New capital flow slows: the softening property catastrophe market is likely to stem the tide of fresh capital flowing into the industry, which could be a boon for the market.

The stream of cash from hedge funds and private equity flowing into the reinsurance market could diminish somewhat in 2007, in light of softening property catastrophe market conditions.

However, extra capital leaving the market will help stabilize pricing and should be seen as the natural outcome of a healthy market.

"The reinsurance market is a much more effective and self-executing and self-regulating market than people give it credit for. It has a way of seeking what it needs and kicking the rest to the curb," said David Attisani, head of the insurance/reinsurance group at Choate, Hall & Stewart, LIE, in Boston.

Hedge funds and private equity streamed into the reinsurance market after the heavy catastrophe years of 2004 and 2005, seeking to gain rich profits from the hardening property catastrophe market.

They invested through different vehicles--catastrophe bonds, industry loss warranties and sidecars--and some profited quite handsomely in 2006, a mild catastrophe year. With shifting demand for property catastrophe coverage, in light of recent changes to the Florida catastrophe fund, among other factors, do not expect to see fresh capital entering the insurance/reinsurance market at the same pace of the past few years.

However, others say that the capital markets' appetite for insurance overall will not wane.

The Boom

According to Guy Carpenter, 2006 was another record year for catastrophe bonds, one form of insurance-linked securities popular with hedge funds and other investors. Following in the wake of record storm years 2004 and 2005, there were $4.69 billion of new cat bond transactions in 2006, which shattered the 2005 record of $1.99 billion.

Reinsurance broker Collins estimated industry loss warranties-which offer reinsurance based on an industry wide loss or trigger in addition to the buyer's loss--grew by about 35% last year.

Sidecars, a special purpose vehicle funded by investors including hedge funds and private equity to provide additional capacity to existing reinsurers and insurers, saw $3 billion in growth in Bermuda through equity and loan capital in 2006, according to Benfield.

"The rise of industry loss warranties, sidecars and cat bonds marked 2006 and was a response to the 2005 catastrophes" said Attisani. "We needed capacity at least in the narrow corridor of retrocessional and property catastrophe classes. The reason we needed it was we really had a 1-in-100-year record loss in 2005."

This isn't a new concept, Attisani said. "These funds have been looking at reinsurance for years. Their prevalence was dramatically increased in 2006, a result of this great need for capacity on this side of the reinsurance world."

Attisani said hedge funds were attempting to capitalize on premiums that increased by as much as 100% in some areas, while diversifying their portfolios and doing better than they could in most corners of the stock market.

"Sidecars allowed them to enter the game in a knowledgeable way without pretending to he underwriters," Attisani said.

The Flow Slows

Capital coming into the Bermuda reinsurance market has slowed, Morgan Stanley wrote in a February report. "Conversations with many on the island provided anecdotal evidence that the pipeline of incoming capital has slowed post the Florida legislative changes. We suspect some sidecar deals have been scuttled, and plans less fully developed may now be on ice:' the report said.

Florida enacted legislation in early January to expand the Florida Hurricane Catastrophe Fund. It's estimated the expansion of the state fund, which will offer cheaper reinsurance coverage to property writers, is akin to the entry of a $38 billion-capitalized reinsurer to the state, according to Willis Group. Up to $2 billion in reinsurance premiums to the private market are expected to be lost.

To put it another way, about $55 billion in property cat reinsurance limits were purchased in 2006. The Florida pool has been expanded to $12 billion, and could be expanded by another $4 billion (see Florida story on page 74).

"That's 20% of the total market buy that's been taken out of the private market," said Rob Bredahl, president of Benfield, a reinsurance broker. "And it's not just any old cat limit; it's the peak exposure in the world, the exposure that pays the highest."

This has impacted the entire reinsurance market, as property catastrophe writers find an excess of capacity where weeks ago there was a shortage. "All the capacity problems we had last year have miraculously gone away," Bredahl said.

Which means the profitable conditions that drew hedge funds and private equity have diminished.

"As prices come down and capacity increases, the need for capital market solutions has dropped a bit. I wouldn't expect to see so many sidecars this year, for instance," Bredahl said.

Those investors will look to other areas to invest in, which isn't a bad thing, Attisani said.

"It's not reasonable to assume that professional investors will stay in this market forever. They are professional investors, not professional reinsurers" Attisani said. "That doesn't cause me to conclude that they are evil. They are serving a need and found vehicles in which to do it. Nimble is a benefit on the front end, and it also means they will have an exit strategy."

Some sidecars may not renew their facilities as capacity intended for the Florida market flows elsewhere, Benfield wrote in the Ben field Bermuda Quarterly in March. "The future of sidecars will be watched closely as market conditions become more challenging," Benfield said.

One way investors such as hedge funds and private equity can recoup their investments is through an initial public offering. Three recent Bermuda start-ups announced IPOs at the end of 2006 or early 2007, including Flagstone Reinsurance Ltd., CastlePoint Holdings Ltd., and Validus Holdings Ltd.

"Hedge funds and other capital market investors look at insurance risk as an asset class, like commodities or equities. They might downsize, but they won't completely drop out," Bredahl said.

But it's good for the market that sidecars can fade away when they're no longer needed, he said.

"What is good about sidecars is that they are serf-liquidating. If the market no longer needs extra capital, they just go away," Bredahl said.

It's also interesting to note that not all sidecars were designed to carry property catastrophe risk.

Validus Re formed Petrel Re to take some of its energy and marine business. Lancashire Holdings sponsored Sirocco Re to take some Gulf of Mexico offshore energy risk. And American international Group's Lexington Insurance Co. sponsored Concord Re to reinsure a portion of Lexington's U.S. commercial property insurance business, rather than reinsurance risks as has been the case with other sidecars, Benfield said.

Pierre L. Ozendo, a member of Swiss Re's executive board, said he didn't expect to see a slowdown in capital market investments in the insurance industry.

"Capital markets is a very secure, broad base of capital. If anything, the attraction will continue to increase, not only in cat bonds, but increase in more and diverse pools of risks," Ozendo said, noting half of the insurance-linked bonds issued last year were in the life sector.

"There's going to be an increasing access to what is becoming bigger, more fluid and more sophisticated capital," Ozendo said.

Bob Deutsch, chief executive officer of Ironshore, a property/casualty insurer launched in January with $1 billion through private placement of its equity securities, said private equity's interest in the insurance industry is broader than the property catastrophe business.

"There doesn't seem to be a lack of private equity money to support the industry," Deutsch said.

The Future

The next time the property catastrophe market hardens, these investors will come back, Bredahl said.

The business that hedge funds invested in was very profitable, he said, noting one deal brought returns greater than 50% for carrying wind exposure for six months.

"They'll be ready to come back into the market pretty quickly," Bredahl said.

Vibhu Sharma, chief financial officer of reinsurance broker Collins, agreed.

"There was a demand [for new capacity], and hedge funds and private equity seized that demand. It was a short-term play. They said, 'when we don't need it anymore, let's pull out.' It's a good example of how the capital markets were able to move in quickly. When there's not a need, they will redeploy money into other lines of business? Sharma said.

Key Points

* Hedge funds and private equities have invested in the insurance industry at record levels, but the pace is expected to slow this year as the property catastrophe market softens.

* Many of those that invested in the market in 2006 profited handsomely.

* Many of the investments were short term in nature, designed to fade away when the capacity was no longer needed.

STRONGER MARKET: Excess capital leaving the reinsurance market is a sign of how healthy and effective the market is, said David Attisani, head of the insurance/reinsurance group for Choate, Hall & Stewart. The reinsurance market "has a way of seeking what it needs and kicking the rest to the curb," he said.

Terms to Know

* Private equities and hedge funds are both private pools of capital that invest in securities and are not subject to the same regulatory scrutiny of public companies or mutual funds.

* Private equities are equity securities of unlisted companies. Private equities are generally illiquid and thought of as long-term investments, such as start-up companies.

* Hedge funds are a type of private equity fund that traditionally offset potential future losses by buying or selling securities in other areas. Most hedge funds invest in liquid assets and permit investors to enter or leave the fund easily. Investors must be highly-sophisticated, such as institutional investors.

Sidecars

For the periods fourth-quarter 2005 and full-year 2006 *
($ Millions)

Sidecars        Formed   Sponsor            Initial Capital

Flatiron Re     Dec-05   Arch Reinsurance           $943.0
Blue Ocean      Oct-05   Montpelier Re                300.0
Cyrus Re        Nov-05   XL Capital                   525.0
Olympus II      Dec-05   White Mountains              156.0
Bay Point Re    Jun-06   Harbor Point                 250.0
Timicuan (1)    May-01   Renaissance Re                49.5
Petrel          May-06   Validus                      200.0
Starbound Re    May-06   Renaissance Re               315.0
Helicon Re      Dec-05   Folksamerica                 145.0
Monte Fort      May-06   Flagstone Re                  60.0
Sirocco Re      May-06   Lancashire                    95.0
Concord Re      Aug-06   AIG                          730.0
Stoneheath Re   Dec-06   XL Capital                   350.0

* As of Dec. 13, 2006.

(1) Timicuan was dormant from 2003 through May 2006, when it was
recapitalized as a sidecar.

Source: A. M. Best Co.