Hedge funds hog the spotlight: although hedge funds played little role in the reinsurance market five years ago, they now reportedly account for as much as half of the capital available for some specific forms of coverage, such as protection against a single storm

Risk & Insurance, March, 2005 by Roger Crombie

Hedge funds have started writing reinsurance coverage. Where once reinsurance companies invested in hedge funds, now hedge funds are investing in catastrophe insurance. Much of this activity is taking place in Bermuda.

For a decade, hedge funds have been flirting with reinsurance. Moore Capital, a hedge fund manager, helped form Max Re in Bermuda five years ago and Max invested a significant element of its investment portfolio in hedge funds selected by Moore Capital. Fund managers have already tried bonds, swaps and direct investment in reinsurers.

Still, hedge funds are estimated to have no more than two percent of the reinsurance market. Some doubt the level is as high as half that. More hedge funds are entering the market, however, with some starting offshore reinsurance units, and hiring insurance veterans to run their operations. Although hedge funds played little role in the reinsurance market five years ago, they now reportedly account for as much as half of the capital available for some specific forms of coverage, such as protection against a single storm.

The hedge funds' embrace of reinsurance is a latter-day consequence of the convergence of the capital markets that drew so much attention a few years back. Reinsurance contracts written by hedge funds represent a source of capital outside traditional insurance channels, if such channels can be said to exist anymore.

"The hedge fund industry's relationship with reinsurance markets began in the '90s, principally via investments in catastrophe bonds and insurance swaps," wrote Willis in its Jan. 1, 2005 ReView newsletter, "but the recent trend shows hedge funds with significant capacity available for traditional property and retrocessional business."

The largest hedge fund players in this market include Nephila Capital, which is headquartered in Hamilton; CIG Re, backed by Chicago's Citadel Investment Group; and CooperNeff Advisors, a unit of French bank BNP Paribas that runs several hedge funds. Nephila Capital has concentrated on reinsurance, particularly catastrophe coverage, since the firm was founded in 1997 as part of Willis. A new entrant expected to set up in Bermuda during 2005 is Independence Re.

Although hedge funds use nontraditional techniques, they have traditionally tended to carry on their investment activities outside the world of insurance. "Investing" in catastrophe reinsurance is a fairly recent development in a market always looking for an edge.

In a typical retrocession deal, a hedge fund might agree to make a significant payment to a reinsurance company if the reinsurers losses from a particular event were to exceed a certain threshold. Such contracts fall under the rubric of excess liability or retrocession, although they may not represent the classic transfer of risk. The hedge fund might charge a premium representing as much as 30 percent of the amount at risk for a one-year contract that would typically protect the reinsurer from the costs of a single event, such as a hurricane or an earthquake. From the reinsurer's perspective, this is backstop reinsurance or a variant of stop-loss.

The hedge funds in this market are mostly privately-owned and do not issue public statements on their profitability. The extent to which the funds were exposed to losses from the four hurricanes that hit Florida and the Caribbean last fall, for instance, will probably never be revealed. As a means of protecting themselves, fund managers writing this kind of business limit their catastrophe allocations to five percent of their overall capital. Some have reportedly invested beyond that level in the cat market, and losses from Hurricane Ivan, in particular, may have threatened the existence of several of the funds, although not any of the funds named in this article.

It would be easy to become too excited about this development. Many hedge funds have had a difficult time of things in the last few years, and managers are always on the lookout for alternative investment techniques that might add bite to returns. "The short duration of the contracts and their relatively high pricing mean that this is a tool we would use sparingly," said the CEO of a Bermuda reinsurer who spoke on condition of anonymity because "people might expect reinsurers to be the last line of defense and I wouldn't want to be seen as diluting that view."

Far from tarnishing the reinsurers' reputation, many would consider these activities, at least from the reinsurers' side, as a sensible spreading of the risk, the raison detre of reinsurance. Using such transactions, reinsurers can reduce the potential volatility of their risk portfolio by capping their losses. Profit forecasting would become the most exact of sciences for property catastrophe reinsurers, were they able to place a ceiling on all their potential losses. But the hedge rinds' influence is small, and is likely to remain that way, given the overall size of the reinsurance market and the relatively hefty premiums the funds are extracting.