New York (HedgeCo.Net) – Fitch reports today that newly formed hedge fund reinsurers are unlikely to achieve an Insurer Financial Strength rating in the ‘A’ category under Fitch Ratings’ methodology. This is due to both general constraints applied to start-up companies, as well as potential unique asset and pricing risks tied to the hedge fund reinsurer business model. Longer term, a hedge fund reinsurer with a successful track record of balancing risks and demonstrating an established business could be rated in the ‘A’ category.

Start-up reinsurers generally have a relatively high risk profile due to the challenges of attracting new business as well as the potential operational and corporate governance issues as a company builds its track record. We often see major strategic changes as new reinsurance companies work to build a franchise or as they move from private to public ownership. This creates uncertainty that we consider inconsistent with an ‘A’ category IFS rating.

Even with a sufficient track record, hedge fund reinsurers would be less likely to achieve an ‘A’ category rating than traditional reinsurers because of their risk exposures. Most reinsurers take on very little asset risk, but hedge fund reinsurers aim to use stable premium flows to support high risk-adjusted returns on their investments and are therefore exposed to both asset and underwriting risk. This creates further risk from the potential for a hedge fund to strategically use its above-average expected investment results to price lower than competitors, resulting in the dangers of cash flow underwriting.

A big fall in asset values could deplete a hedge fund reinsurers’ capital, putting potential strain on the company if it coincided with unusually high claims payouts. To balance this, hedge fund reinsurers could take on less risk on the liability side, though this is not always the case. We are also likely to take a more conservative view of portfolio risk than a reinsurer’s management or owners.

Hedge funds often view portfolio risk in terms of both the nature of the assets held and their belief that their investment strategies can be executed to significantly mitigate risks.