Hedge funds increasingly involved in reinsurance business as diversification tool

Hedge funds are showing increased interest in the reinsurance sector as they look for ways to diversify their investment strategies and to deploy their accumulated capital, according to a briefing paper published by ratings agency A.M. Best. The extent of the catastrophic losses experienced during 2011 has served to heighten this interest as hedge fund entrants to the reinsurance sector look to replace capital lost due to the catastrophes of 2011.

Usually, A.M. Best note, the investment banking sector would have provided this top-up capital for the reinsurance industry but this time around hedge funds are taking the lead. A.M. Best say that it isn’t clear whether it is the investment opportunity that attracts hedge funds, reinsurance linked investments offer some of the best returns in the current financial market situation, or that investment banks are still wary of regulatory hurdles required to enter the reinsurance market.

Interestingly A.M. Best explains why hedge funds have been moving towards starting up reinsurance companies over purely investing in capital market reinsurance instruments such as catastrophe bonds. A.M. Best says that while cat bonds were the entry point to the sector a few years ago, the length of exposure and extremes of risk/reward don’t always match a hedge funds strategy. So hedge funds have moved to starting up their own reinsurers or deploying capital into other startups. A.M. Best goes on to discuss that many funds kept some interest in the cat bond market but also added a strategy focused on low-volatility property/casualty business. Of course the other area that hedge funds are pushing capital into is the higher volatility, longer duration retrocessional reinsurance sector which is highly specialised but offers much greater returns if portfolios are well managed.

Whenever capital is required in the reinsurance market, particularly if due to heavy loss experience, hedge funds are likely to step forwards to provide some capital inflow as it would typically be at a time when rates may be rising and the potential returns are greater. That said, there are hedge funds who keep capital operating in the reinsurance sector and who are unlikely to pull out should rates decline, these hedge funds typically deploy capital into mixed investments in insurance-linked securities, catastrophe bonds and the high-risk retro reinsurance contracts which offer the best returns. These specialist investors are sufficiently large that they can afford to keep hunting the best returns and diversification that the reinsurance market and insurance-linked investments can offer them.

The remainder of the briefing discusses A.M. Best’s methodology for rating hedge fund reinsurers. You can access the briefing here.