plodding progress. For a wise man once told me: "Don't break the law, when you're breaking the law...". I've thought about this pearl many times, in many different situations. And I think the same advice might be taken on board by those tempting the underwriters OR the risk-investors fate...


Anonymous said...

how's life cassandra?

i think you meant david einhorn, i wasn't too sure, who steve was.

i see your point, but having permanent or quasi-permanent capital is a huge advantage in times like these. it's certainly very tempting to be able to wait things out vs. forced redemption-driven liquidations.

the options seem to be:
1) stacking or building a predictable business with negative working capital that provides cash to invest (BRK's early approach)
2) having a lot of your own money to manage either through entrepreneurship &/or inheritance (the Chandler brothers approach)
3) starting a reinsurer or an insurance company (in the most extreme case, Peter Kellogg's scheme)

your emphasis on having a core competency is certainly true, but i've concluded in the past six months that i enjoy balance, and part of that comes from having two sources of income/wealth: investing which is lumpy, but fun, and a business that provides predictability for those rainy days.

how do you find balance cassandra?

A said...

Hi Cassandra

Cool blog. Have not come across this reinsurance story anywhere else. So these hedge fund managers set up reinsurance companies as separate investment management vehicles ? How is this capital locked in? Appreciate your thoughts.

"Cassandra" said...

Theodore - The question perhaps is "who" if anyone deserves permanent speculative capital? A permanent job is also a bonus, but no one should expect such in the event of abysmal performance. Scornful of Mr Buffet as the Niederhoffer gang is, he has earned such right, and continues to be an example. He, Mr Soros, and the likes did it the old fashioned way, start small, and build it. Few post-TMT pedigreed wunderkinders who launched with billions can say the same (e.g. Jon Wood).

"A" - The original idea was taken from captives where a firm (UPS here was one of the originators) would effectively insure themselves and get the benefit of the tax-free roll-up on everything ferreted offshore. In their example, the true cost of insurance (call it x cents per package) was billed by their offshore captive co. OPL, at X * 100% (or more), an onshore expense (saving tax) into the insurance co which could compound untaxed profits and then brought back at will to smooth earnings etc.

The MaxRe idea was to capitalize an offshore reinsurer, (watching CFC thresholds) that would invest in hedge funds (primarily Moore), while paying lip-service to risk-transfer litmus tests by pursuing "low-risk" finite ART deals (smoke and mirrors). Like Stockton, these deals ended up being riskier than perceived, while the Moore exposure was more concentrated than palatable, causing them - out of necessity - to accept more risk, and diversify their investment portfolio, the result which can be seen in the relative value chart in the post.

Greenlight Re proposed something similar, though more as a way for Einhorn to "lock-in" capital through the investment management contract with the offshore reinsurer. This was less of a tax-dodge for Mr Einhorn than a way to grant investors much-coveted access to Greenlight in exchange for a more or less permanent committment. One could exit of course by selling their Greenlight Re shares, but there would be no relationship to NAV or recoupment of premiums paid for GLRE shares.

So, kudos to Mr Einhorn for executing the scheme, but sad for the GLRE investors who probably learned some valuable lessons in the process.

A said...

Thanks for the explanation Cassandra.

I moved from real money into the hedge fund industry 5 years ago. There are agency problems on both sides of the fence but surely the investor has the right to expect better performance from a pool of professionals charging 2/20? The more I observe and learn, the more repulsed I am.

Anonymous said...

I agree Cassandra. We are seeing the cleansing now.

My point with the 3 examples was that in all of those cases they earned their permanent capital independently - it wasn't institutional money being thrown at them, so there are no shortcuts.

How did you get started in this business?

Anonymous said...

Steve Einhorn or David Einhorn, there is a big difference? I think it is not David Einhorn.

"Cassandra" said...

Theodore..."The old fashioned way", of sorts, cutting my teeth with knowledgable people, then building on behalf of large investors, and then partnering with quality long-term investors.

Anonymous, it is of course David