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Hungry hedge funds: known for employing unusual and creative types of investments in their quest for profitability, hedge funds have set their sights on reinsurance.

Hedge funds--once regarded as secretive investment vehicles for the very wealthy--have entered the reinsurance business. The reinsurance companies backed by hedge funds don't necessarily operate the way traditional reinsurers do, but they do bring additional options and additional capacity to the marketplace.

Traditional reinsurers could see hedge funds as competitors or potential partners, but some wonder if hedge funds' reputation for seeking out high returns--and bailing when the returns drop--will impact the insurance industry.

New Opportunities

Originating in 1949, hedge funds are newly popular as investors seek alternatives to sagging stock market returns. Hedge funds are estimated to be a $875 billion industry, growing 20% annually, according to the Hedge Fund Association, a trade group. An estimated 8,350 hedge funds are active today, scouring the world for opportunities.

"The barriers to enter the reinsurance market are low," said Robert Hartwig, chief economist for the Insurance Information Institute.

Hedge funds have invested in insurers and reinsurers through catastrophe bonds or insurance swaps since the 1990s. Now, hedge funds are launching their own reinsurance companies.

"They've gotten comfortable in making investments with insurance companies and reinsurance over the last decade, and have gotten to the point where they are comfortable taking the risk themselves as opposed to having someone else do it fur them," said Bert Golinski, a managing director of Guy Carpenter.

The appeal is that reinsurance markets aren't related to the equity markets, so it's a way for them to reduce the volatility of their investments, said Kurt Karl, chief economist, North America, for Swiss Re.

New Faces

New hedge fund-backed reinsurers include Switzerland-based Glacier Reinsurance A.G., which was capitalized by two hedge funds--Soros Fund Management LLC and Dallas-based HBK Investments L.P. Benfield Investment Holdings Ltd., a subsidiary of Benfield Group, put up 10% of the $300 million start-up capital. The company plans to write mostly short-tail lines, including retrocessional coverage, as well as marine and aerospace reinsurance and war and terrorism business, according to A.M. Best Co. reports.

Bermuda-based reinsurer Cig Re Ltd. was established last year by Citadel Investment Group, a $10 billion Chicago-based hedge fired, with $450 million in capital, according to Guy Carpenter and Benfield Group. Ritchie Re, a Bermuda-based reinsurer registered in March, was founded by Batavia, Ill.-based Ritchie Capital Management. Both Cig Re and Ritchie Re opened their doors for business without financial strength ratings, said Golinski of Guy Carpenter's Bermuda office.

The companies are able to compete with highly rated traditional reinsurers by fully collateralizing their potential future claims, he said.

"From a counterparty credit stand point, they set up a trust fund or trust agreement, which is basically an escrow account, up to the limits of [the policy] in cash in the event of a loss," Golinski said. "It's not that much different from a traditional insurance company buying insurance from a reinsurer. I look at that as a flight to quality in that it's hard to beat wholly cob lateralized limits. In the eyes of many buyers, that's viewed as highly as a highly rated carrier."

Non-rated hedge-fired backed entities also can offer rated paper by partnering with a traditional reinsurer to act as a fronting company, Golinski said, although the hedge fund is likely to still set aside the full dollar amount of potential claims, either in an account or as a letter of credit.

"The short story on these hedge funds is all of them are interested in writing short-tail insurance/reinsurance risk. Most have the ability to write it on their own, on their own paper, but if a counterparty wants rated paper, they have relationships with rated carriers to provide the paper, then collateralize the deal with the carrier," Golinski said.

Also, hedge fired managers such as Bermuda-based Nephila Capital Ltd., formerly known as Willis Asset Management, are active in catastrophe bonds, insurance swaps and weather derivatives, which also can be alternatives to traditional reinsurance, Golinski said.

Another way hedge funds assume insurance risk is through "industry loss warranties," which are reinsurance products that provide the insurance-company buyer with coverage in the event that the industry is struck by a set loss amount. These warranties are similar to a catastrophe bond with an industry-indexed trigger, except the transaction is between the insurer and the issuer--often a hedge fund--instead of between the insurer and a host of investors who can buy the cat bonds.

"The demand for cat bonds far exceeds the supply," Karl said. "This is a competing way to get insurance risks to the capital markets."

Fresh Companies, Familiar Faces

New capital doesn't necessarily mean green staff.

Glacier Re hired Robbie Klaus, a former General Electric reinsurance executive with 18 years of underwriting experience, while Cig Re tapped Christopher McKeown, a former head of Acc Tempest Reinsurance Ltd., to be chief executive officer and the new company's first employee.

"Citadel has been interested in the reinsurance business for a number of years, and came to the conclusion that investing in a reinsurance company managed by reinsurance veterans and professionals was the appropriate way to write reinsurance in the current marketplace," said McKeown.

McKeown said the company has been well-received in the marketplace, in part because of its unique way of doing business.

"If we wrote a limit of $10 million, we would put $10 million into a trust account, or provide a collateralized letter of credit to the counterparty. That's a superior product to what's typically available in the reinsurance marketplace," McKeown said.

He said the company is interested in writing short-tail property and casualty catastrophe business, including aviation, and catastrophe workers' compensation (for earthquakes and terrorism). The company has grown to six employees.

"We bring such a different product and approach to clients, I'm not sure there's any real direct competition or a direct comparison to another reinsurance entity out there," McKeown said.

Unique Perspective

Unlike more traditional insurers, hedge-fund reinsurance start-ups also can differ in how they staff operations, including using consultants instead of full-time employees, said Andrew Barile, an insurance consultant based in Rancho Santa Fe, Calif.

Hedge funds may have another advantage in being new: not worrying about competition the same way an established company might. "In America, reinsurers say 'we don't write so-and-so's retrocessional coverage because it just gives them more capacity to take our clients away from us Ion the reinsurance or primary side]'. A hedge fund manager doesn't think that way," Barile said.

This fresh capital entering the insurance market is unencumbered by past losses, such as asbestos, Hartwig said.

Here Today, Gone Tomorrow?

Hedge funds have a reputation for being opportunist and looking to make a quick profit, compared with an insurance company that is capitalized through an initial public offering or a private equity placement, possibly giving it a longer time horizon.

Given the historic cycles of the insurance market, some industry observers worry that when, not if, the insurance business becomes unprofitable, hedge-fired backed companies will close up shop.

"Hedge funds' commitment is exactly equal to the period they expect to make money in. Then they'd look to sell off their business or sell their investment in the company," Hartwig said.

McKeown of Cig Re said he's often been asked about the company's hedge fired roots, and what that will mean for the future of Cig Re.

"It's important to remember that Citadel as a company has been around since 1990, and does predate a number of reinsurance companies," McKeown said. "It's a successful company, and they wouldn't have made the decision to invest in a reinsurance company if they hadn't seen some long-term value."

"If an insurance company blows up, can you count on the owners putting more money into it? Munich Re has recapitalized American Re several times. Would a hedge fund do that? Maybe not if the long-term returns on the new money are unacceptable," said Rob Bredahl, executive vice president of Benfield Group's Financial Solutions Group. "But are hedge funds less disciplined than other insurance company owners? I don't think so. If anything, they are more disciplined risk takers."

Indeed, McKeown said Cig Rc was being "very selective" about what risks it would take. "We attract a different type of client, we have a different pricing discussion, we are very selective in our risks. We spend a lot of time talking to a lot of people, but at the end of the day, the material discussions have been with just a few carriers around the world," McKeown said.

What regulators should concentrate on, Hartwig said, is whether the insurers are adequately capitalized. "They can't discriminate on where the money comes from, whether it's through equity, private placement or hedge fund investors," he said.

Still, savvy reinsurance buyers would be wise to pay as much attention to the hedge fund backing a reinsurer as they do the reinsurer itself, Barile said.

"In the same way you used to monitor the parent company of a captive, you better have a good sophisticated buying team that is monitoring the hedge fund," Barile said.

Some say it's irrelevant whether insurers backed by hedge funds become long-term players in the market. Even if primary insurers have looked to form a long-term relationship with reinsurers, some traditional reinsurers haven't kept up their end of that commitment, said Bredahl of Benfield. "When rates drop to unacceptable levels or claims rise, they don't renew treaties," Bredahl said. "The more disciplined risk takers aren't much different from hedge funds."

Secondly, potential buyers of insurance and reinsurance could argue that if more capacity and more options drive pricing down, it's a good thing, even if it doesn't last.

"From a broker standpoint, we're always happy to see additional capital coming into the marketplace to allow our clients to get a better deal," said Guy Carpenter's Golinski. "Our biggest question is from a claims standpoint. But handing out [letters of credit] and trust agreements helps protect our clients."

If this new capacity evaporates quickly, bringing market instability, "most main line reinsurers will tell you that's a bad thing," Hartwig said. Yet the established reinsurance companies have seen competition come in and out of the market for years.

Those established players "can be concerned that new capital is taking business away from them, but they will do what they always do: let some clients go," Barile said.

On the Horizon

It's difficult to say just how much reinsurance capacity stems from hedge fund capital, but Bredahl said it's a "meaningful" amount, and likely to grow.

Barile suggested that the new hedge fund insurers might be interested in writing finite reinsurance. "They are paying attention to what the new guidelines are, and what the playing field has already done. That's one advantage when you start new," he said.

Hedge funds "are not going to be fully satisfied playing just in reinsurance. I expect them to get into certain insurance lines," Bredahl said. "They will probably start as equity investors. But they will demand good returns.

This fresh blood may even help dampen the legendary swings of the insurance pricing cycles, Bredahl said.

"If the trend is toward more disciplined risk takers and investors, that should mean the cycles are shallower. From what I see, this is the case," Bredahl said.
Growth in Hedge Funds

 # of Hedge Funds Assets in Billions

1995 2,080 $76
1997 3,000 $130
1999 3,500 $221
2001 4,800 $408
2003 5,700 $592
2005 8,050 $934

Source: Hennessee Group LLC

Note: Table made from line graph.

SUNNY OUTLOOK: Hedge funds, known for seeking out profitable areas in which to grow, are sprouting up in the field of reinsurance, said Bert Golinski, managing director of Guy Carpenter's Bermuda office.

Key Points

* Hedge funds are estimated to be a $875 billion industry, growing at about a 20% annual rate.

* Hedge funds have been active in investing in insurance-linked securities for the past decade.

* At least three hedge funds have backed the creation of new reinsurers in the past year.

Hedge Fund Basics

Hedge fund is not a legal term, although it is often used to refer to an investment pool for high net-worth clients that is operated as a partnership and not registered with the Securities and Exchange Commission. The manager of the hedge fund is responsible for investing the pooled assets, with investors and the fund's managers sharing in the profit and loss of the investments. The definition of hedge fund, however, is changing.

"Hedging" refers to the practice of buying or selling a security to offset the potential loss of an investment.

Traditionally, hedge funds have been exempt from SEC regulations if they limited the number of investors to fewer than 100, and those investors had assets of at least $1.5 million. But with poor returns from the stock market in recent years, demand for hedge funds as an alternative investment has skyrocketed.

The SEC recently ruled that most hedge funds will have to register beginning next year, subjecting them to new regulation. Many already have voluntarily registered with the SEC so that regulated entities, such as pension funds, could invest in them more easily.

Once geared toward highly sophisticated and wealthy investors, some hedge funds have reduced their investment requirements to $150,000 or less, making them available to more investors.

Hedge funds and those that run them typically are reluctant to talk about their investments, and are banned from advertising for investors. One reason that hedge funds are fond of secrecy is that they look to take advantage of imperfections in the marketplace. "If their actions become known, others will copy them, and they won't have the same opportunities they once had," said Rob Bredahl, executive vice president of Benfield Group's Financial Solutions Group.

For instance, one famous hedge fund, Long Term Capital, came to the brink of failure when Russia defaulted on its debt in 1998. As the fund worked to unwind its investments, copy-cat investors who had followed the same strategy worked to unwind their investments as well, and prices on underlying investments crashed. The Federal Reserve stepped in and organized a bail-out of the fund.

Unlike mutual funds, there's no limit to what rewards hedge funds can give their management staffs, whose compensation is typically based on a percentage of the pool they manage in additional to a healthy percentage of the profits from the pool's investments.

Hedge funds have historically borrowed money to increase their returns. Today, hedge funds are not nearly as leveraged due to their increased size and attractiveness of investment opportunities, said Bredahl.

Investment Techniques

HEDGE FUNDS--a nickname for a sophisticated pool for wealthy investors that has traditionally offset potential future losses by buying or selling securities in other areas. Hedge funds often use the following complex investment techniques:

DERIVATIVE--a type of financial instrument, including futures and options, that's priced according to underlying securities, commodities or indices.

FUTURES--an agreement to buy or sell securities or commodities at a set price at a set time in the future.

OPTIONS--an agreement that gives an investor a right, but not an obligation, to call (buy) or put (sell) a certain number of shares of a specific stock or commodity at a set price for a limited time.

SHORT-SELLING--borrowing a certain amount of stock at a price you believe is too high. When the stock's price falls, you can repay the loan with the cheaper stock, and earn a profit.

ARBITRAGE--the act of buying and selling a security in different markets at the same time, hoping to make a profit from the difference in prices.

LEVERAGING--borrowing money for investing. Also called buying on margin.

Learn More

Glacier Reinsurance AG A.M. Best Company # 77461 Distribution: Brokers

Swiss Re Group A.M. Best Company # 85010 Distribution: Reinsurance brokers

For ratings and other financial strength information about these companies, visit
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Title Annotation:Reinsurance/Capital Markets
Author:Green, Meg
Publication:Best's Review
Date:Jul 1, 2005
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