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

This development can also be seen as a sign that too much money is chasing too few opportunities in the capital markets. Like many of the better-known venture capital funds, many of the private hedge funds are closed, as fund managers have lately been swamped by capital from investors disenchanted with the stock market's performance in the past few years, and discouraged by continuing low interest rates.

Reinsurers have in the past decade gained a much better profile of their likely losses, which has allowed some to stray from the safety of fixed income portfolios. The percentage of equity, shares in reinsurers' portfolio has increased since the eight property catastrophe reinsurers who formed the Class of '93 were set up in Bermuda. Other insurance industry sectors, notably the life class and some European companies, have fared less successfully in this arena. Britain's Standard Life, for example, now lives in a world of pain as a direct consequence of its ill-timed investment in the equity boom of the late '90s. The relatively sluggish performance of the hedge fired market in the past few years now sees Max Re write mostly traditional reinsurance, and invest its portfolio in more traditional vehicles.

The move into reinsurance has been described as hubris on the part of the hedge fund managers. The cat reinsurers they are betting against are among the best-managed companies in the world. If one of those companies does not want the very risk it exists to underwrite, why would anyone else? The danger for hedge fund managers is overexposure, too much of a good thing. "If you were a primary reinsurer, and you had a choice, would you prefer a reinsurance company or a hedge fund to underwrite your risk?" a London broker asked, to which the answer is that you wouldn't care, so long as whoever wrote the policy paid claims as they fell due. Hedge funds experience illiquidity more frequently than reinsurers.

The question of regulation will arise, sooner or later. While this business remains small, regulators will have more important issues to face, but should it take off in a meaningful way, regulators will want reassurance that the hedge funds have the depth to carry the risks they are taking on. Those risks are greater than is the ease with catastrophe bonds, which pay slightly above comparable corporate bonds and usually sustain losses only if a rare, very damaging event occurs.

Hedge fund managers have been reportedly pursuing these deals quite aggressively. From the reinsurer's perspective, such deals can be expensive, like buying spot in an exchange market, but ultimately it is just another cost of doing business. Whether one or a series of catastrophes turns the practice into a receivables problem for the reinsurers remains to be seen.

RELATED ARTICLE: Hedge funds: will they stick around when the going gets tough.

Hedge funds emerged in the 1950s as private investment partnerships that specialized in a combination of short selling and leverage to reduce market risk. The term hedge fund now applies to investment vehicles with a range of aggressive investment strategies and objectives, with less regulatory supervision than mutual funds.