Hedge funds are all over the news these days, but you may not be aware of the role they play in the insurance and reinsurance businesses. Privately owned investment companies, hedge funds focus on generating "absolute returns" (those greater than zero) from any market environment. With the dual goal of increasing returns while at the same time reducing the volatility of their portfolios, they invest in a variety of asset classes and can use investment strategies that are not open to other funds, including borrowing money, selling short and using options.

Why Hedge Fund Insurance?

Hedge funds have been involved in insurance, most notably in purchasing reinsurance catastrophe bonds (cat bonds), since the 1990s. Investing in insurance is attractive to these funds because the returns are unaffected by other investment market movements and it diversifies their portfolios. Following the substantial losses from the 2005 hurricane season, and the subsequent capacity shortage and rates increase, hedge funds seized the opportunity to invest in the industry, helping to provide new coverage at a time of reduced capacity.

"The supply-demand imbalance created by the 2005 hurricane season provided hedge funds with the opportunity to invest in insurance when rates were among the highest in history," says Charles McGill, director in Aon Capital Markets.

The funds’ involvement in insurance has taken a number of forms, including investing in and forming their own insurance and reinsurance companies, participating in reinsurance "sidecars" (financial structures created to allow investors to take on the risk and return of a reinsurer’s book of business) and purchasing cat bonds. This capital was essential in providing much needed capacity after heavy losses forced many insurers and reinsurers to leave the market.

"Hedge funds have played a positive role in helping to expand the market post-Katrina," says Krish Kistnassamy, lead actuary with Aon Reinsurance (UK). "Without their investment, we would not have been able to place certain risks for our clients, particularly U.S. wind."

What's next for Hedge Fund Investments?

Hedge funds are often thought of as short-term-focused investments that leave when a market imbalance has been restored. After the benign hurricane season in 2006 some analysts have predicted that hedge funds may begin to move their capital out of sidecars. Compounding that belief, in January 2007, the state of Florida passed new insurance legislation that expanded the Florida Hurricane Catastrophe Fund, which allows insurers to purchase less expensive reinsurance. This state-funded reinsurance freed up approximately USD$25 billion in capital, about 10 percent of total capacity. Consequently, analysts have predicted that the property-catastrophe reinsurance market could lose up to USD$2 billion in premium and a quarter of its profits.

"The legislation will have worldwide consequences, as Florida is the peak risk zone for worldwide reinsurance, so it will have a softening effect on prices around the world," says Bryon Ehrhart, president of Aon Re Services. "As a result there will be a significant exit of hedge fund capital from the market during 2007, particularly that invested in sidecars."

Despite this reduction in capital, hedge funds are likely to remain in the sector due to the diversification it offers them, reduced portfolio volatility and potential for yielding significant returns. "Hedge fund capital is dynamic and can come in and out quickly, so it can be there when capacity is short," Aon's Kistnassamy says. "It should help to dampen the cycle and make it less pronounced, but time will tell if the industry repeats the mistakes of the past."

Hedge Funds: Sparking Innovation in Capital Markets

Due to this stabilizing effect, insurance industry leaders believe hedge funds could ultimately prove a catalyst for innovation across the industry. Paul Schultz, president of Aon Capital Markets, believes hedge funds are an important alternative to traditional carriers. "This new capacity option in the capital markets offers our clients a different risk distribution strategy, and we worked with them after the hurricanes to understand and access all the forms of capital available to them," he says.