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.


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.

Triggers vary by territory. They start at $5bn for US catastrophe exposures, but $10bn is the preferred figure. European triggers begin at $2.5bn, but $5bn is the preferred starting point, while Japanese loss triggers start from $5bn. The price of cover is close to standard market rates, but varies depending on the fund offering the product and the exposure under the contract. It is understood that the hedge funds are offering cover for Japanese exposure at a slightly higher price than market rates for conventional ILWs, but that the cover for US and Europe is in line with the market.

Buyers may want to know who is providing the capital. According to the Hedge Fund Association, the hedge fund industry, with approximately 7000 funds world-wide, manages between $400bn and $500bn, and is growing by 20% per year. Hedge funds' strategies range from the leveraged use of derivatives to very conservative. Most are highly specialised, driven by the expertise of their senior management. Investors range for the largest banks and pension funds to, in some cases, wealthy individuals.

Hedge funds are attracted to the cat risk market because fund managers see potential and believable returns-on-equity that fit their models.

Their interest was probably spawned by their observation and participation in the cat bond market (it has long been rumoured that one of the only profitable investments in the portfolio of the spectacularly defunct Long Term Capital Management was its investment in USAA's ground-breaking securitisation), although there is no obvious relationship.

Similarities in the offering are obvious. Today's cat bond issues are few and sizeable; hefcore contracts will be sizeable too, or they won't fly. Big, easily modelled risks are the subject of peril for both, and the community of potential buyers of protection is small - perhaps three dozen. There are differences, however. The hedge fund products are cheaper than cat bonds, with less of the frictional expenses that have bogged down that market. And they are potentially more flexible. Both attributes improve their prospects.

What is the outlook for this new phenomenon? As with all new products and new entrants to the reinsurance market, buyers need to be convinced of the sustainability of the concept. A great deal of their success will depend on the purchasing appetite of a few very large scale retrocession buyers and the largest US primary insurance companies.


It is highly possible that these significant hurdles will be overcome and that the big (re)insurers buy in because of hefcore contracts' major advantage - collateralisation. In a world where credit risk is becoming much more comprehensively recognised, it could be a very important factor - and it could have ramifications for other providers of ILW capacity.

However, cat bonds are also collateralised, and while the cat bond concept has by no means failed, it has not redefined the insurance world as some promised it would.

There is no doubt that large new capital streams are entering the reinsurance market at a high level. The providers are highly informed about the margins available for such catastrophic risk, and they are already working with the leading brokers to get the message out to potential buyers. However, insiders believe that the presence of the hedge funds in the ILW market is unlikely, at this point at least, to bring down catastrophe reinsurance prices or to destabilise the established market. Perception means a great deal in the reinsurance sector, but at present the level of promise made by the hedge funds simply doesn't match the delivery. Of course all that could change with just a few deals - and they are already in the works.

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