The partnership-reinsurance model is simply swapping one problem for another

On Wednesday morning this week, Watford Holdings, the owner of Bermudian hedge fund reinsurer Watford Re, announced it had filed paperwork in order to pursue its long-anticipated IPO.

Watford Re was founded in March 2014 as a joint venture between Bermudian (re)insurer Arch and investment manager HPS Investment Partners (formerly Highbridge), a New York-based investment manager with $42bn of assets under management.

The company had been rumoured to be seeking a public stock listing since September 2017. Though the company has probably been waiting for the confluence of stronger results and good equity market conditions, in many ways the company and its principals have simply run out of time. With the founders warrants expiring in March 2020 and a liquidity commitment to some shareholders, it is essentially now or never.

But the announcement came at an interesting juncture for the market for two reasons, one of which conspired with almost ironic timing this week.

First, and more generally, the market has somewhat cooled on the concept of hedge fund reinsurers.

For example, from a peak of well north of book, both Greenlight and Third Point Re now trade at a discount to book value.

The decline in their valuations speaks not only to the less-than-stellar results, but also the diminished appeal of "super star" hedge fund managers, given the underperformance of the asset class versus passive investment products.

Even so, Watford does have one feature that differentiates itself significantly from the first generation of hedge fund reinsurers.

One of the challenges that Greenlight and Third Point have faced is access to business.

With capacity plentiful, cedants have numerous opportunities for higher rated and better tested counterparties, and with hedge fund results lackluster, there has proved little investment synergy to share between cedant and reinsurer.

Of course, Watford was designed precisely to counter this flaw. Rather than trying to access business in a competitive market, the firm sources the vast majority of its business from Bermudian Arch.

This, so the theory goes, solves the access to business problem. And so long as the conflicts of interest are managed and incentives are appropriately aligned, both parties can mutually benefit from the arrangement.

Watford gets access to business it wouldn’t ordinarily see - let alone write - and Arch gets to convert higher volatility risk income into more predictable and less volatile fee income.

However, this arrangement is not without its own problems. The partnership model solves the access to business issue in the short run, but in the long run it is simply swapping one problem for another.

That is, that the hedge fund reinsurer becomes entirely dependent on its carrier partner.

As I have written previously, this causes two key problems.

First, the ceding company simply has so much leverage at each contract renewal to squeeze as much economics out of the transaction as possible.

And second, the model is extremely difficult for equity investors to value. There is simply a non-trivial risk that the sole source of premiums can be taken away at the end of every contract period.

This does not lend itself well to a public equity-like investment, which discounts expected future cash flows, typically as a growing perpetuity. There is simply too much binary “option-like” risk.

Sometimes timing can be fateful.

On Wednesday evening, AmTrust and Maiden made a surprise announcement that it would be ending its reinsurance relationship entirely after more than a decade.

Now Arch is not AmTrust and Watford is not Maiden, and there are many idiosyncratic reasons why the AmTrust-Maiden relationship got to where it is today. But it still serves as an interesting case study of the problems of business dependency for single-cedant reinsurers.

Throughout its history Maiden traded at widely varying multiple ranges, including as high as 1.4x book value as recently as February 2017. Clearly, investors sometimes have short memories and are willing to look past risks so long as the results appear strong.

But, the timing for Watford could not really have been worse, and the company will likely face an uphill battle in convincing investors the business deserves a premium valuation.