A conversation with the head of Validus Group's fund management business.
Validus was established in 2005 during the recapitalisation of the reinsurance industry that followed Hurricane Katrina. It has enjoyed considerable success in building a platform that caters to its equity shareholders as well as third party capital. Lixin Zeng has been with Validus since its inception and has been the CEO of AlphaCat since 2011.
Why did Validus decide to establish AlphaCat?
From day one, Validus has recognised the benefits of running third party capital. Even before AlphaCat was established we ran a sidecar for a private equity fund partner. Validus benefits from both the fee income and the strategic value of ILS. Third-party investors and Validus often have complementary risk appetites. By combining first and third party capacities, Validus offers more comprehensive solutions to reinsurance buyers.
How do investors view the choice of allocating money to an independent fund versus a fund associated with a reinsurer?
Investors with in-depth knowledge of the business understand that, to succeed in catastrophe reinsurance, a reinsurer/manager must possess two key competences:
First, it is important to have access to as much of the market as possible. In this regard, funds affiliated with major reinsurers have a clear sourcing advantage relative to standalone funds. For example, Validus and AlphaCat see close to 90% of the property catastrophe reinsurance market through reinsurance brokers.
Having superior analytical and risk selection capabilities is another key competence. Reinsurers have typically invested more heavily in this area than standalone funds, giving reinsurer-affiliated funds another advantage. Again, using AlphaCat as an example, we have access to unparalleled analytical resources from Validus Research Inc., when we are compared to not only standalone funds but also most other reinsurers.
Conflict of interests is another frequently mentioned consideration when investors decide whether to invest with a reinsurer-affiliated fund. We believe it is extremely important to have a corporate structure and policies in place such that the interests of AlphaCat investors, Validus Re, and AlphaCat Managers are aligned. We manage this through organizational independence, financial incentives, and policies/procedures.
How important are expenses for investors?
Investment returns are uncertain by definition, but expenses are certain; so controlling expenses is a high priority for investors. But investors also appreciate that certain resources and expertise can potentially generate superior returns. Meaningful investments are required to build such expertise. Based on our experience, investors tend to view the fee in the context of such expertise possessed by the manager. For investors highly sensitive to fees and expenses, we believe low cost, beta strategies are most appropriate.
What new types of risk could represent growth opportunities for AlphaCat?
We call ourselves AlphaCat because we believe in our ability to create Alpha in catastrophe reinsurance, where we have demonstrable expertise and resources substantially superior to that of the market average. We still consider the $300+bn property catastrophe reinsurance market our near-term growth area.
Furthermore, with the growth of the property insurance businesses of our sister Validus companies – Talbot Underwriting at Lloyd's and Western World in the US – we expect a broadening of our source of risk in the long term. Regardless of the source of risk, we expect to continue to focus on natural catastrophes, where we are a clear leader in resources and expertise.
How important are the returns in other asset classes to your investors?
Investor seeks to optimise their portfolios. The allocation to an asset class depends on its relative return and correlation with respect to other asset classes. So when the risk premiums of other asset classes go up then investors demand a higher risk premium for ILS or reduce their exposure to ILS, and vice versa.
What is your 18-month outlook for reinsurance if there are no major losses?
Following the logic above, in the absence of major catastrophe events, reinsurance pricing should be driven by the risk premiums available in other asset classes. Based on our analysis, the unlevered return from the US property catastrophe reinsurance market today is converging to that of high-yield bonds, hinting at a slowing down, if not a reversion, of the downward trend of reinsurance pricing.
What is your 18-month outlook for reinsurance if there is a major dislocation in the market?
I believe the post-event price peak will not be as sharp as those in the past because there is a substantial amount of institutional money available to enter the catastrophe reinsurance market after an event. Those ILS funds that perform well relative to their peers will be able to replenish capital more quickly than those with average or inferior returns.
Will traditional and collateralized reinsurance products remain complementary?
We expect that traditional and collateralized reinsurance products will coexist in the foreseeable future. It is well known that ILS capital has a cost advantage, which we do not need to reiterate here. However, I would like to point to two benefits of traditional products that are highly valued by reinsurance buyers but cannot be provided by ILS-backed collateralized products. These features point toward greater collaboration in the future.
Firstly, most cedants want to use reinsurance to manage not only systemic risks but also idiosyncratic risk. ILS capacity is most effective and competitive in helping the cedants manage the systemic risks such as hurricane and earthquake, but less so for other types of risks such as aviation or terrorism which have greater capital markets correlation, longer development tails and more complicated claims settlement procedures.
Secondly, many buyers of reinsurance are concerned about loss development after collateral release. On the other hand, traditional reinsurance products offer an evergreen promise to pay, which is attractive to cedants.
In an ideal world we would have ILS capital assuming a higher proportion of the systemic risk. They could assume this risk in a very simple parametric format, increasing liquidity and transparency; this will attract more investors and further lower the cost of hedging systemic risk. The traditional re/insurance capital would benefit from this source of capital and in turn focus on managing the idiosyncratic risk and providing an evergreen promise to pay to the ultimate reinsurance buyer. For this reason I believe that both traditional and ILS capital can coexist and build on their respective strengths.
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Posted: Monday, February 9th, 2015