A conversation with the head of Lancashire’s third party capital group
The rapid structural changes in the reinsurance market have left many ‘traditional’ reinsurers struggling to adapt. At the end of 2013, Lancashire, a leading insurance/reinsurance group, consolidated its third-party management strategies as Kinesis Capital Management. Since then, Kinesis has enjoyed considerable success raising and deploying capital for its investors.
InsuranceLinked spoke to Darren Redhead, Kinesis’s CEO, about where he sees the opportunity, the importance of capital management in the current environment and how quickly new money will be deployed in the aftermath of a major dislocation.
Tell me a bit about why Kinesis was set up...
Lancashire have had a number of sidecars since 2005 with different structures. One was for energy, one was for worldwide retro and one was multi-class. My role was to come in, rationalise those and work out what we could do... and that was really the birth of the Kinesis brand.
What we decided to do is form our own entity, Kinesis Capital Management, which is majority owned by Lancashire Group. We've created an investor club, which is a nice marriage of pension funds, hedge funds and private equity funds, and we do a twice a year capital raise on the 1st January and 1st June, and at other times when there is an attractive reinsurance market opportunity.
What makes it different from the other insurance-linked funds out there?
What makes Lancashire different as a company is the lines of business it writes. It writes property reinsurance, along with most people, but it also writes significant amounts of terrorism, aviation, war, marine & energy: specialty lines that are potentially very profitable. And it writes them on an insurance basis and has a proven and very successful track record.
So what we set about doing with Kinesis was selling products to insurers and reinsurers by packaging up exposures together, different perils or single risks. We try and create alpha through our multi-class approach to try and give our clients more value for money by packaging the exposures up that the traditional market wants to sell individually.
The traditional market – what I call the “promise to pay market” – doesn't collateralise its risks dollar for dollar. They want to try and sell you their dollar of capital as many times over. I say to my clients: “do you really need six limits of cover at certain parts in you reinsurance structure? I'll put them together, only sell you one limit, so you haven't got the same depth of coverage but you'll make savings by bundling them all together”. We can do this because we have the expertise as Lancashire Group in these specialty lines, and investors like our track record.
So this approach is appealing to investors?
There will continue to be investors who want to pure play on wind or quake, but we're seeing some of the more sophisticated investors and they want diversification. It tends to be the private equity funds, hedge funds and some pension funds that we appeal to and they see the value we add in selling a different product. Rather than going with property cat and with the crowd, especially on the current cycle, we're trying to do something different.
In the past, other Lancashire vehicles have returned money that it hasn’t used to investors. What will Kinesis do with excess capital?
If the opportunity isn't there we would give the money back. We would not hold on to it. It's something I'm passionate about. It's not our job to hold onto the money, charge fees on it and dilute our own returns.
If you look at a number of insurance-linked funds at the moment, the loss free return for last year was, say, 20%, but most of the money is returning just under 15%. One of the main reasons for that is they didn't fully deploy all the money.
If we can't find a place to deploy the money we give it back - that's within our structure. We raise money twice a year and if we can't find anything to do with it we give it back to the investor.
It's not within our job to hold onto it because you're almost forced then to invest it just anywhere. You see some of these funds investing 20% in industry loss warranties. Well everyone acknowledges that ILWs are at their lowest pricing ever, so why would you invest in them?
Why have so many other reinsurers struggled to create asset managers?
There's not been a clear focus. There are a lot of conflicts and we try and manage those by having a completely separate division and underwriting team, but leveraging the Lancashire internal back-up accounts, modelling etc. Some people just try and plagiarise their own existing account and that's really defeating the object.
We've got our own collateralised vehicle and it's got its own separate identity and even markets its own products. For us that's probably been the most successful thing, to make sure there are clear demarcation lines.
The consensus seems to be that third-party capital is here to stay in the reinsurance business and many traditional players have adapted. How about those reinsurers that haven't yet dipped a toe in?
The ones who sit there on the sidelines will struggle. It's definitely had an effect on the market in that it's taken away people's property cat revenue. Property cat is approximately 15% of industry premiums, but it's at least two times that in profits. And as that business has been eroded through rates, some are looking to other lines that they aren't necessarily experts in, which has caused a general softening everywhere.
You've got to have a strategy to deal with the new money coming in, both in terms of how you run your business and how you access the capital when you need it.
How big could third-party capital get?
One broker says $100 billion. I don't think it gets to $100 billion without losses. I think you'll hit a glass ceiling of $60-$70 billion. With losses you could easily get to $100 billion. Does it get into direct property/casualty? Not impossible but unlikely in the immediate future.
At the moment cat bonds are going through a period of growth because they are so competitive and the money is readily available, in my view cat bonds will grow over the next 12 months. Collateralised reinsurance will be more muted. The traditional market has seen the threat is fighting back against the collateralised market and saying, 'look we can sell things that they can't with reinstatements, multiyear limits etc'.
At the end of the day we're all reinsurance underwriters. We just have a different capital base and our cost of capital is different to a traditional reinsurer. Over time we will coexist and it will be a natural evolution.
What is your 18-month outlook for reinsurance if there are no major losses?
I think reserve releases are going to dry up and you're going to see a lot of capital management. People should be giving back capital to investors, but they won't. Their returns will be diluted through results and having too much capital. It is going to be a difficult 12-18 months without any losses for everyone.
The biggest difference I've seen in the last 30 years is when I started work the top price for a risk might have been $1 and the bottom price might have been 20 cents. There was a massive differential in what underwriters charged for risk and now there isn't. Most people's pricing is within 10% to 20%.
What differentiates companies is capital management, the lines of business they write and how they manage that exposure. So the challenge for people is how they look after their capital base over the next 12-18 months, whether they hand it back to the investors, whether they go and try to buy someone else.
If there are no losses people will have to decide what to do with the surplus capital. I would love to work out how much surplus capital the industry is holding... it's at least $100 billion.
What is your 18-month outlook for reinsurance if there is a major dislocation and how big does that loss, or series of losses, have to be?
You saw over $100 billion of insured losses in 2010 and 2011 and that didn't last long. It depends how much of it finds its way into the traditional arena. If it's a loss or losses in Europe or the US - especially Florida - most of that will find its way in. Florida hasn't had anything for a decade, so the clock is ticking. To move the dial you've got to be north of $100 billion of losses.
What happens? I think most of the money comes into the collateralised space and comes in very quickly and is deployed very quickly and might even be deployed quicker than in the traditional market.
If it's big enough you've wounded a lot of traditional players. You saw it happen after Katrina and 9/11. They tend to sit on their hands, lick their wounds and see what's happening. But this time third-party money will come in quicker than traditional. If there is market dislocation Kinesis will be ready within a week with additional capacity.
Third-party capital is here to stay and there is just under $50 billion in the space now, say $20 billion in cat bonds and $30 billion in collateralised reinsurance. Come a big market dislocation some of that won't come back, but there's probably two to three times as much waiting to come in.
Rather than the start ups that you saw in the Class of 2001 and 2005 - even back to 1992 - you probably won't see that anymore. You'll see the third-party vehicles get much bigger and deploy the cash that way.
About Darren Redhead
Darren Redhead has had a rich and varied career over 30 years within the re/insurance industry. Starting out within the Lloyd's market he issued the first multi-class private note in 1994. In 2001 he helped form Talbot, where he was responsible for capital raising and underwriting. In 2007, following the acquisition of Talbot by Bermuda Class of 2005 reinsurer Validus, he left to become chief underwriting officer of hedge fund-backed DE Shaw Re Bermuda, where he developed products for the collateralised reinsurance market. In March 2013 Redhead joined Kinesis Capital Management where he now serves as chief executive officer.
Posted: Monday, May 19th, 2014