Hedge fund reinsurers may be helping to upend an industry that’s already fiercely competitive between traditional players and other, alternative sources of capital. But they’ll have to come closer to their more traditional, conservative rivals before they can grab a significant piece of the market, Standard & Poor’s analyst Taoufik Gharib concluded in a new report.

“It seems that one of the key aims of HFRs [hedge fund reinsurers] is to deliver attractive returns to shareholders that exceed those of traditional reinsurers,” Gharib wrote. “The premise of this strategy is to target, in general, low-volatility reinsurance business and allocate most of their capital to alpha-generating hedge fund investments” (those with returns exceeding a benchmark on a risk-adjusted basis).

That very business model limits their ability to achieve longer-term market expansion, Gharib said. He described the investment strategies of hedge fund reinsurers as varying widely but “significantly riskier and [consuming] considerably more capital than those typical of traditional reinsurers, which may increase the volatility of earnings and capital over time.” This leaves hedge fund reinsurers as bit players, he said, relatively speaking.

“The HFR model will likely carve out a niche market for itself and compete with smaller reinsurers,” the S&P report noted. “However, we still believe the traditional reinsurers will continue to dominate the landscape and provide stable capacity to their cedents.”

This will become particularly true when rates inevitably start rising, Gharib argued in the S&P report.

“When interest rates start rising, as we expect, the traditional reinsurers will likely become more price competitive in these subsectors as they earn more investment income, possibly undermining the sole value proposition of the HFRs’ model,” Gharib said. “Also, HFRs may be more likely to experience investment losses under such scenarios if not fully hedged, potentially disrupting their businesses.”

A bigger issue, he said, is the high-level competition already in place between traditional reinsurers, convergence capacity and hedge fund reinsurers.

“Under these circumstances, it will be hard for HFRs to remain opportunistic in finding pockets or subsectors where they can underwrite adequately risk-adjusted priced business,” Gharib wrote. “The potential undercutting of reinsurance pricing by HFRs to win business will weaken our view of their competitive position in our credit analysis.”

So how could hedge fund reinsurers (including Greenlight Re, Third Point Re, Hamilton Re, PaC Re and Watford Re) grab a bigger piece of the reinsurance pie under these circumstances? The answer, according to the S&P report, is for them to behave more like traditional reinsurers.

“The potential crossover between hedge funds and reinsurers offers compelling possibilities,” the S&P report concluded. “However, a commensurate focus on additional risks would have to supplement the singular focus on higher investment returns,” allowing for hedge funds and reinsurers together to create more benefits of diversification that don’t exist when they work on their own.

“Closing the gap between reinsurer and hedge fund risk cultures and implementing prudent risk controls is necessary to realize these benefits,” Gharib added in the S&P report.