Greenlight Capital LP has earned a reputation as one of the best shops on the street, and deservedly so, the hedge fund has averaged a return 21.6% annually from its inception in 1996-2011 with only two down years (based on 2015 fund performance expectations) and no leverage. The fund was launched into the spotlight in 2002 with company president David Einhorn’s speech at a charity investment conference to benefit a children’s cancer hospital, announcing a short position in Allied Capital over what it considered questionable accounting. Greenlight also went on to make large and profitable short bets on Lehman Brothers in 2008, further establishing its reputation.
However following a period of volatility through August 2015 as well as series of poor and ill timed positions, the fund is down in the region of 16.9% for the year (as of October 1st) according to Forbes. Latest figures from the New York Times suggests that roughly 15% of the Greenlight Capital LP outside capital comes from its reinsurance firm Greenlight Capital Re, LTD. Greenlight Capital Re, LTD (NASDAQ: GLRE) is a public firm, this enables those of whom cannot gain exposure Greenlight Capital LP to do so indirectly.
When the operating portion of reinsurance business is running profitably, the float acts as a form of interest free loan to Greenlight Capital LP. This is why the origination of reinsurance firms supported by hedge funds have become a popular notion with the likes of Daniel Loeb of Third Point and Steven Cohen of SAC capital advisors.
However with the latest poor performance at Greenlight Capital LP, as well as turbulence in the reinsurance business, Greenlight Capital Re, LTD is trading at below book value.
Brief Industry Analysis
Most insurance companies generally provide either PC (property & casualty) or LH (life & health) insurance, some have operations in both. PC underwriting involves greater uncertainty than LH contracts, both the frequency and size of PC liabilities are more volatile than that of LH liabilities. In addition, PC underwriting is sensitive to catastrophic events which LH do not typically experience. The result is that PC underwriters generally invest in less risky assets compared to LH underwriters.
According to AON, as of January 2015 “Reinsurer capital grew to USD575 billion including USD62 billion of deployed alternative capacity—both records. The growth rates in reinsurance capital and alternative capital deployed were 6 and 25 percent, respectively”. It’s important to note the growth rate in alternative capital, examples of which include Hedge funds Re and other sidecar structures. Since reinsurance is largely a homogenous product the increase in competition results in aggressive pricing and profit pressure.
Additionally, the current low interest rate environment has created a demand among money managers for catastrophe bonds, the result has been a lower appetite for certain reinsurance. Low interest rates that still reside following Federal Reserve’s latest announcements continue to put upward pressure on asset prices, this has the effect of increasing the liability cover in PC contracts, hurting profitability. The effects are also felt in LH underwriting. Furthermore, due to this increase in insurer balance sheet strength there is a trend for cedents to retain more risk. The result is a wave of consolidation in the industry as capital is concentrated among fewer participants, it may allow for specialist reinsurers to survive and serve a niche.
The outlook for the reinsurance industry as a result continues to look bleak all major rating agency paint a negative outlook for the future. The result of which as been a general sell off in the industry.
Greenlight Capital Re, LTD was established in 2004 and operates through its subsidiaries in both the Cayman Islands and Dublin, Ireland. Mr Einhorn is chairman of the board and holds substantial interest in the company.
The underwriting portfolio is heavily weighted toward frequency business (meaning the loss event happens regularly and can be expected to occur regularly in the future) with the majority of its portfolio focused in property and casualty reinsurance, though it has licensing to write LH contracts. The business operates in global markets, with primary focus on United Kingdom, Lloyd’s of London, France, Germany and Scandinavia, providing coverage to primary carriers.
Greenlight Capital Re, LTD focuses in property with controlled catastrophe exposure (as well as retro exposure) , general liability, personal accident, niche and non standard motor and medical stop loss, selectively offering customised reinsurance solutions in markets where capacity and alternatives are limited.
The core investment principles of the company are to achieve higher rates of return over the long term than traditional, fixed-income strategies. In addition, to maximise total risk-adjusted return with a focus on capital preservation. It should be noted that investments at Greenlight Capital Re, LTD is managed through a subsidy of Greenlight Capital LP called DME advisor, with fees reduced from the traditional 2 and 20 hedge fund rates. Due to DME’s long/short equity approach, there are restrictions to the amount of catastrophe underwriting (higher margins) the firm can undertake.
Using the combined ratio, we can see the performance of the company’s underwriting abilities. A combined ratio above 100% means that the company paid out more in claims than it received in premiums, taking into account the costs of the underwriting. Illustration 1 below shows their underwriting performance (summarised from table A in appendix).
Recent Q1 and Q2 2015 combined ratios were 101.5% and 109.2% respectively, a further raising. This weakness in underwriting performance increases cost of float, putting a strain on ROE and growth in book value. Top quartile underwriters regularly post sub 90% combined ratios, however according to Verisk Analytics, the past 55 years has seen the average however around 103.9%. It doesn’t seem unreasonable for Greenlight to revert some ways towards a 103% ratio, given the performance over the last 5 years.
Estimates provided by Greenlight in illustration 2 below connect the underwriting performance effects with investment performance. However above all else, this illustrates just how resilient ROE is to changes in the combined ratio given a strong investment performance.
In addition Greenlight Reinsurance, Ltd. is rated A (Excellent) and Greenlight Reinsurance Ireland, Ltd. is rated A (Excellent) from rating agency A.M. Best with no leverage as of Q2 2015. This should provide some assurance as to the downside risk of the firm and ability to meet claims against it.
In terms of growth and profitability, the company has been growing its premiums earned at a rate around 26% from 2007-2013 and has been able to grow book value per share at around 11.1% pa. However there was a slowdown in the value of gross premiums written in 2014 due in part to the company’s focus on larger and fewer deals. This trend continued into 2015 as shown below. large investment losses and loss and loss adjustment expenses continued to contribute to the pre tax loss for the period.
The investment performance here relates to the management of the company’s float or net insurance liabilities. As previously stated, investments at Greenlight Capital Re, LTD are managed by chairman David Einhorn through Greenlight Capital LP subsidy DME advisors. Illustration 4 below is a summary of investment returns at Greenlight Capital Re, LTD ttm.
Geometric average performance through 2011-2014 was 7.1%, a respectable return considering most PC reinsurers are invested in traditional fixed income products. However since its inception DME advisors through Greenlight Capital LP have averaged a rate of return around 19.5% according to people familiar with the matter up until 2014.
The turbulent year for Greenlight Capital LP has been due large part to poor investments in SunEdison (down over 70% since mid july), miss timing the industry cycle in Micron as well as volatile pricing in Gold, Apple and General Motors. This run of bad performance was mirrored by managers such as at Leon Cooperman, Daniel Loeb and Bill Ackman.
A return to form for David Einhorn and Greenlight Capital LP could see DME advisors push investment return back into familiar territory.
Providing there is a reversion to the mean in investment performance (for which there is good reason to believe) and management continues to underwrite at a combined ratio efficiency close to an industry average 103% (well within the range of historical performance) with the assumptions of 52% of capital deployed and 130% capital is invested, we should see a ROE around 10-12% according to company data (illustration 2).
Considering the company’s historical return on equity of 11.1% through 2005-2014, a price to book valuation of 1.1 is still conservative to the current business and industry risks, whilst in line with previous valuations for the same ROE performance at the company.
The stock is currently trading at 0.8274 P/B (as of October 19th), the current industry average according to data obtained by yahoo finance would suggest a P/B of around 1.3. At 1.1 P/B, this would equate to stock worth around $32.57 as of (October 19th) per class A share. This equates to an almost 35% discount to fair value.
Overall investors have oversold the stock for reasons relating to the culmination of negative industry forces and consolidation, coupled with large investment losses and underwriting losses. However, the sell off was caused by an overreaction to risks related to the business and thus caused a buy opportunity. The release of Q3 results on October 28th should provide some catalysts for a market re-evaluation.