Cash-rich hedge funds shake up the reinsurance industry

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SAN FRANCISCO (MarketWatch) — Under increasing pressure to extend a string of huge returns for their super-wealthy clients, several top hedge funds are making forays into what may seem an unlikely new business for high-flying investors: reinsurance.

And their entry into a market once dominated by a few old-guard insurance specialists has raised hackles among the industry’s leading players. Established reinsurance companies fear that hedge funds, which are virtually swimming in cash, command an uncommon ability to drive down prices, in turn eroding their premiums.


In recent years, hedge funds have won over massive pools of new assets as wealthy people have grown enamored of investing with them. But while those huge assets have ballooned, managers face a steeper challenge seeking to extend their track records year after year as more money chases a finite number of investment ideas. See main story.

“Hedge funds are being increasingly drawn into the reinsurance business because they’re searching for substantial returns,” says Andy Barile, an independent reinsurance consultant in Rancho Santa Fe, Calif. “They’re flush with cash, and that money has to find investments — or they may have to give it back to investors.”

Soros and more

Reinsurance is purchased by insurers looking to spread the risk of policies they’ve sold.

Hedge funds are fond of reinsurance in particular because its returns don’t hinge so much on the ups and downs of the broader financial markets. After all, the main way that hedge funds market themselves to clients is by generating gains irrespective of how stock and bond prices are moving.

Last year, George Soros’ fund joined with HBK Investments to help start Glacier Re, a Switzerland-based reinsurer with $300 million in capital. Soros and HBK own about 90 percent of the company, while British reinsurance broker Benfield Group (BFDBFD) and Glacier Re management own the rest.

In September, Citadel Investment Group, Ken Griffin’s $10 billion, Chicago hedge fund, set up its own Bermuda-based reinsurer called CIG Reinsurance Ltd.

And Ritchie Capital Management, a $1.4 billion hedge-fund firm also based in Chicago, has hired a group of former bankers with Citigroup to help it branch out into reinsurance underwriting.

 

Alternative products

Hedge funds are investing in new, alternative types of reinsurance products, such as catastrophe bonds, which compete with traditional forms of coverage.

Sometimes called “cat bonds,” the notes are sold to help insurers transfer the risk of future disasters to the capital markets. In return for assuming the risk of earthquakes and hurricanes, investors can earn a high yield.

If the magnitude of a disaster surpasses pre-arranged limits, or if the cost of an event rises above a certain level, investors lose much of their principal or interest, or both, and the insurer uses the cash to pay claims.

CooperNeff, a division of France’s BNP Paribas (BNPZY), runs a $133 million hedge fund that invests in cat bonds.

Nephila Capital, a hedge-fund firm founded in 1997 by Greg Hagood and Frank Majors, also invests in the bonds, as does a fund run by Cochran Caronia & Co., a boutique insurance investment bank.

Funds such as Soros, HBK and Citadel have gone one step further by forming their own companies to underwrite reinsurance directly.

Some hedge funds have so much cash to put to work in the reinsurance market that they’re taking the unusual step of setting aside capital to collateralize the risks they’re underwriting, according to Barile, the insurance consultant.

The result? An insurance company considering buying reinsurance from a hedge fund-backed entity won’t have to worry as much about their creditworthiness as they would when purchasing coverage from traditional reinsurers, he explained.

Confidence

“That’s mind-boggling,” Barile says. “If hedge funds set the assets aside, reinsurance buyers can be a lot more confident that they’ll get paid if they make a claim.”

Citadel, Nephila and CooperNeff are known to be among hedge funds offering collateralized reinsurance, according to a January report by Benfield.

This type of reinsurance can be attractive to some insurers because the credit and debt ratings of many previously strong traditional reinsurers have deteriorated in recent years.

“A very important part of the service that these funds provide is fully collateralizing the coverage they issue,” says Steve Breen, a senior vice president at insurance broker Willis Group (WSH). “It’s a great comforter for certain clients, as credit issues have troubled the industry in the past.”

Because they represent new competition for reinsurance giants such as Swiss Re (SWCEF) and Munich Re (843002843002), hedge funds are sending chills through the industry establishment.

One concern is that a new infusion of capital into the market will lower prices, cutting into the earnings power of the dominant players in the business.

“It doesn’t matter whether it’s hedge funds or some other source of capital; when a new reinsurer is established there’s going to be pricing concern,” says Bob Hartwig, chief economist at the Insurance Information Institute.

Willis’s Breen says new capital that isn’t hampered by losses from old policies — what he called unencumbered capital — is welcome, as long as it doesn’t affect prices.

“So far we haven’t seen any evidence of that,” he adds

Source of capital

Even Maurice “Hank” Greenberg, the recently ousted insurance boss of American International Group, has expressed caution about the trend, while noting that hedge funds likely will become “a significant source of capital” in the reinsurance market. At an industry conference back in November, before he was ensnared in the accounting investigation that besieged his company, Greenberg also suggested that hedge funds may lack reinsurance experience.

The entrance of hedge funds into reinsurance markets recalls a period in the 1980’s and early 1990’s when another source of new capital appeared.

That money came from so-called captives, which were offshore firms set up by large U.S. corporations to help them insure some of their own risks in a more tax-efficient way, Barile says.

To maintain favorable tax treatment, captives had to reinsure the risks of other companies too.

“They wrote reinsurance business for big insurers without really knowing what they were taking on and ended up losing a lot of money,” Barile says. In the process, their money earned the moniker “naïve capital.”

Longevity

This time round, hedge funds are trying to avoid a similar fate by poaching talented executives from the reinsurance world to run their businesses.

Citadel hired Chris McKeown, a former head of Ace Ltd.’s catastrophe reinsurance business, to run its CIG Re unit, according to industry newsletter the Insurance Insider.

Glacier Re tapped Robbie Klaus, a former General Electric reinsurance executive with 18 years of underwriting experience.

Even so, some observers question how long hedge funds will stick with the reinsurance game.

“Hedge funds are known for getting in and out of markets quickly,” says Hartwig of the Insurance Information Institute. “They may sell their interests when they feel they’ve made a good enough return.”

Insurance broker Benfield says questions about the longevity of hedge funds will only be answered when a catastrophe sparks big losses in the market.

In an ambiguous conclusion, the firm adds: “Only then, of course, will the mettle of the hedge funds be truly tested.”

By Alistair Barr –

Source: Investors.com


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