Description

Summary:

It’s not easy today to find good absolute return ideas, especially ones that are straightforward and reasonably liquid.  Third Point Re (TPRE) lacks predictability and is heavily reliant on skilled management—in both its insurance and investment operations.  But I think we know enough to conclude that we are in very good hands in both cases.  TPRE is tracking well along its original business plan and is now operating at scale.  The stock now trades at a very slight premium to book value and, on this metric, has in its short history never been cheaper except for brief moments in January and April.  

TPRE is not simply a bet on Dan Loeb and Third Point with ready access, moderate liquidity and tax advantages.  It is a levered bet—currently the leverage is 1.3:1 and should creep a little higher over time. The company generates investment returns on the insurance float as well as the invested capital.  Here is CEO John Berger on the first quarter conference call.

Yes, we think, obviously, leverage -- asset leverage is a characteristic of the insurance/reinsurance business. We think, if we can get to a 1.4 asset leverage, that's very good. And an important component of that is, A.M. Best is the rating agency, and we get capital charges for various things.

With the typical company, probably, their biggest capital charge is their property catastrophe exposure. For us, it's -- because of our investment strategy, we get a relatively large capital charge for that. And so I think, when you look at the full equation today, a 1.35 or 1.4 asset leverage would be very good for us

We're at those levels today, and we plan to manage our float business so we stay at those levels

If TPRE achieves good (but not great) results in its reinsurance business, it should produce higher returns to investors than the hedge fund—even if it never trades at much of a premium to book value.  And if it should trade at more of a premium to book, which might come with a longer track record and/or a favorable reinsurance cycle, this should be a really well-timed investment.

History:

Modeled after Greenlight RE, TPRE was founded in late 2011 with $784MM in capital, sourced from Kelso, Pine River, Permal, VJ Dowling and Dan Loeb.  TPRE is highly valuable to Third Point LLC, as it now represents about 10% of total capital that is permanent.  For example, in 2014, when TPRE investments appreciated 5.3%, total investment  fees and incentives were $53MM (most went to Third Point but a portion to the other company founders). And, as will be discussed further, its investment prowess is the key variable in the prospective earnings and returns for TPRE.

TPRE went public in August, 2013 at $12.50/share and has since been a lackluster stock. Importantly, though, the company has made solid progress in growing its book of business.  In 2013 written premiums were $392MM, a double from 2012 levels.  Over the last 12 months, they reached $738MM.  The combined ratio was 102.7 in 2014 and, on a run-rate basis, is now approaching 100.  

Management:

Founder and CEO John Berger is a respected reinsurance industry veteran. From the early 80s, Berger worked with and learned from some of the most accomplished reinsurance professionals at F&G Re.  In 1998, Chubb hired him to launch Chubb Re, which was spun off in 2005 as Harbor Point and then merged with Max Capital in 2010 to form Alterra, where Berger stayed until the formation of TPRE.  Berger personally invested $5MM at the inception.  The COO is Rob Bredahl, who came from Aon Enfield, a leading reinsurance broker.  In that capacity, Bredahl introduced Berger to Loeb. 

Well-designed incentives are, of course, important in any business.  Given the “self graded exam” aspect of reinsurance, i think they are especially important here and pretty well designed.  TPRE uses a mix of annual and long-term incentives.  The annual program sets aside the total of 12.5% of investment income on cumulative float and 22.5% of adjusted underwriting income (if positive) in a bonus pool. In 2014, this was topped off to give bonus-eligible employees a threshold bonus of 50% of base salary, as the Compensation Committee reasoned that TPRE was achieving good progress on its strategic plan but had not yet reached a steady-state level of premiums and float.  

In the long-term plan, restricted shares are awarded for meeting underwriting profitability and float generation over rolling three year periods.   The key metric is the Underwriting Return Ratio—which looks at the combined ratio and investment income on float generated, but assuming the float was not invested in Third Point but rather in a medium-term investment grade bond portfolio.  Here is the proxy language, which I think makes a lot of sense:

The Compensation Committee set URR as the performance goal because it believes that this metric will appropriately align the Company’s goal of increasing profitable underwriting premium generation within the Company’s underwriting guidelines without exposing the Company to undue risk as to the quality of those premiums, and provide an incentive which offers an appropriate balance between the increased insurance float and underwriting risk.

Insurance Strategy, Results and Industry Conditions:

TPRE focuses on lower margin but more stable segments of the reinsurance market and doesn’t play in property catastrophe, which has historically been the biggest driver, but the most volatile component, of industry profitability.  The company focuses on three areas: (1) Quota shares for small-medium insurers, primarily in auto, homeowners and workers’ com. Here, TPRE assumes a percentage of premiums and losses.  (2) Reserve deals, where buyers get capital relief, protection against adverse development and an investment credit that might be better than they can earn on their own given limitations on their portfolios (Lloyds, for example).  (3) Opportunistic; “distressed type”  situations.  

The combined ratio was 107.5 in 2013 and 102.2 in 2014. In the first quarter, it was 102.8, better than a 4 point year over year improvement.  Management believes that they can exit 2015 at a C/R of about 100.  Note that a one point swing in the C/R is only about $0.05/share.  As long as TPRE can stay in the band they are in now (a C/R near 100) and avoid blowups, the real key to performance comes on the investment side of the house.  As everyone who has read this far knows, inadequate reserving has crippled many reinsurers over time.  Though TPRE has a short record, it has enjoyed very modest reserve releases (as opposed to reserve deficiencies).   

There is no doubt that the reinsurance industry is in a down cycle.  Relatively light catastrophe losses and the impact of alternative capital entering the industry—both through new company formation and, more importantly, catastrophe bonds have driven down rates in many segments.  At the same time, as a recent Goldman report highlights, a number of important primary insurers are retaining more risk on their own balance sheets.  Against this backdrop,a wave of reinsurance consolidation is occurring:  PartnerRe, Platinum, Montpelier, Catlin Group and Brit PLC have all been acquired in the last several months.  

This environment definitely will make it more challenging for TPRE to earn an underwriting profit, but, given its business mix and corporate strategy, it is unlikely to earn high insurance margins even in a very hard reinsurance market.  Talented individuals come on the market in these times and represent a potential opportunity for the company.  But where TPRE stands to gain the most is from business that comes up for grabs as a result of consolidation, either because insurers do not want to do business with current or potential competitors or, as a consequence of consolidation, that TRPE’s competitors decide to shrink or withdraw from interesting business segments.  As CEO John Berger recently said at the Morgan Stanley  Insurance Conference (a presentation worth listening to), “One plus one is always less than two.”

Passive Foreign Investment Company (PFIC) Rules:

The IRS has proposed (but not yet issued) rules that would “clarify” circumstances under which investment income earned by foreign insurance companies comes from active conduct of an insurance business for the purpose of the PFIC rules.  This is a response to an inquiry from Senator Ron Wyden, the ranking Democrat on the Finance Committee, last summer.  Wyden’s letter describes a “loophole” in which investors use insurers domiciled in tax havens as a shelter for investment income from hedge funds.  Most observers believe that the proposed regulations,which will be finalized by late July after a comment period, will cover active involvement in the insurance business, as opposed to outsourcing critical functions, and perhaps establish clear guidelines on premiums:net investments and/or insurance reserves:total assets:  

Price Waterhouse Coopers Analysis:  http://www.pwc.com/en_US/us/tax-services/publications/insights/assets/pwc-treasury-issues-proposed-regulations-pfic-exception-foreign-insurance-companies.pdf

Sullivan & Cromwell Analysis:  http://www.sullcrom.com/siteFiles/Publications/SC_Publication_Passive_Foreign_Investment_Companies.pdf

A quick Google search will produce many other opinions, all sounding very similar.  It’s clear that TPRE should have no issue meeting the test around active involvement.  It’s somewhat unsettling that there is no “bright line” on the relationship of invested assets to premiums or reserves.  In the worst case, though, the risks around new regulation do not seem so large with the stock at a very modest premium to book value.  

Investment Portfolio:  Third Point:

Third Point manages TPRE’s entire portfolio, which now exceeds $2.1 billion, in almost perfect alignment with its core hedge fund. I think everyone knows that Third Point has a remarkable record, but, just in case, a couple of  statistics:

—Since inception in 1995, compounded net returns of 20%/year.  Only 3 down years, one of which was down less than 1%.

—Perhaps more meaningful, over the last 10 years, when it was a large fund, net compounded returns of 12.2%/year, or 450 basis points/year better than the S&P 500.

—Even over the last 5 years (through the end of 2014), when few large hedge funds have outperformed the indices, Third Point compounded at 17.7%/year, or 220 basis points/year ahead of the S&P.

And while Dan Loeb is best known for US long/short equities and activism, Third Point is a much broader firm, with demonstrable expertise in foreign stocks, corporate and structured’ credit and sovereign debt.  

I have no special insights into how Third Point will do going forward.  It’s  obviously harder to excel with $20 billion in assets.  And motivation is always very hard to assess from the outside. But I am happy to have them manage some of my capital—particularly as the leverage inherent in TPRE, which I don’t think has significant risk accompanying it, magnifies the underlying returns of the fund.

Model:

Very simple:  TPRE’s book value grows at 1.3X the returns of its investment portfolio.  I assume investment leverage, which stood at 1.33:1 at the end of Q1 ($18.57 invested assets/share), does climb to management’s goal of 1.4:1 and stay there.  But the C/R won’t be 100, let alone better, every year and the formation of a US subsidiary will lead to modest corporate taxes over time, so I subtract a little.  Feel free to subtract more or less.  So that leaves the key question:  How will Third Point do?  I am comfortable assuming 8-10%/year, which I think its managers would regard as quite disappointing.  So I would expect book to compound at 10-13%/year.  If at points in time the stock commands a modest premium to book, so much the better.  

Catalyst

PFIC rules clarified; continued corporate progress.