Hedge Fund Reader : Will Hurricanes Rain on the Hedge Fund Parade?

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August 18, 2006

Will Hurricanes Rain on the Hedge Fund Parade?

Hedge funds are proving that they play for high risks by staking their dollars on Mother Nature. Following the catastrophic destruction wreaked by hurricanes in 2005, these funds have rushed to grab a piece of the action and a bigger slice of the profits.

Hedge funds are raising capital for both current and new reinsurers besides setting up “sidecars” or special-purpose entities that allow funds to pass capital to existing reinsurers. This is an all-or-nothing ploy; what with insurance premiums sky-rocketing post Katrina and Rita, the hedge funds who have invested in the insurance industry are set to make a killing if the skies are peaceful. On the other hand, they are likely to run up billions of dollars in losses if nature strikes with all its fury as it did a year ago.

The Reinsurance Association of America reports that of the $23 billion capital raised for new and existing reinsurers since the hurricanes hit in 2005, $13.9 billion has come from hedge funds, with $7.3 billion going into start-up companies and $3.6 billion to sidecars. Ten reinsurance companies and ten sidecars have emerged since Katrina.

They’ve not stopped there; the funds are busy snapping up catastrophe bonds too. These bonds are issued by insurance or reinsurance companies, pay 5 to 15 percent on the coupons, and return on the principal if the bonds mature without the occurrence of natural disasters. Around $1.8 billion has been invested in catastrophe bonds in 2005, with an additional $2.5 billion so far this year.

Some of the big names that have forayed into reinsurance territory are Citadel, Magnetar, Highfields Capital Management, XL Capital, and Eton Park Capital Management. Will smaller fry join the predators of the high heavens? This year’s hurricane season holds the answers.

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August 18, 2006 in Emerging Markets | Permalink