Why Haven’t More Asset Managers Done This ?
Many asset managers who are unaware of our services think that the costs for devoting precious executive time that they cannot afford, starting the process but failing to launch, or launching a vehicle that ultimately fails to raise capital are too great, so they do not even try.
Over the years, we have made presentations to at least 1,000 hedge fund managers, so they were aware of how we mitigate the launch and post-launch risks of failure. 200 of those managers had at least $100 million of AuM, which is a viable business. Today, they have $ O of AuM. They are out of business.
Thus, even those who were aware of our services often found other priorities to be more important than securing permanent capital as a cheap insurance policy against going out of business and they did not even try.
For many that have tried, startup insurers, reinsurers, or banks look seductively easy, but they are really, really, really difficult.
What Have Been the Costs of Trying to Launch and Failing to Do So ?
Some investment banks, law firms, and accounting firms that advise asset managers and banks are aware of our services, but most are not. Those who are not aware of our services usually advise the asset managers that the vehicle must raise a minimum amount of capital to be competitive and they must also procure a management team in advance in order to raise that capital.
This advice causes a chicken and egg problem. How can the vehicle raise the minimum amount of capital without a management team and how can they afford a management team without raising the capital first ?
The best management candidates are usually employed and unwilling to take a career risk on the uncertainty of a capital raise. In order for the capital raise to present with a management team in harness, asset managers who wish to proceed often try to hire unemployed executives to minimize costs (which may not augur well for post-launch success), or make compensation guarantees to lure employed candidates to the cause.
The magnitude of these guarantees can be substantial, and the manager forfeits them if the vehicle fails to launch. In one case, the guarantees were more than $25 million. Rumor has it that Pine River’s launch failure cost it more than $13 million. Rumor also has it that Golub’s launch failure also cost it several millions.
How Can Asset Managers Mitigate the Costs of Failing to Launch ?
Aside from engaging us, one way to finesse the chicken and egg problem is to partner with an established insurer or reinsurer in lieu of hiring management and have that insurer or reinsurer source premiums for the vehicle. Examples of this are Mariner and PX Re (Select Re), Paulson and Validus (Pac Re), Highbridge and Arch (Watford Re), Blackrock and ACE (ABR Re), and Blackstone and Axis (Harrington Re).
Unfortunately, there are only a limited number of insurers and reinsurers willing and able to do this and because conflicts of interest could arise if they partnered with more than one asset manager or family office, the asset managers generally insist that the reinsurers partner with them exclusively in creating a total return reinsurer. Thus, the reinsurers want to use their single option only with the largest and most prestigious of asset managers.
While there is a lot of merit in this idea, all is not necessarily perfect. First of all, the insurers and reinsurers are generally publicly traded. As such, the CEO of the insurer or reinsurer cannot tell its shareholders and the markets that they are only sharing their best risks (to the detriment of their shareholders). In the same vein, they cannot say they are sharing only their worst risks (to the detriment of the total return reinsurer).
The answer to this conflict of interest is to have a quota share on the insurer’s or reinsurer’s whole account book of business. The problem with this is who represents the asset manager or family office on the pricing of this quota share. The insurer or reinsurer has a substantial home field advantage in these negotiations (if the quota share did not improve the insurer or reinsurer’s prospects in an obvious manner, why would it bother ?).
If the new vehicle is represented in these negotiations by investment bankers, lawyers, or accountants, the insurer or reinsurer can easily take advantage of their naivete. If they are represented by underwriters paid on success or the management of the new vehicle, the negotiators are compromised, because if they push back too hard during the negotiations, they might not get paid or be out of a job.
In the past, we have offered to negotiate these arrangements on behalf of total return reinsurers for a small fee whether or not a transaction consummates and take a slice of the quota share on identical terms for an alignment of interests if negotiations are successful.
What Does Taussig Capital Do to Mitigate Launch Risk ?
First of all, our Operating Partners provide the project management management function to secure each license. We also provide board members and executives who are regulatory and investment worthy to not only obtain the license, but also raise startup capital. These board members and executives can also operate the startup at its inception and either become permanent staff or find their replacements subject to regulatory and Lead Investor approval.
We also source premiums and originate and service loans for some of our clients’ Structural Alpha vehicles, so our clients do not have to hire unemployed executives nor offer substantial compensation guarantees to launch the vehicles.
In addition, we also provide centralized services for each Startup (legal, accounting, compliance, admin, HR, IT, treasury, purchasing, facilities, etc.) so that none of the Startups has build this type of infrastructure and can focus on delivering the product strategy that defines its business.
Lastly, we greatly reduce the non-compensation costs of a launch (legal, accounting, and set up costs) and compress the time. We also allow our clients to use our offering memorandum templates to raise additional capital, eliminating another cost that might otherwise exceed $1 million.
What Does it Cost to Launch a Structural Alpha Vehicle
There are three answers to this. The first is to engage us with a specific insurance, reinsurance, or banking product strategy in mind that is paired with a specific investment strategy. For this, we charge a monthly retainer, commissions on the capital raised, and some combination of warrants and/or a portion of asset management and performance fees. If we underwrite insurance or reinsurance business or originate and service loans, we also charge for those services.
The second answer is to invest in Structural Alpha Holdings ("SAH") www.structuralalphaholdings.com. In this case, the investor's launch risk is limited to a portfolio of shares and warrants in Startups and all of the launch risk is borne by SAH. However, no one should try to launch via SAH, unless he or she is highly confident that he or she can act as a Lead Investor with at least $15 million of capital. Once SAH has its first closing, we will no longer entertain engagements except through SAH.
The third answer is to invest in StatSure Financial www.statsurefinancial.com, whereby an asset manager or family office may enter the reinsurance business with as little as $1.5 million of capital at a cost of $25,000 and be operable within a month (versus 4 to 6 for most reinsurance startups that do not use us).
It is important to understand that these mini reinsurers are primarily vehicles that can provide leveraged outperformance with lower taxes than a fund (some might also optimize tax efficiency), and while they can theoretically grow to become another Greenlight Capital Re (NASDAQ: GLRE) or Third Point Re (NYSE: TPRE), it will be difficult to raise capital from investors other than current LPs.
While levered outperformnce with lower taxes or optimal tax efficiency is nothing to be sneezed at, turning a Structural Alpha vehicle into a permanent capital, asset gathering, fee generating machine, will require its Lead Investor to invest at least $15 million of startup capital.
Why Have so Many Failed After Launching ?
Three words. Poor underwriting results.
Before explaining why there have been poor underwriting results, it is important to understand how most insurers and reinsurers operate. Their profits are a function of investment returns plus or minus underwriting profits or losses. Expertise in most insurers and reinsurers is concentrated on the right hand side of the balance sheet (underwriting) and their compensation structures usually preclude hiring top tier asset managers (unless they outsource it).
As such, they do not want to take risk on both sides of the balance sheet and play it safe on the left hand side by investing in high grade, short duration, fixed income securities.
In the low interest rate environment over the last 10 years pressure on underwriting has intensified. Not counting $1.7 billion of realized gains (versus $65 million in 2017), Swiss Re earned roughly 2.67% on assets last year. Munich Re earned roughly 1.8% on assets. If investors thought that a professional asset manager’s returns would consistently be at those levels, they would not allocate funds to them. This puts pressure on insurers and reinsurers to significantly leverage their balance sheets, generate underwriting profits, or do both.
Most insurance and reinsurance executives and their underwriters have built in moral hazards equivalent to two free options. If the insurer or reinsurer is going to suffer underwriting losses, it often takes years to realize them. Meanwhile, the insurer or reinsurer books earnings that may not actually materialize over time, executive and underwriter employment continues, and bonuses are paid, shares are traded, and stock options are granted and exercised on those reported earnings. If the top line continues to grow, an insurer or reinsurer can cover up past underwriting mistakes for decades without being caught.
Buffett often writes that when pricing is bad, Ajit Jain can put away the pen without losing his job. Few executives and underwriters at other insurers or reinsurers have the same confidence that they can put the pen away and still remain employed if the insurer or reinsurer ever cuts back on staff. With a top line growth an imperative in case past years’ mistakes need covering up, those who do not underwrite will be the first to be let go.
So, the first free option is that they underwrite even when they know pricing is bad (or might be bad) and use the most liberal of actuarial assumptions to justify their position (at the end of the day, actuarial assumptions mean nothing – only actual results matter). If they do not underwrite, they are likely to lose their jobs sooner than if they underwrite bad business and are discovered later, so they underwrite come hell or high water.
The second free option concerns the types of risks that they underwrite. At the extremes, there are basically two types of insurable risks. On one end are low frequency, high severity risks such as hurricanes and earthquakes. On the other end are high frequency, low severity risks such as life insurance and workers compensation.
On the continuum of risks between these extremes, underwriters are paid a lot more for underwriting risks that fall toward the low frequency high severity end of the spectrum than the high frequency low severity end of the spectrum because they are perceived to require more skill. Since the only consequence of being wrong is losing one’s job (which may also be lost sooner for not underwriting), while the upside can be worth orders of magnitude more than one year’s salary and employment, they underwrite come hell or high water.
Furthermore, they can often blame a bad result on luck (no one can really predict hurricanes or earthquakes) and may either keep their job or move on to another insurer or reinsurer since it is almost impossible for the next employer to verify prior results at a previous employer.
Over the last 10 years, insurance linked securities in the form of catastrophe bonds, industry loss warranties, and collateralized reinsurers (collectively the “ILS markets”) have had a major impact on low frequency, high severity pricing, because they enjoy a far lower cost structure and the capital markets are 200 x deeper in capital and can better absorb losses than a regulated insurer or reinsurer with a fixed balance sheet.
Today, the ILS markets total roughly $90 billion and represent roughly 25% to 30% of the low frequency, high severity insurance and reinsurance. As such, the price of a unit of low frequency, high severity risk has fallen by roughly 50% over the last 10 years, but the actual risk itself hasn’t fallen at all.
The pricing problems of the low frequency, high severity business appear to have also infected high frequency low severity pricing. To illustrate this theory, 9/11 caused a medical malpractice insurance crisis in America. On the surface, that does not make sense.
In 2001, the St. Paul Companies underwrote 35% of all med-mal insurance in the U.S. In 2002, they wrote none and roughly one third of all doctors in America had no coverage and could not practice in clinics and hospitals as a result. The reason for this is that marine and aviation pricing skyrocketed after the attacks (British Airways’ insurance premiums increased 600%). Med-mal is longer tail and heavier on capital charges, so the St. Paul Companies reallocated their capital to marine and aviation and withdrew from med-mal.
We feel a similar form of contagion persists today. For years, the established insurers and reinsurers used the cyclic nature of low frequency, high severity pricing to enjoy many good years interrupted by a limited number of bad years from time to time. With the destruction of the pricing of low frequency high severity business over the last 10 years, the imperative to grow top line (which can paper over prior years’ mistakes) has greatly increased price competition for high frequency low severity business, rendering the already low margin side of the insurance and reinsurance business even less profitable.
Hank Greenberg, the genius who built AIG into the great company it once was said “there is no such thing as a bad risk, there is only the bad pricing of risk”. In 2019, prices seem to be firming. We hope we are wrong, but in our opinion, this firming is the equivalent of a dead cat bounce.
In examining successful Structural Alpha launches that ultimately failed or exited the business, most can be attributed to poor underwriting results. PX Re’s bad results sunk Mariner’s Select Re. Citadel entered the business just in time to experience Katrina, Rita, and Wilma in 2005. The same thing happened to Soros and HBK with Glacier Re.
The ultimate fates of Magnetar’s Pulsar Re and Harbinger’s Front Street Re were also the products of poor underwriting results. Since neither Lee Ainslie, nor Louis Bacon ever ran any or much of their investments, Scottish Re and Max Re had to rely on underwriting and the poor results required them to put themselves up for sale. In AQR’s case, they were smart enough to recognize the pricing problems of the low frequency high severity business and exited before they could be damaged. It is not clear whether Paulson’s Pac Re folded its tent because of poor underwriting or the withering attacks on it as a tax shelter by Senator Wyden.
Why haven’t More of Taussig Capital’s Launches Failed ?
The simple answer is that we emphasize high frequency low severity risks in highly structured contracts with a very narrow range of outcomes.
No one ever bought a share of Berkshire Hathaway because he or she was excited about investing in the insurance or reinsurance business and decided that Berkshire Hathaway was the best underwriter. They invested in Berkshire Hathaway as the only way to access Uncle Warren’s magic. By the same token, investors in our Structural Alpha vehicles want to access top performing asset strategies in a different manner than they can access in a fund or SMA.
Underwriting for a Structural Alpha vehicle only needs to follow the Hippocratic Oath (first do no harm) and breakeven or lose very little. If an investment strategy can consistently return more than 5% over time, a Structural Alpha vehicle should be a levered tax efficient vehicle that is virtually certain to outperform a fund or SMA with an identical investment strategy.
What Happened to Greenlight Capital Re and Third Point Re ?
First of all, Structural Alpha is predicated on investment returns greater than 5% over any rolling 5 year period of time. In the case of GLRE, its investment CAGR for the last 5 years was not a gain, but an 8.1%/year loss. Applying those losses to the leverage created by reserves, its self-declared success metric of book value per share declined even more.
The CAGR for TPRE's investment returns for the last 5 years has only been a 3.96%/year gain, which would be marginally OK if its "cost of insurance" were the industry average of 3%, but it has not been that low.
Our target of 5% investment returns is based on only underwriting high frequency low severity risks where the "cost of insurance" should be less than 5% in the worst case scenario. Both Greenlight Re and Third Point Re were conceived as high frequency, low severity underwriters to leverage the investment talents of David Einhorn and Dan Loeb. In their early years, both reinsurers followed this script and were very successful.
Meanwhile, each of their IPO prospectuses noted the moral hazard where investment performance fees might encourage the investment managers to take unnecessary risks since there was no penalty for losing money, but great reward for making it. At the same time, GLRE's and TPRE's underwriting compensation plans were heralded for rewarding good underwriting over time in order to align the interests of the underwriters and shareholders.
These compensation plans actually encourage a moral hazard similar to the concerns over investment performance fees. First of all, their underwriters are incentivized to underwrite write severity risks (hurricanes, earthquakes etc.), because the results are immediate. They will be right in most years and collect an immediate bonus without having to wait for several years as they would for frequency risks. When the gods do not cooperate, they will not have to cough up to offset the losses. Their downside risk is losing their jobs, which is unlikely since they can blame the gods, and even if they lose their jobs, they can usually find another one since their individual underwriting track records are opaque.
Worse, it also creates moral hazard for frequency risks. The simplest way to never get a bonus for underwriting frequency risks is to put the pen away when frequency pricing is lousy as Buffett suggests. Again, if premiums grow, it is easy to cover up past mistakes by continuously under-reserving.
The upshot is that both of these reinsurers abandoned the original script and as premiums flattened ave had to restate prior years' reserving. Each has had such poor underwriting results that it has fired its CEO, been put on "Negative" Ratings watch by A.M. Best, and have had to take more than 50% of their investable assets out of the strategies that made their asset managers famous (putting them into high grade short duration fixed income securities like any other insurer or reinsurer, partially losing the one thing that truly differentiated them).
Why Are the Vast Majority of Structural Alpha Vehicles Sponsored by Hedge Fund Managers ?
Hedge fund managers have taken the lead on Structural Alpha, because they are entrepreneurial and have a significant amount of their personal net worth in their funds. By contrast, most traditional asset managers have to go through layers of bureaucracy to get a go ahead and even more bureaucracy to get the seed capital, since they do not have the personal net worth to seed a vehicle.
That said, there is nothing to prevent any investor capable generating returns greater than 5% over any 5 year rolling period and capable of seeding a vehicle from managing the assets and collecting fees for doing so, even if the sponsor manages no outside money and is not regulated.
This makes the vehicles very attractive for family offices that do not manage non-family assets and we expect a number of them to join hedge fund managers and a smattering of traditional asset managers in launching Structural Alpha vehicles in the future.
Buy or Build ?
If you decide that you want to join the parade, then you must decide whether or not to buy an existing insurer, reinsurer, or bank or start one from scratch. In general, we do not like acquisitions, because we do not trust most balance sheets. There is great moral hazard in setting reserves when: (1) bonuses are paid for activity today when the results will not be known for years; (2) earnings are under pressure; and (3) the value of stock incentives are tied to near term earnings which are easy to inflate.
Remember. As long as premiums are growing it is relatively easy to continuously under-reserve and cover up previous years' mistakes, so due diligence is often a time consuming and expensive exercise in futility, and the price might require a premium to book value. For many acquisitions, any premium to book value would likely exceed the total amount of signing bonuses necessary to poach the key executives in the target, which would allow the buyer to replicate the business as a startup and use the difference as additional equity capital.
A startup has no legacy issues and no premium to book value. A startup reinsurer can be launched in 90 to 120 days, at relatively minimal cost, with relatively little overhead if our operating partners are used as the initial executives, and with relatively few restrictions on its investment strategy.
Furthermore, startups can access the capital markets through a 144A offering or an IPO if the story is strong enough (9 Bermuda reinsurers have raised more than $4 billion in startup capital via a 144A or IPO). The smallest was $175 million and the last was in November of 2013). GLRE went public 2 years and 9 months after its Series A funding and TPRE went public 18 months after its Series A round.
There are a number of reasons that launches fail. Some have been due to exogenous events such as Long-Term Capital, 9/11, Katrina, Wilma, and Rita in 2005, and the Financial Crisis of 2008. However, most failures occur because an in-house asset management executive wants to make his or her mark and grossly underestimates the complexity and cost of launching a Structural Alpha vehicle.
Do It Yourself startups can consume significant internal resources for 18 months to 2 years (six years in the case of one of our successes) and the length of the calendar increases the likelihood that an exogenous event can sideline success, not to mention running up launch expenses. Other launch failures occur when the manager goes out of business before completion (Pequot and Fairfield Greenwich Group), when startup expenses spiral out of control (often topping $5 million and more than $30 million if executives have to be lured with compensation guarantees) and the sponsor gives up before completion, and when capital targets were set too high and could not be reached.
In the cases of Scottish Re and Max Re, investment banks were engaged, and Wall Street suggested that they significantly alter the investment strategy towards long only short duration high grade fixed income securities, because it would be easier for the investment banks to raise capital from traditional insurance investors (they did not know alternative asset investors). As such, Ainslie never managed any assets for Scottish Re and Bacon only ran 10% of the assets for Max Re.
At their peaks, Scottish and Max each had book values of roughly $1.3 billion. Using Maverick’s and Moore’s published performance, each would have had book values in excess of $3 billion in the same time frames if Ainslie and Bacon ran all the assets as was originally intended (as Einhorn and Loeb have done for GLRE and TPRE). Wall Street took two Ferraris and put Volkswagen engines in them.
We think that our launch success rates are higher than when in-house executives or investment banks run the project because we know how to compress the calendar, keep expenses in check, pitch the right investors, and can supply the initial executives to obtain a license without compensation guarantees.
When the startup outsources as much as possible, starts small, learns by doing, grows gradually, and raises enough capital before hiring full time staff, success rates are far higher.