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Hedge funds' involvement in industry likely to continue

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Hedge funds' involvement in the reinsurance industry is likely to wax and wane depending upon the investment opportunities presented by the market, say observers.

But even if potentially highly lucrative investment opportunities disappear with a softening market, hedge funds are likely to maintain some involvement in the industry as they seek to take advantage of the expertise they have already acquired, some experts say.

The relationship between hedge funds and reinsurers is often seen as mutually beneficial: Reinsurers get much-needed capital, including retrocessional capacity, whether in the form of sidecars, catastrophe bonds or equity from the hedge funds. And the hedge funds for their part diversify their investments and get returns on investments that are uncorrelated with their other stock, bond or currency market investments.

Hedge funds' involvement has helped the market, say observers. "Through sidecars and other temporary capital vehicles, our clients are able to secure more capacity" than they would have otherwise, said Paul Schultz, president of Chicago-based Aon Capital Markets.

Before hedge funds' involvement in the industry, it was almost impossible to obtain a cat bond below an 80- or 90-year frequency-of-loss expectation, "which meant that cat bonds were an extreme catastrophe product," said Chris O'Kane, London-based chief executive officer of Aspen Insurance Holdings Ltd., whose company has hedge fund backing.

Today, though, it is possible to buy a cat bond for a one in 50-year event. This has made cat bonds "a more vibrant, more useful market, which I think is a useful adjunct to the cat capacity," said Mr. O'Kane.

Both insurers and reinsurers are increasingly "going down to lower risk layers, or riskier tranches," said Judy Klugman, managing director and head of distribution at Swiss Re Capital Markets in New York.

"Those types of securities are being purchased by hedge funds because it's similar to a natural fit for them in terms of a diversification to their general business, and it has a return profile that's very attractive" compared with other opportunities, said Ms. Klugman.

"We think there's a fairly good match between the current hard market for catastrophe risks and the investors who are taking advantage of that market," said Bruce Ballentine, vp and senior credit officer at Moody's Investors Service in New York. "The hard market may be relatively short-lived, and the investors are providing capacity through vehicles that are meant to be short-lived—sidecars and cat bonds—so it's a short to medium response, probably, to a short- to medium-term opportunity."

Investors make a commitment, whether it be through a sidecar or a cat bond, through a certain date, "so both parties can watch the market develop, watch the business develop and plan for an orderly exit or, if both parties see a continuing opportunity, they can negotiate it, and perhaps extend or supplement the transaction," Mr. Ballentine said.

The capital market's capacity "is more flexible to come and go than a traditional reinsurer would be," he said. "It's hard for a traditional company to shut down or retrench dramatically as an opportunity fades."

Cat bonds and sidecars are "a form of capital that comes in in the hard market and leaves in a soft market," said Steven K. Bolland, president of reinsurance intermediary Gill & Roeser Inc. in New York. "The problem in the industry has always been overcapitalization in a soft market," which pushes prices down.

Hedge funds' involvement means "that probably we will not see the high peaks and the low troughs that you've seen in the cycle in the past, because capital is exiting the business very rapidly," said Mr. Bolland.

Many observers say hedge funds will be increasingly involved in the industry, at least in the short-term.

Given how attractive the returns were for investors this year, "I think there'll be an appetite for investors to continue to participate in this sector, and so I anticipate we'll see an increased flow of capital supporting insurance risks," said David Priebe, CEO-Europe for New York-based reinsurance intermediary Guy Carpenter & Co., a unit of Marsh Inc.

Investors that entered the market in the past year have "done very well, and they probably will want to continue to do this class of business for the coming year," while their success will attract more new entrants, said Morton N. Lane, president of Wilmette, Ill.-based Lane Financial L.L.C., an independent reinsurance consultant.

But some believe hedge funds' involvement in the industry may have already peaked.

There are two ways to look at it, said Steve McElhiney, president of Dallas-based EWI Inc., a reinsurance intermediary: Will more capital come in and seek the phenomenal returns hedge funds have earned so far, "which is an aberration" or "will firms move onto other opportunities?" Mr. McElhiney said he believes the latter will be the case.

Others also say they believe hedge funds are not in the market for the long haul.

"I think as companies rebuild their balance sheets somewhat, and as people's memories of '05 and the '05 hurricanes decline and there is more pressure on premium rates," hedge funds will find the reinsurance sector less attractive, said Mark Rouck, senior director at Fitch Ratings in Chicago. "I think from a hedge fund perspective, it all comes down to a risk-return relationship, and I wouldn't see them as necessarily long-term investors."

John Wicher, principal of John Wicher & Associates in San Francisco, said, "When the hedge fund pricing models turn upside down, they're going to be gone. That's just the way the capital markets work."

Observers point out that hedge funds have had few losses thus far.

Robert DeRose, assistant vp at Oldwick, N.J.-based A.M. Best Co. Inc., said that although the relatively inactive 2006 hurricane season has enabled hedge funds to make a lot of money, an earthquake "could happen at any time, and it'll be interesting to see, if there is a loss, how they react to that scenario. Time will tell."

The hedge funds can meet their obligations in terms of financing claims payments, said Pierre Ozendo, Armonk, N.Y.-based CEO of Swiss Reinsurance Corp.'s Americas division. "The question is, how many times will that happen, and are they committed to the marketplace? I don't think so," said Mr. Ozendo. "I don't see them having any longstanding impact on the need to mitigate exposure over the long haul."

But others say they believe hedge funds are in the reinsurance market to stay—at least to some degree.

Hedge funds "will want to keep their toe in the water in case other opportunities arise," said Mr. Lane. The relationship has "worked out well this time, and it may be needed again. I think once a relationship is established, it becomes a part of the menu of alternatives that management will consider," he said.

Christopher McGhee, managing director at MMC Securities Corp. in New York, an affiliate of reinsurance intermediary Guy Carpenter & Co. Inc., said it should be kept in mind that when hedge funds have "invested time and energy into understanding an asset class, there is some inertia about maintaining a presence in that class. You've learned about it, and you've studied it." As a result, "I think it's unlikely there would be a complete removal from the marketplace."

Instead, Mr. McGhee said he expects hedge funds' involvement "to ebb and flow with the perceived opportunities, which is not necessarily a bad thing, because we know capital in the business has not always moved in and out as efficiently as possible to meet market conditions."