Are hedge funds friend or foe? Some reinsurers have got the jitters despite an exemplary track record. Lindsey Rogerson asks why.

Hedge funds have a long and successful involvement in reinsurance. As the Bermuda Class of 2005 proved, hedge fund managers were quick to spy opportunity. One could be forgiven for thinking that as these hedge fund-backed reinsurers have done so well, all reinsurers would be keen to get into bed with them (see table 1).

Not so. The latest round of hedge fund interest in reinsurance groups has been rather less well received by the targeted parties (the reinsurers that is) as it is of the activist variety. Activist hedge fund investors move in when they sense a company is worth more than its current share price, perhaps (though not always) believing that the sum of the parts is worth more than the whole.

The most high profile victim of activist investors in recent months has been Dutch banking group ABN Amro. The ongoing and increasingly bitter battle between Royal Bank of Scotland and Barclays began after activist hedge fund, The Children's Investment Fund, pointed out it thought ABN might be worth more broken up. A move that has doubtless sent shivers down the spines of many a reinsurer.

The next big break-up

“Activist hedge fund investors move in when they sense a company is worth more than its current share price

Nick Martin, an analyst, on the £75.1m Hiscox Insurance Portfolio believes it was only a matter of time before the activists turned their attention to the insurance sector in the quest for value. He said: "Pre all this [credit market] blow-up it was inevitable that hedge funds would look at some of the big groups in terms of 'who is the next break-up target' once ABN is done. The banks are a fairly consolidated market so it is natural to look at the insurers after that. Most hedge funds and boutique houses that go for the banks are equally well-versed in insurance."

Inevitable it was. In May, two hedge funds, Odey Asset Management and Polygon, teamed up to thwart the £162m purchase of London-listed, Bermuda-based reinsurer Alea, by Fortress. The pair believed the price on offer was too low. Also that month, Odey snapped up just short of 1% of German reinsurance giant Munich Re.

It is easy to see why both Alea and Munich Re have attracted the attentions of hedge funds in recent months. Alea's exposure to the 2005 hurricanes meant that by May 2007 its share price had slumped by two thirds on its list price in 2004. Despite the decline, the hedge fund groups believed there was more residual value in its remaining book than the £16m price tag suggested.

At the other end of the scale, and for completely different reasons, analysts and fund managers (not just Odey) believe Munich Re is sitting on a pile of cash. So is it the end of good relations between the hedge fund managers and reinsurance groups?

“Hedge fund money is unlikely to seed another bullish wave of start-ups, leaving the path clear for reinsurers to dramatically increase their rates at renewal

Ironically, the current round of belt tightening in the global debt markets, on the back of the US subprime mortgage crisis, may yet throw a spanner in the works for any hedge funds with unsolicited ambitions in the reinsurance sector. This could simultaneously boost the fortunes of existing reinsurers if, as predicated, 2007 proves a bad year for hurricanes.

This is because any hedge fund wanting to take on the might of Munich Re will need the cash to do it. With credit markets still showing no great enthusiasm for lending, as Global Reinsurance went to press, it is by no means certain that the easy borrowing of the last few years can continue to be relied upon.

At the same time, with credit markets dried up (albeit temporarily), if 2007 does see a significant peak in hurricane claims there is unlikely to be a repeat of 2005. Hedge fund money is unlikely to seed another bullish wave of start-ups, leaving the path clear for reinsurers to dramatically increase their rates at renewal. So it that the end of hedge funds dabbling in reinsurance?

The love affair continues

“Capital market capacity will hopefully help to flatten out the cycle and prevent swings from boom to bust

Not likely. A cursory scan of recruitment adverts in August, at the height of the credit crunch and with Hurricane Dean about to make landfall in Mexico, certainly found hedge funds still looking for reinsurance analysts. While peripheral, it does not suggest a wholescale claw back of activities in the reinsurance market by hedge funds. Separate research by broker group Benfield would also seem to indicate that hedge funds are in reinsurance for the foreseeable future.

Benfield's report card for the Class of 2005, "Maiden Innings", reveals that backers of the post-Katrina start-ups, predominately hedge funds, have seen healthy returns. And while the debt markets are still trying to gage the fallout of the US subprime market, hedge funds have traditionally been at the forefront of innovations including sidecars and industry loss warranties. It is unlikely that investors' appetite for such products, given their history of generating superior returns, will abate for long.

Flagstone Reinsurance, a hedge fund-backed 2005 start-up, recently had its "buy" rating reiterated by Citigroup analysts Joshua Shanker and Yaron Kinar. The pair admittedly has also marked Flagstone "high risk" on the back of its exposure to flooding in the UK and an estimated $23.5m of losses from storms and floods in Australia. According to Mark Byrne, chairman of Flagstone: "Our globally diversified book of business means that when there are significant losses in non-peak zones, our portfolio will experience losses which a peak zone strategy might avoid."

"We believe that Flagstone represents an opportunity to buy stock that essentially trades at 'net asset value' for investors seeking investment risk uncorrelated to the market," said Shanker. "This is an entry point where essentially no premium is paid for future earnings."

Indeed Hiscox's Nick Martin believes that while hedge funds may not be able to take advantage of any heightened hurricane activity in 2007, in the long run their presence can only be good for reinsurance. He said: "If you have an industry that can tap into the capital markets [and hedge funds] as and when it needs for temporary capital rather than resort to a rights issue, it is much better. It can only be a good thing, which will hopefully help to flatten out the cycle and prevent swings from boom to bust."

Lindsey Rogerson is a freelance journalist.