Hedge funds' interest in reinsurance roils markets

(updated with correction)

A small increase in allocations from institutional investors — mostly through hedge funds — is playing havoc with the property-catastrophe reinsurance markets.

“Fifteen years ago, the catastrophic reinsurance market was close to 100% dominated by traditional reinsurance companies, like Berkshire Hathaway Inc.,” said John Lummis, CEO of AQR Re Ltd., Hamilton, Bermuda. AQR Re is the reinsurance affiliate of alternative investment manager AQR Capital Management LLC, Greenwich, Conn.

“The reinsurance business definitely is evolving under the influence of significant assets coming from the institutional investment market. The changes are on the margins now,” Mr. Lummis said, but likely will become more significant as institutional dollars suck up the industry's limited capacity.

Assets invested in reinsurance by non-industry investors rose 800% to $45 billion as of June 30 — from just $5 billion in 2005, according to an estimate in an Aug. 7 report by Goldman Sachs Group Inc.'s global investment research unit.

Much of the growth has been from pension funds, endowments, foundations and sovereign wealth funds via hedge funds, industry observers say.

If pension funds — with an estimated $20 trillion of aggregate assets — allocated just 0.5% of their assets to P-CAT investments, the resulting $100 billion would be more than double the existing amount of alternative capital in the reinsurance industry, the Goldman Sachs report noted.

“The total amount of pension fund assets … dwarfs the size of the whole reinsurance industry. Even a small fraction of those trillions would completely swamp the reinsurance industry,” said Michael Luft, managing director and consultant, insurance-linked securities, at investment consultant Rocaton Investment Advisors LLC, Norwalk, Conn.

Reinsurers already have seen significant decreases in the premium prices they can charge insurers, Mr. Luft said, because there is so much outside capital coming into the industry.

Sources said the supply-demand relationship in the reinsurance business has been disrupted, probably not for the better, at least for reinsurers.

“Is the new money changing the dynamics of reinsurance? Does reinsurance still make sense for institutional investors? The jury is still out about insurance-linked securities and the amount of capacity that's really there,” said Ryan Bisch, principal, leader of the alternatives boutique for Canada and global director of exotic alternatives research, Mercer Investments. Mr. Bisch is based in Toronto.

That increased demand for insurance-linked securities is putting pressure on traditional reinsurers, leading them and their intermediaries to develop new investment structures with greater appeal to institutional investors and the hedge fund managers that largely invest on their behalf.

Unlike the insurance claims-driven upswing in the catastrophe bond market following Hurricane Katrina, market dynamics are now being driven by investor demand from a variety of new sources, most notably institutional investors and traditional money managers.

“Everything is changing in the ILS market from the size of deals to the players involved,” said Tim Faries, a partner in the insurance group at Appleby Global Group Services Ltd., a Hamilton, Bermuda-based financial services firm that advises insurance companies on setting up single-purpose reinsurance companies in Bermuda.

“Historically, our market was dominated by single-strategy hedge funds. They have been extremely successful and still make up a big percentage of our market, but that is beginning to shift as more generalist money managers take an interest,” noted Judith E. Klugman, head of ILS distribution and sales for Swiss Re Capital Markets Corp., New York.

“What we've seen is that pension funds have largely been behind the capital that has continued to flow in,” said Paul Schultz, CEO, Aon Benfield Securities, who is based in Chicago.

A few large, sophisticated institutions have invested in the reinsurance area for some years, including the C$129.5 billion (US$125.9 billion) Ontario Teachers' Pension Plan, Toronto. But most of the growth from pension funds and endowments — especially in the U.S. — has come only recently.

Institutional investors have become increasingly enamored of ILS strategies because in a low-interest rate environment, their returns tend to range between 7% and 8%, topping the ho-hum returns of traditional fixed-income securities. Plus, they are uncorrelated with financial markets.

While catastrophe bonds remain the largest reinsurance-related investment area for institutions and hedge funds, many observers expect to see investments in industry-loss warrants and sidecars to increase. (ILW contracts are reinsurance agreements that protect against a specified level of insurance industry losses in a defined region. Reinsurers set up sidecar financial vehicles following a disaster in order to raise capital from external investors to increase their own risk-bearing capacity.)

These vehicles have a short-term investment horizon and typically are kept small in order to remain nimble in exploiting the fleeting opportunity — typically between two weeks and four weeks — following a disaster. The concept of moving quickly to take advantage of unique investment situations is familiar to many institutions that regularly co-invest in similar kinds of deals with credit, private equity and hedge fund managers.

Increased transparency and education, as well as structural changes in the securities, have increased investor and issuer comfort with insurance-linked securities, said sources.

For example, catastrophe bonds increasingly are employing indemnity triggers, which are based on the losses suffered by the bond issuer. These have gained popularity at the expense of both parametric triggers — which rely on measures such as wind speed experienced during a storm to trigger the bond — and indexed triggers, which are based on an industrywide index of losses, Swiss Re's Ms. Klugman said.

“What we are finding is that as our investors have become more sophisticated, there is a greater acceptance of indemnity triggers,” she said.

The most recent institutional investments in insurance-linked securities include the NZ$23 billion (US$18 billion) New Zealand Superannuation Fund, Auckland, which committed up to NZ$275 million in Leadenhall Capital Partners LLP's P-CAT hedge fund. In 2010, the fund invested NZ$250 million in Elementum Advisors LLC's specialist catastrophe reinsurance hedge fund.

The $13.2 billion West Virginia Investment Board, Charleston, invested $40 million in Elementum's fund.

Other investors are getting reinsurance exposure through hedge funds of funds or multiasset alternative investment strategies.

The Oregon Investment Council, Tigard, which runs the $63 billion Oregon Public Employees Retirement Fund, Salem, invested $250 million in hedge funds-of-funds manager Blackstone Alternative Asset Management's Tactical Opportunities Fund, which includes a reinsurance allocation.

Aside from the New Zealand fund's outsized NZ$525 million investment and a $100 million investment by the $51 billion Pennsylvania Public School Employees' Retirement System, Harrisburg, in Aeolus Capital Management Ltd.'s P-CAT hedge fund, most institutional reinsurance allocations are fairly small, in the $30 million to $50 million range, said sources.

And, Aon Benfield's Mr. Schultz noted that demand for catastrophe bonds has experienced ebbs and flows lately.

“In the early part of the year, there was significantly more capital looking to be deployed than transactions coming to market. Since then, we've seen a healthy stream of issuances and supply and demand is now about the same,” said Mr. Schultz.

But over the long haul, small investments, when aggregated, have the potential to deluge the reinsurance investment market over the long haul, industry sources said.

Consultants and money managers alike question whether the largest and most sophisticated asset owners would bother to spend the time and energy researching insurance-linked securities when even a $500 million investment would barely move the needle in terms of overall investment returns.

“A lot of big institutional investors and their consultants tend to skip reinsurance investments. It may be the exact thing your portfolio needs, but the industry is quite capacity constrained. It's too much work for a very small reward,” said Andrew J. Sterge, a vice president of AQR Capital Management and chairman of the portfolio management committee of AQR Re.

But insurance-linked securities might end up in the portfolios of many midsize pension funds, endowments and foundations for which a $40 million allocation to an uncorrelated, healthy return stream would be “just right,” Mr. Sterge said.

Christine Williamson is a senior reporter at Pensions & Investments; Bill Kenealy is an associate editor at Business Insurance, a sister publication of P&I.