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Experts eye insurers' exposure to hedge risks.

Given the increasing role hedge funds are playing in the insurance industry, high-profile problems such as the recent disclosure of Amaranth Advisors LLC's $6 billion loss on energy trades may shed light on the dangers inherent when high-risk players mix with the risk-mitigation business.

Hedge funds have come to the fore in the past two years as investors in insurance and reinsurance startups, mostly based in Bermuda, were created to fill voids in capacity left by record hurricane losses. Hedge funds also invest in catastrophe bonds and other risk-securitization instruments. They are investors in, and investments for, insurers and reinsurers.

As the Amaranth story broke, at least one reinsurer warned investors it expects losses on hedge fund investments to impact third-quarter results, without specifying the source of those losses.

Hedge funds also buy coverage, most notably financial institutions policies such as errors and omissions coverage.

Given that influence, what does a case such as Amaranth say about the insurance industry's exposure to hedge funds?

Tim Mungovan, a specialist in investment partnership litigation with Nixon Peabody LLE described what happened with Amaranth as "a circumstance of moral hazard." The Amaranth trader involved in the loss appeared to be taking "outsized risks for outsized gains" after having had a successful year in 2005, he said.

"The trader is betting other people's money on extraordinary risks in the pursuit of extraordinary gains" he said. "If the bets go well, he wins. If the bets go badly, tough for the investors."

While cautioning against overgeneralizing the Amaranth situation when looking at the rest of the hedge fund industry, Mungovan said as the market grows, hedge fund managers and traders may be tempted to take ever-greater risks in light of their track record of big returns.

"With more competition, I think by nature it requires people to reach more for yield," he said. "They are likelier to take riskier bets and to concentrate those bets more fully."

Aside from investment losses, insurers can be exposed to hedge fired problems through financial institutions coverage, a type of surety protection similar to that written for banks.

Richard Bortnick, an insurance litigation specialist with the law firm Cozen O'Connor, said that when a hedge fund implodes, insurers may be on the hook for some of the risk. "I don't think hedge funds are much different from any other financial institution in terms of insurance," Botnick said. "Underwriters have to vet the proposed insured and get to know who they're dealing with, what the company's about, what their financials look like and what's the credibility of the individuals involved."

Without the extra layer of regulatory scrutiny that other financial institutions may have, hedge funds are a tougher bet for insurance coverage, he said.

Bortnick said the hedge fund industry does need some oversight, if not by regulators, at least by investors and insurers.

One tricky aspect of hedge funds is that they generally are structured as limited partnerships, said Mungovan. An investor in a hedge fund is a limited partner--a very different arrangement from the shareholder in a mutual fund or stock.

Kevin Mattessich, who practices insurance law and commercial litigation with Cozen O'Connor, said some of the smaller hedge funds may seek liability coverage known as "registered representative" or "affiliated service provider" coverage, similar to the kind of coverage investment brokers might get.

The limited-partnership structure of hedge funds, along with their penchant for secrecy in terms of trading positions, means they shy away from such terms as "investment adviser," said Mattessich. Investment advisers generally are taken to be under the regulatory jurisdiction of the SEC.
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Author:Pilla, David
Publication:Best's Review
Date:Nov 1, 2006
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