Enter the hedge funds

Do the new Hefcore products signal the beginning of a revolution in the reinsurance market?

Not since the development of catastrophe bonds in the mid 1990s has the reinsurance sector seen the introduction of a completely new source of capacity. Now something new is emerging, and it has the potential to make an impact much greater than that of the spluttering catastrophe bond market. These new products - we will call them 'hefcore' contracts - are already adding significant retrocession capacity in advance of the 2004 renewal.

"Potentially hundreds of millions of dollars of capacity or more are being brought to the non-marine industry loss warrantee (ILW) and aviation markets," one person familiar with the deals told Reinsurance. "Cover bought in the non-marine ILW market could increase by up to 40%." The reinsurance purchased is likely to be complementary to the capacity already offered, he said, and most or all of the potential buyers have had an initial introduction.

INTEREST IS GROWING

Hefcore is the acronym for hedge fund collateralised reinsurance. Three hedge funds have been marketing their interest underwriting catastrophe risk through the new instruments. A handful of deals have been written already, although so far only one fund - Citadel - has actually underwritten risk. The other two potential hedge fund markets, thought to be Corona and CitiCorp's Global Reinsurance, have not yet completed a deal, but that could change (even by the time this article is published), as knowledge of the products is spreading rapidly.

The concept is simple. The buyer arranges a (re)insurance contract (typically for a 12-month period) through a transformer from the hedge fund in the usual way, probably with the help of a reinsurance broker. The hedge fund collateralises a special trust fund using the premium received from the buyer, and its own additional cash, up to the limit of the policy. Contracts are usually, but not necessarily, contracts of indemnity. In the event of loss, the (re)insured will draw down the fund according to the loss.

If the contract expires without loss, the hedge fund will draw down the premium.

In some cases hedge funds have altered the model, by offering contracts that are not fully collateralised. The exact nature of the paper that would support the deal in such cases is not yet clear, although it is plain that some of the capacity on offer is intended to support standard, non-collateralised (re)insurance contracts.

Highly modelled commodity risks suit the hefcore product well. Non-marine catastrophe risks are the clear contender. They have been the subject of the handful of deals signed to date, although proponents believe that aviation hefcore contracts will soon follow, and that hefcore contracts for man-made perils could be constructed.