We had written about the structural advantages of re-insurers before here. We ran through some numbers and here is what we found.
Both Greenlight Re and Third Point Re are structured similarly with Greenlight Capital and Third Point LLC running the investment books. Both follow 2% management fee and 20% incentive agreements with high watermark. Currently unearned premium is around 50% of equity (actually close to 40% of equity) for both the insurers. We have assumed cost of float as 2% for both the insurers. We tried to model the returns to the shareholders under various circumstances of underlying returns from the hedge funds. The shareholder equity varying as a function of float net of the cost of float.
| Underlying Equity | $100.00 | |||||
| Float Leverage | $ 50.00 | |||||
| Total Assets | $150.00 | 102% | ||||
| Underlying Rates of Return | $150 Invested | After 2% Management Fee | After 20% Performance | Net Underlying Returns to Investor | Cost of Float | Net Underlying Returns of Shareholder Equity |
| -30% | $105.00 | $102.90 | $102.90 | -31.4% | 1.0% | -48.1% |
| -20% | $120.00 | $117.60 | $117.60 | -21.6% | 1.0% | -33.4% |
| -10% | $135.00 | $132.30 | $132.30 | -11.8% | 1.0% | -18.7% |
| 0% | $150.00 | $147.00 | $147.00 | -2.0% | 1.0% | -4.0% |
| 5% | $157.50 | $154.35 | $153.48 | 2.3% | 1.0% | 2.5% |
| 10% | $165.00 | $161.70 | $159.36 | 6.2% | 1.0% | 8.4% |
| 20% | $180.00 | $176.40 | $171.12 | 14.1% | 1.0% | 20.1% |
| 30% | $195.00 | $191.10 | $182.88 | 21.9% | 1.0% | 31.9% |
Over a period of time, if one assumes that the insurers grow their float to get a structure where they have $100 of float for $100 of equity (which is still conservative as reinsurers typically write 5X of capital) However, given the general risky nature of where the float is invested, 1X is a more proper allocation for this strategy.
| Underlying Equity | $100.00 | |||||
| Float Leverage | $100.00 | |||||
| Total Assets | $200.00 | 102% | ||||
| Underlying Rates of Return | $200 Invested | After 2% Management Fee | After 20% Performance | Net Underlying Returns to Investor | Cost of Float | Net Underlying Returns of Shareholder Equity |
| -30% | $140.00 | $137.20 | $137.20 | -31.4% | 2.0% | -64.8% |
| -20% | $160.00 | $156.80 | $156.80 | -21.6% | 2.0% | -45.2% |
| -10% | $180.00 | $176.40 | $176.40 | -11.8% | 2.0% | -25.6% |
| 0% | $200.00 | $196.00 | $196.00 | -2.0% | 2.0% | -6.0% |
| 5% | $210.00 | $205.80 | $204.64 | 2.3% | 2.0% | 2.6% |
| 10% | $220.00 | $215.60 | $212.48 | 6.2% | 2.0% | 10.5% |
| 20% | $240.00 | $235.20 | $228.16 | 14.1% | 2.0% | 26.2% |
| 30% | $260.00 | $254.80 | $243.84 | 21.9% | 2.0% | 41.8% |
One thing is very evident here, if the re-insurers are not prudent and conservative, it will wipe out equity fast as float functions exactly how leverage does. Companies like Berkshire own whole companies where earnings are less volatile compared to stock market instruments and they also own a lot of fixed income instruments. Third point returned -32.6% in 2008 and Greenilght Capital returned -22.6% in 2008. The above table clearly shows what would happen if another such year were to occur for these two insurers whose investment books are managed by the insurers. As the investments are starkly different from other insurers, it might be worthwhile to consider the volatility of the instruments.
How would Berkshire or Markel look with a similar capital structure? Remember, they do not charge 2% and 20%. However, they have taxes to drag them down and both of them have great historical performance to their back on running a reinsurer and its investment books. Markel lost 16% of their book value in 2008 which is remarkable considering that they were leveraged 2.2:1 on their float largely thanks for their fixed income instruments which was up 0.2% and equities were down 34%. Berkshire was down (9.6)% in 2008 thanks again to the fortress balance sheet and the fixed income securities that Berkshire owns.
If Markel or Berkshire had a similar structure, this is how they would look.
| Underlying Equity | $100.00 | ||||||
| Float Leverage | $50.00 | ||||||
| Total Assets | $150.00 | 100% | 35% Full Tax | ||||
| Underlying Rates of Return | $150 Invested | After 2% Management Fee | After 20% Performance | Net Underlying Returns to Investor | Cost of Float | Net Underlying Returns of Shareholder Equity Before Tax | Net Underlying Returns of Shareholder Equity After Tax |
| -30% | $105.00 | $105.00 | $105.00 | -30.0% | 0.0% | -45% | -45% |
| -20% | $120.00 | $120.00 | $120.00 | -20.0% | 0.0% | -30% | -30% |
| -10% | $135.00 | $135.00 | $135.00 | -10.0% | 0.0% | -15% | -15% |
| 0% | $150.00 | $150.00 | $150.00 | 0.0% | 0.0% | 0% | 0% |
| 5% | $157.50 | $157.50 | $157.50 | 5.0% | 0.0% | 8% | 5% |
| 10% | $165.00 | $165.00 | $165.00 | 10.0% | 0.0% | 15% | 10% |
| 20% | $180.00 | $180.00 | $180.00 | 20.0% | 0.0% | 30% | 20% |
| 30% | $195.00 | $195.00 | $195.00 | 30.0% | 0.0% | 45% | 29% |
With $100 of Float to $100 of equity
| Underlying Equity | $100.00 | ||||||
| Float Leverage | $100.00 | ||||||
| Total Assets | $200.00 | 100% | 35% Full Tax | ||||
| Underlying Rates of Return | $200 Invested | After 2% Management Fee | After 20% Performance | Net Underlying Returns to Investor | Cost of Float | Net Underlying Returns of Shareholder Equity | Net Underlying Returns of Shareholder Equity After Tax |
| -30% | $140.00 | $140.00 | $140.00 | -30.0% | 0.0% | -60% | -60% |
| -20% | $160.00 | $160.00 | $160.00 | -20.0% | 0.0% | -40% | -40% |
| -10% | $180.00 | $180.00 | $180.00 | -10.0% | 0.0% | -20% | -20% |
| 0% | $200.00 | $200.00 | $200.00 | 0.0% | 0.0% | 0% | 0% |
| 5% | $210.00 | $210.00 | $210.00 | 5.0% | 0.0% | 10% | 7% |
| 10% | $220.00 | $220.00 | $220.00 | 10.0% | 0.0% | 20% | 13% |
| 20% | $240.00 | $240.00 | $240.00 | 20.0% | 0.0% | 40% | 26% |
| 30% | $260.00 | $260.00 | $260.00 | 30.0% | 0.0% | 60% | 39% |
Markel at the end of 2014 had $145 of float to $100 of equities. Remember the fixed income securities and why Markel will not be very volatile and probably the returns will not exceed 10% on assets invested.
| Underlying Equity | $100.00 | ||||||
| Float Leverage | $145.00 | ||||||
| Total Assets | $245.00 | 100% | 35% Full Tax | ||||
| Underlying Rates of Return | $200 Invested | After 2% Management Fee | After 20% Performance | Net Underlying Returns to Investor | Cost of Float | Net Underlying Returns of Shareholder Equity | Net Underlying Returns of Shareholder Equity After Tax |
| -30% | $171.50 | $171.50 | $171.50 | -30.0% | 0.0% | -74% | -74% |
| -20% | $196.00 | $196.00 | $196.00 | -20.0% | 0.0% | -49% | -49% |
| -10% | $220.50 | $220.50 | $220.50 | -10.0% | 0.0% | -25% | -25% |
| 0% | $245.00 | $245.00 | $245.00 | 0.0% | 0.0% | 0% | 0% |
| 5% | $257.25 | $257.25 | $257.25 | 5.0% | 0.0% | 12% | 8% |
| 10% | $269.50 | $269.50 | $269.50 | 10.0% | 0.0% | 25% | 16% |
| 20% | $294.00 | $294.00 | $294.00 | 20.0% | 0.0% | 49% | 32% |
| 30% | $318.50 | $318.50 | $318.50 | 30.0% | 0.0% | 74% | 48% |
When one takes a closer look at the economics of the business models, it looks like third point and Greenlight re have managed to replicate a capital structure that replicates similar economics to Berkshire or Markel while getting much much better deals for themselves in the process instead of the taxman.
However, things get interesting further. Greenlight Re is trading at 0.87 book and Third Point Re at 1.07 times book. Berkshire is trading at 1.46 book and Markel at 1.64 times book.
| Underlying Equity | $ 100.00 | ||||
| Float Leverage | $ 50.00 | ||||
| Total Assets | $ 150.00 | GLRE | 3Re | ||
| 0.87 | 1.07 | ||||
| Underlying Rates of Return | $150 Invested | Net Underlying Returns of Shareholder Equity | P/B =1 | P/B =1 | |
| -30% | $105.00 | -48.1% | -41.8% | -51.5% | |
| -20% | $120.00 | -33.4% | -29.1% | -35.7% | |
| -10% | $135.00 | -18.7% | -16.3% | -20.0% | |
| 0% | $150.00 | -4.0% | -3.5% | -4.3% | |
| 5% | $157.50 | 2.5% | 2.9% | 2.3% | |
| 10% | $165.00 | 8.4% | 9.6% | 7.8% | |
| 20% | $180.00 | 20.1% | 23.1% | 18.8% | |
| 30% | $195.00 | 31.9% | 36.6% | 29.8% |
If the re-insurers grow the book to have float to 1X of capital.
| Underlying Equity | $100.00 | ||||||
| Float Leverage | $100.00 | ||||||
| Total Assets | $200.00 | GLRE | 3Re | ||||
| 0.87 | 1.07 | ||||||
| Underlying Rates of Return | $200 Invested | Net Underlying Returns of Shareholder Equity |
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| -30% | $140.00 | -64.8% | -56.4% | -69.3% | |||
| -20% | $160.00 | -45.2% | -39.3% | -48.4% | |||
| -10% | $180.00 | -25.6% | -22.3% | -27.4% | |||
| 0% | $200.00 | -6.0% | -5.2% | -6.4% | |||
| 5% | $210.00 | 2.6% | 3.0% | 2.5% | |||
| 10% | $220.00 | 10.5% | 12.0% | 9.8% | |||
| 20% | $240.00 | 26.2% | 30.1% | 24.4% | |||
| 30% | $260.00 | 41.8% | 48.1% | 39.1% |
A good comparison would be Markel today. I have just included what Berkshire would do with a similar capital structure.
| Underlying Equity | $100.00 | ||||||
| Float Leverage | $145.00 | ||||||
| Total Assets | $245.00 | 35% Full Tax | Berkshire | MKL | |||
| 1.46 | 1.64 | ||||||
| Underlying Rates of Return | $200 Invested | Net Underlying Returns of Shareholder Equity | Net Underlying Returns of Shareholder Equity After Tax |
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| -30% | $171.50 | -74% | -74% | -81.8% | -83.8% | ||
| -20% | $196.00 | -49% | -49% | -65.1% | -68.9% | ||
| -10% | $220.50 | -25% | -25% | -48.3% | -54.0% | ||
| 0% | $245.00 | 0% | 0% | 0.0% | 0.0% | ||
| 5% | $257.25 | 12% | 8% | 5.5% | 4.9% | ||
| 10% | $269.50 | 25% | 16% | 10.9% | 9.7% | ||
| 20% | $294.00 | 49% | 32% | 21.8% | 19.4% | ||
| 30% | $318.50 | 74% | 48% | 32.7% | 29.1% |
Clearly given the valuation difference between Third Point, Greenlight Re’s with the Markel’s of the world, the risk-reward points clearly towards the former.
However, one must be very mindful on how the volatility is handled within the books. Markel and Berkshire have their fixed securities helping them manage well through a downturn. Will Greenlight and Third Point be able to replicate with their long / short strategies and event driven value investing?
Will the shareholders want the comfort of the Berkshire balance sheet at expensive valuations and a size that kills performance or the risk / reward of the newer re-insurers with seasoned hedge fund managers like David Einhorn and Daniel Loeb who have been lackluster of late and are still new to the re-insurance business. Or is there a place for both categories in one’s portfolio?
Disclosure: Own BRK.B, MKL; Evaluating GLRE and TPRE
Beowulf Capital 