Hedge fund reinsurers need to bridge the gap between the risk cultures of hedge funds and reinsurers, if they are to remain viable in the long-term.

That is the view of analysts from Standard and Poor’s Global Ratings, who note that HFRs have managed no underwriting profit over the past three years, while their investment returns have failed to live up to expectations.

A report entitled Hedge Fund Reinsurers: Dead or Alive? concludes that while HFRs have increased their market share, traditional reinsurers will continue to dominate.

“Over the past few years, the HFRs have grown their top line aggressively in a soft reinsurance market, which is a never a good recipe for success,” the report, authored by Taoufik Gharib, states.

“As a result, the HFR industry has yet to generate an underwriting profit and continues to underperform the traditional Bermudian reinsurers.

“In addition, the ‘alpha’ generating hedge fund strategies weren’t too kind either, as investment returns were subpar in 2015 and the trend continued into first-quarter 2016.

“As market headwinds continue to blow strongly, reinsurance pricing continues to decline across the board, and subdued investment returns fail to compensate for underwriting losses, we might start to see bigger cracks in certain HFR models.”

S&P noted that several newcomers entered the HFR space in 2015, notably Fidelis, ABR Re, and Aligned Re. Harrington Re, a start-up backed by Bermudian insurer Axis Capital Holdings and investment giant Blackstone, joined the group this year and announced this week it had raised $600 million in capital.

Meanwhile, AQR Re and PacRe have closed down, while earlier this year XL Group dropped its plan to launch its own HFR, Alloy Re, with alternative fund manager Oaktree.

“Much like chefs perfecting a recipe or software developers improving each new release, HFRs are learning from other’s earlier mistakes while seeking to perfect their business models,” the report states. “For instance, some of the latest entrants to the field are more involved in their investment strategies than are their older brethren.”

S&P added that HFRs have chalked up a lot of new underwriting business, with gross premiums written for the group rising 40 per cent to $1.93 billion in 2015, compared to 8 per cent growth to $49.15 billion for Bermuda’s traditional reinsurers.

HFRs accounted for 4 per cent of Bermudian premiums last year, up from 2 per cent in 2013.

Traditional reinsurers had comfortably outperformed HFRs on underwriting profitability over the past three years, S&P added. Last year, the traditional group’s combined ratio — the proportion of premium dollars spent on claims and expenses — was 86.7 per cent compared to the HFRs’ 110.2 per cent, an outperformance of 22 points. In 2013, the outperformance was 15 points and in 2014, it was 19 points.

The HFRs generally take greater risks on investments than traditional reinsurers as they seek greater returns. After two years of robust growth, “like poor Icarus who flew too close to the sun, HFRs saw their net investment income plummet 63 per cent year-over-year to $247 million in 2015”, the report states.

S&P added: “The theory is that the higher returns from non-traditional investment strategies should offset the reduced profitability (or lack of profitability thus far) from underwriting.

“However, we believe this thinking can be flawed and may not hold up in a risk-based analysis.”

S&P said the crossover between hedge funds and reinsurance offered compelling possibilities.

The rating agency added that HFRs’ “long-term viability depends on whether combining hedge funds and reinsurers can create diversification benefits beyond what occurs in these organisations independently, thus creating a more capital-efficient vehicle.

“We believe it’s possible. However, bridging the gap between reinsurer and hedge fund risk cultures and implementing prudent risk controls will be necessary to realise these benefits.”