Out from under the radar

Out from under the radar

It enjoyed a low profile for a long time, but as it hits $9 billion in capital under management, Nephila Capital has become a big player in reinsurance and, as the debate over the long-term effect of so-called alternative capital rages, it is keen to ensure it is not misunderstood, co-founder Frank Majors tells Intelligent Insurer.

The idea that the reinsurance market can be split into two camps comprising traditional reinsurers on one side and alternative capital providers on the other is unhelpful and misleading. Instead, the market is better understood as a spectrum of different types of companies with many operating in the grey area in between these two business models.

That is the view of Frank Majors, director and co-founder with Greg Hagood of Nephila Capital and a principal of its affiliate, Nephila Advisors. Many commentators might lump Nephila Capital into the class of ‘alternative capital’, a perception that Majors sees as inaccurate and a gross simplification of what have been far more complex and sophisticated changes in the dynamics of the reinsurance markets in recent years.

Founded in 1997 in London as part of Willis, Nephila Capital relocated to Bermuda in 1999 in order to deepen relationships in the world’s largest catastrophe reinsurance centre. For many years, the company enjoyed a relatively low profile—something that suited its founders. But Majors says that what they see as recent misunderstandings around the nature of alternative capital have prompted the company to speak more openly about its business model, in order to be better understood.

In 2010 Nephila Advisors LLC was established, predominantly to assist in investor relations, develop strategic trading relationships and aid business development in the US.

“For the first dozen or so years in business we kept quite a low profile and we preferred that,” Majors says. “But if we remain silent now, we will become defined by others, and we want people to understand us and what we do better. We have $9 billion in capital under management and write about $1 billion of catastrophe premium—that makes us a substantial player in the catastrophe space. We think it is important that people understand where we fit in and the durability of our approach.”

Different models, no battle

He emphasises that the company is more than just an investment fund—it employs underwriters, utilises proprietary models and sources its business through the traditional broker channels. Yet unlike truly traditional reinsurers, and at the other end of the spectrum to a fund, the company has no rating agency or diverse group of shareholders (or analysts) to consider in its strategy. It also enjoys lighter regulation compared with truly traditional players.

“I am a little bemused by all the noise in the market at the moment which seems to be turning the situation into a battle of the business models. Which is better: traditional reinsurance or alternative capital? But to us, that argument misses the point. The definition of each sector is too narrow. It presumes that the traditional market and the alternative market are indeed separate things.

“At the end of the day, it is about access to capital. By and large it doesn’t matter where that capital has come from. There are a lot of rated, equity-backed companies that are accessing different forms of capital which are referred to as ‘traditional’. On the other hand the traditional, reinstateable indemnity product is among the products we offer and we source our business through traditional channels, but we are sometimes referred to as ‘alternative’. We can get grouped in with everyone else but we are not a cat bond fund or a traditional player.

"Our goal is to deliver the existing product through the existing channels, plus add product choices to meet cedants’ needs, and do it more efficiently."

“Our view is that cedants want product choice and a value proposition that makes sense; we keep what works from the traditional market—and there is more that works than doesn’t—and then deliver the capital as efficiently as possible. We view this approach more as an innovation to the existing business model than an alternative business model.

“When you buy a car, do you care if the manufacturer used just-in-time inventory techniques? No, you just want a dependable car at an affordable price. Our goal is to deliver the existing product through the existing channels, plus add product choices to meet cedants’ needs, and do it more efficiently.

“In this case, efficiency means accessing deeper, wider pools of capital, maintaining the non-correlation of the underlying risk to add more value to investors beyond just return, and allocate capital free of rating agency pressures.”

Majors explains that if a fund such as Fermat Capital is at one end of the scale and Munich Re at the other, Nephila would sit somewhere in the middle. “We are closer to companies such as RenaissanceRe and Validus in that sense. We have very good underwriters and we are taking judgements on risk. But we have a far easier ride when it comes to keeping stakeholders happy, because we have fewer constituents.”

A big advantage he sees in the business model Nephila has adopted is the lack of varied stakeholders, whose interests and views on the business the company has to contend with and constantly appease.

“I do think that can be tough for the truly traditional players. They have what are often conflicting demands of rating agencies, regulators, shareholders and analysts to consider strategically, which takes a lot of time and a lot of effort. And some reinsurers also have sidecars now—yet another group of stakeholders to consider.

“For us, it is much simpler. We are majority employee-owned, so we don’t have external pressures on how we manage the company. We have our fund investors to keep happy and that is about it. They are tough, but are knowledgeable and our interests are aligned. That gives us much more flexibility to be responsive to the demands of the market and offer good products and a good service at a price that is realistic for cedants.

"These days some risks are simply not diversifiable, resulting in a chronic under-allocation of capital to some areas of the industry, particularly peak catastrophe risks."

“But it is certainly not a case of one business model versus another—it is all points on a spectrum. If you look at the smarter traditional guys you see they are adopting so-called alternative aspects to their business model. We think this is more evidence that the story here is about embracing innovation to deliver efficiency, regardless of the label on your business model, rather than a battle of business models per se. We refer to our business model as ‘efficient capital’ rather than ‘traditional’ or ‘alternative’.”

Cedants, Majors says, are not as interested in which business model reinsurers use as the trade press would lead one to believe—they see all players as capital providers and use them to put together the best reinsurance programme at the best price which best fits their portfolio of business.

Change for the better

He does acknowledge, however, that the rapidly growing use of business models like Nephila’s is changing the industry. He also believes that the new investors that are entering the industry and the new business models and innovations that are developing around them as a consequence, also have the potential to change the industry for the better—growing its scope and coverage in a way that traditional reinsurers could never have done.

“There is a limiting factor in the traditional business model,” he claims. “It is based on the companies writing a diverse book of business and using the same capital to cover a variety of risks.

“That was sufficient 20 years ago when the losses from peak catastrophe events from hurricanes were much smaller, and still makes sense for the majority of risks that come to market today. But we think that these days some risks are simply not diversifiable, resulting in a chronic under-allocation of capital to some areas of the industry, particularly peak catastrophe risks.

“We believe the rated business model is already at its capacity when it comes to peak risks. As a result, there is un-met demand out there which is not coming to the market because it is too expensive. By lowering the cost of capital this market, even only around peak risks, can grow considerably.

“Cedants can start to transfer risks they have traditionally retained and improve their capital allocation in the process. There are lots of cedants—and businesses, and households—who will respond to price signals and bring their risks to market at the right price.”

This dynamic is one that Majors thinks will be good for the industry in the long term, bringing in new clients and new business and growing the market in the process.

“The traditional reinsurance model is not the most efficient method for dealing with peak risks. The model has resulted in a system where many risks in the world are simply never dealt with by the industry, with risks pushed back on would-be customers and their governments. Our business model can potentially move to solve some of these problems. It has the potential to grow the percentage of risks that actually come to the market.”

In such a changing environment, he acknowledges that there will be winners and losers. “There will be multiple winners in the future. Certainly many traditional players will adapt and will be winners, and we think there is scope for ILS funds to be winners. And there will no doubt be winners with an approach we haven’t yet seen. There is a positive view on all this and we are perplexed by the general negative tone of views we hear and read.”

Another misperception that he believes has developed around what some have defined the ‘alternative’ market is that its capital providers are somehow less sophisticated compared with the traditional players.

“There is a lot of talk about how funds and their investors will react if there is a big event but it is not obvious to us that they would be any more flighty than any other form of capital. Our investors understand this market well, including the messiness of losses. Most have been involved for many years now and are very mature. In 1997 we had to explain everything to everyone all the time. But people in the market now are educated.

“It’s important to remember that as far as some of the big investors such as pension funds are concerned, their allocation to this market represents only a tiny percentage of their overall funds under management. So even if there is a big loss, this is not a huge event for them. The idea they would be scarred and therefore turned off this market is ridiculous. They may fire their manager, but their decisions are unlikely to be based on emotion.”

Majors also dismisses the suggestion that investors could move away from the reinsurance space if interest rates improve, offering them attractive returns again in more traditional asset classes. This is because he believes investors see diversification as an important benefit from participating in this space—as much as the attractive returns it offers.

“People also say the flow of capital into reinsurance will stop if interest rates improve. But I think a big reason for their participation stems from lessons learned around the Lehman Brothers crisis. That period saw a lot of supposedly diversified assets losing value together, proving how rare—and valuable—a truly diversifying asset is. Investing in the reinsurance space provides a very attractive portfolio addition.”

He explains that Nephila’s investment philosophy is based on the premise that institutional investors are attracted to the non-correlated, relatively high-yielding returns offered by insurance-linked instruments. The company manages multiple investment vehicles exclusively for institutional investors. In addition to insurance-linked instruments, which are predominantly focused on natural catastrophe risk, the company has been trading weather risk since 2000 and launched a dedicated weather vehicle in 2005.

Growth on demand

 Far from investors potentially retreating from the market, Majors believes it will continue to grow. In the case of Nephila Capital specifically, its funds are currently closed to new investors. But he believes that over the next five years significant growth is a possibility.

Its size will ultimately be driven by the needs of the market, he says. Nephila’s philosophy is very much to be reactive to what the market and clients want, rather than to impose a set formula on to clients—a trap he believes too many reinsurers have fallen into in the past, which has contributed to stagnation in the market.

Much of this growth will be around the existing peak perils it covers now, driven by more businesses and homeowners—and therefore more cedants—buying more coverage in these areas. He expects some diversification but not into other classes of business just yet.

“We could migrate into riskier products on existing perils or maybe participate in new peril zones—that will probably happen eventually,” he says. “But we are unlikely to move into new classes of business beyond cat risks in the foreseeable future. Going down that route might make sense for others but we prefer to stick to what we know.”

It would also seem logical for Nephila to continue to expand its reach to investors. In February this year, it backed the formation of new Lloyd’s syndicate 2357, which is managed by Asta Managing Agency.

The move gives Nephila access to a new source of business in a market that has remained relatively untapped up to now by the ILS and collateralised markets. The syndicate, which launched with initial capacity of $100 million, underwrites catastrophe excess-of-loss reinsurance, targeting clients who find their needs are not met by traditional structures and players.

Majors says the business has received a warm reception in Lloyd’s. In addition to the obvious benefits its participation in the market will bring—new sources of business and relationships—Majors implies that the arrangement also gives it credibility in the market.

“We did have a warm welcome in Lloyd’s which I think is reflective of a change in attitude in the past 12 months. People are no longer denying the validity of alternative approaches. We want to be on the inside of the market looking out and we have been pleased with the reception, which goes a long way towards helping us achieve that.”

The company also looks well positioned to grow thanks to the composition of its shareholders. In January this year, the company completed a deal with KKR & Co in which the private equity company acquired a 24.9 percent stake in Nephila. Its investment complements that of the Man Group, which invested in the company in 2008.

KKR’s commitment to the firm has given investors and clients more certainty about the long-term intentions of Nephila. “It was a very important deal for us,” Majors says. “It allows us to better leverage some of the long-term relationships we have, it improves our access to capital and proves we have staying power in the market.”

Majors is bullish on the future of the market across all sectors. He believes the new capital entering the market will have the size to drive innovation, triggering growth for the entire industry—and there will be many beneficiaries of that.

“We are bullish on the prospects both for us and for existing reinsurers,” he says. “Alternative capital is hugely transformative to the industry but if the incumbent players adapt and change their business models in the right way, they have a lot to look forward to.” 

Intelligent Insurer, Frank Majors, Nephila Capital, Reinsurance

Intelligent Insurer