March 21, 2023

Deal Professor: Hedge Funds Rush to Open Reinsurance Firms in Bermuda

Deal ProfessorHarry Campbell

The hedge fund industry has been rushing headlong to open Bermuda-based reinsurers.

Reinsurance, already something of a murky business, may become even more complicated as a result. And while the hedge funds are likely to profit, the question is: Who’s watching to make sure this doesn’t lead to another financial calamity?

Reinsurance is the business of providing insurance to insurers. To hedge their risk, insurers will cede part of their claims by buying their own insurance from reinsurers. It’s a big business. Holborn, a reinsurance brokerage firm, estimated that $215 billion to $220 billion in reinsurance was written globally in 2011.

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The reinsurance business plays an important role in paying claims from catastrophes for which regular front-line insurers don’t want to take the full risk. According to Holborn, the reinsurance industry spent an estimated $48 billion last year on claims related to the New Zealand earthquake, the Japanese tsunami and nuclear disaster and Hurricane Irene in the United States. If you are hit by a disaster, it’s probable that your insurance claim will be paid by the reinsurers.

Surprisingly, these big profits make it a good time to be a reinsurer. Less-capitalized companies have fallen by the wayside and premiums are likely to rise.

So why are hedge funds entering this business?

It’s the money. Hedge funds are perpetually plagued by fickle investors who want to withdraw money at the first sign of deteriorating results. But a hedge fund can set up a reinsurer in Bermuda or the Cayman Islands. Under the regulations of these islands, the new reinsurer can then use the premiums it collects to invest with the hedge fund itself. The hedge fund suddenly has hundreds of millions in permanent capital that can’t be withdrawn.

The hedge funds are also looking to capitalize on the increased interest by pension funds and endowments in reinsurance. With the stock market a shaky investment and yields low, pension funds and others are piling into the reinsurance market in search of higher yields. The Pennsylvania Public Schools Employees’ Retirement System, for example, recently invested $200 million in the Aeolus Property Catastrophe Fund, which finances reinsurance of catastrophe claims.

David Einhorn’s Greenlight Capital pioneered the hedge fund-sponsored reinsurer in 2004, when Greenlight set up Greenlight Re in the Cayman Islands. Since then, a number of other hedge funds have entered the reinsurance market, but in the last six months what was a trickle is turning into a flood. Daniel S. Loeb of Third Point has announced the creation of a $500 million Bermuda reinsurer named TP Re. Steven Cohen’s SAC Capital Advisers has also created a Bermuda reinsurer called SAC Re, which is also raising $500 million.

Hedge funds are also big players in a reinsurance instrument known as a catastrophe bond. These bonds pay out only if there has been a significant event like a hurricane. According to GC Capital, $13.5 billion in catastrophe bonds were outstanding as of the first half of 2012. The catastrophe bond market has been around for a while, but as money pours into this sector, it is likely that hedge funds and other financiers will rush to create other types of reinsurance financial products to draw in money.

This new market is arising outside the United States, mostly in Bermuda and the Caymans.

And that may be a problem.

These new reinsurers still operate as hedge funds. If you examine Greenlight Capital Re’s filings with the Securities and Exchange Commission, its appears as focused on its investment return as its reinsurance business. Indeed, Greenlight Capital Re’s assets are managed by Greenlight Capital’s investment adviser, DME Advisors, for 20 percent of the profits and a 1.5 percent administration fee, the same as would be the case for a hedge fund.

Yet while they are partly hedge funds, these new companies are regulated as reinsurers. And Bermuda requires only minimal capital requirements and disclosure of financial positions, and it does not strictly regulate how these companies invest their money. The Cayman Islands has similarly light regulation.

For American regulators, the reinsurance industry is largely outside its jurisdiction, dominated as it is by foreign companies. So no regulator is really watching to ensure that these reinsurers do not make excessively risky investments that blow up.

According to Best’s Special Report, companies domiciled in Germany wrote about a quarter of the global reinsurance business in 2011 while companies from Bermuda wrote a third of premiums. The last two big American reinsurers left are Berkshire Hathaway and Transatlantic Holdings (now a subsidiary of the Alleghany Corporation), but they are at an increasing disadvantage because of the better tax treatment and lighter regulation for offshore reinsurers.

Yet the concern is not that so much of the business is offshore, but that the growing role of hedge funds may push the main reinsurers to be more aggressive with their own investing. The result would be to push the reinsurance market into becoming a giant hedge fund industry.

We’re already seeing some movement in this direction. The big reinsurer Validus is forming the Bermuda-based PaCRe with the hedge fund magnate John Paulson’s Paulson Company.

According to a recent study by the International Association of Insurance Supervisors, we don’t have much to worry about. First, these investments are countercyclical — meaning that if the stock market goes down, reinsurance is unaffected. After all, disasters just happen; they aren’t caused by the economy.

Furthermore, stress tests have shown that a huge loss can be sustained by the reinsurance industry far greater than losses caused by Hurricane Katrina. The reinsurers are also required to post collateral in the United States when they write policies. This collateral typically takes the form of letters of credit backed by the reinsurer’s investments.

All this assumes that there are few links between the insurance market and the stock market. But insurers and reinsurers are already big investors in stocks, and some are invested in hedge funds themselves. And this connection to the capital markets will become more pronounced as hedge funds reinvest their reinsurance business money.

Given hedge funds’ penchant for leverage, any movement in the markets will be exacerbated as a result. In a catastrophe like Sept. 11, which sent the market into a tailspin, reinsurers operating as hedge funds may face their own enormous losses, which are magnified by their investment losses.

This could create a serial shock to the system as reinsurers default on their collateral, leaving the banks that issued letters of credit holding the bag for billions in unexpected losses.

In other words, the reinsurance market is starting to look like many of the markets before the financial crisis — lightly regulated and interconnected in ways that policy makers can’t see, with banks potentially left with the wreckage. The industry may be right that reinsurance is different and has its own checks and balances, but we’ve also heard that before. It behooves United States regulators to make sure.

Steven M. Davidoff, writing as The Deal Professor, is a commentator for DealBook on the world of mergers and acquisitions.

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