WHERE THERE ARE healthy returns to be made, there will be a hedge fund manager lurking nearby, and the insurance industry has been no exception. With hedge funds predominantly playing the insurance-linked securities area of catastrophe bonds, hurricanes Katrina, Rita and Wilma (KRW) in 2005 sparked a new means of gaining exposure to the insurance market for managers. Desperate for capital to meet losses, reinsurers were forced to turn to hedge funds to make up the shortfall, and the door to participating directly in the insurance market was opened. Almost half of the $12 billion in capital raised towards meeting the KRW losses is estimated to have come from hedge funds.
The significant returns on offer encouraged hedge fund managers not only to take direct exposure to insurance through joint ventures with reinsurers in sidecars but, in some cases, to go as far as setting up their own separate reinsurance businesses.
But two years on, with no big natural catastrophes having occurred, the majority of hedge funds that diversified into reinsurance are bored. Property catastrophe reinsurance renewal rates in the US fell by as much as 20% over 2007 in some areas. And with the man-made catastrophe of sub-prime taking centre stage now, hedge fund managers have more pressing concerns and, in some cases, better investment opportunities elsewhere.
Those that set up permanent roots in reinsurance, however, are convinced that reinsurance is a legitimate long-term opportunity.
Farewell to sidecars
The sidecar phenomenon boomed with the substantial capital shortfall that reinsurers faced after KRW. According to Standard & Poor’s, specialized property catastrophe players lost between 40% and 100% of their June 2005 capital base, and the equivalent of many years’ earnings. Not only were the reinsurers facing record claims, the ratings agencies increased the capital requirements to underwrite property catastrophe risk. The reinsurers needed extra capital – and fast.
Sidecars, or limited-life vehicles as they are also called, were set up to allow hedge funds and other investors to quickly deploy capital to the reinsurers. The investors typically put 100% of the capital that covers a percentage of the reinsurer’s catastrophe risk into the sidecar from which the reinsurer can draw down. In return, the investor receives a percentage of the premiums paid in. Returns were attractive. During 2006, sidecar investment returns averaged between 20% and 30%.
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Sidecar appeal lessens |
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Amount raised in sidecars issued per year |
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Source: Morgan Stanley, MMC, Benfield |
In 2005 and 2006, 17 sidecars were established. Together, they raised almost $5 billion in capital, providing 17% of the total capital raised after the KRW season – more than that provided by catastrophe bond and insurance-linked securities. They were invaluable rapid-response reinsurance providers, and have helped smooth the volatile property catastrophe market. "Sidecars were an important source of temporary capital for the insurance and reinsurance industry, and for hedge fund managers made good sense," says Aditya Dutt, executive director at Morgan Stanley in New York. "Hedge funds assume the role of an LP, some more active than others, and are willing to buy illiquid securities." Sidecars typically have a limited life of one to three years.
Since 2006, however, with no big natural catastrophes, reinsurer need for sidecars has diminished and, consequently, so have the returns that they would offer to investors. About $1.1 billion was invested in sidecars in 2007, and less still is predicted to be raised in 2008. Until a big natural catastrophe once again puts pressure on the insurance industry, the return of sidecars with such vigour as seen in 2006 is unlikely.
Some hedge fund managers, however, consider that sidecars merely served a short-term purpose, and were cleared at market levels favouring the issuer. "There is no doubt that sidecars are great for reinsurers," says Barney Schauble, partner at Bermuda-based Nephila Capital, "and for hedge fund managers, sidecars can provide swift insurance exposure to a broad portfolio when it is most profitable. But they are a costly way of accessing insurance risk." Essentially, sidecar sponsors are playing hedge fund managers at their own game, charging investors a high embedded management fee and a performance fee for what was essentially an index product.
Many of the sidecars that were established offered access to the entire property catastrophe portfolio of the reinsurer. Schauble is not sure that this generated the best value for hedge fund managers. "Investors put their money with hedge funds and expect them to manage that money and make the decisions. But investing that money into a sidecar where the reinsurer is choosing the risk is tantamount to a fund of funds. If you truly understand the risk, then be selective."
Nephila Capital manages investor vehicles that write direct reinsurance in a trust structure covering individual reinsurers and insurers, as well as investing in the more common insurance-linked securities.
Niche sidecars that focus on specific areas are a more likely evolution from the bulk of KRW sidecars of 2006. Brenton Slade, at reinsurer Flagstone Re, says several sidecars offered by his firm have recently been renewed. "As long as there are opportunities in certain niche lines of business or regions, there will be continued interest from some hedge fund managers," he says.
Flagstone Re started life as a hedge fund. Mark Byrne was running fixed-income hedge fund West End Capital in Bermuda in 2004. The firm had been set up to run capital from Warren Buffett and the Byrne family in 1998 and, having opened up to outside investors in 2003, was managing more than $1 billion in high-grade fixed-income arbitrage. One year on, though, opportunities were declining.
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Reinsurance opportunity been and gone? |
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US property catastrophe renewal rates |
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Source: Benfield Group |
"Yield curves were flattening, volatility had exited, and what was a double-digit business in 1998 had diminished to Libor plus a few basis points," says Slade. The fund had dabbled in reinsurance. "We’d done a number of reinsurance transactions with our own private capital, and owned parts of a handful of private reinsurers," says Slade. It was unsurprising given Mark Byrne’s background. Byrne’s father, Jack, is founder of White Mountains Insurance Group, and is credited with single-handedly turning around insurance company Geico during his period as chief executive at the firm.