Hedge Fund

New York Times published an article on September 4th that observes how risky trades are flourishing in hedge funds, amid flexible regulations. In places like Bermuda and the Cayman Islands, hedge funds can generate millions in permanent capital through the reinsurance business. As the reinsurer will itself invest in the hedge fund, the investment becomes permanent.

The report explains how hedge funds venturing into the reinsurance market could lead to a “chain reaction”, where hedge funds will rush to sell risky assets, in order to fulfill payment on claims-loss liquidity needs. As insurers and reinsurers invest heavily in the stock market and any economic catastrophe will magnify their losses, the detrimental effects will be felt on the stock market as well. Miller Tabak & Co.’s Thomas Mitchell is out with a report today rebutting the Times Piece. Mitchell thinks that the author did not get the full picture in his article.

Mitchell argues that all reinsurers, hedge funds and others alike, have their loss reserves invested in corporate bonds, equities, real estate, and other investment media. So whatever negative effect the rapid selling is expected to have on the capital market is not going to be a new phenomena as reinsurers already sell their invested assets when they have to meet payment claims.

The opinion also contests the view that the reinsurance market is unregulated. A more stringent policy could help, but the effects will be minimal, when buyers of reinsurance regulate and control what the sellers invest in. Buyers have learned with their history of experience that weak reinsurers will meltdown anytime. Thus, buyers are more evolved and they choose the big names like Berkshire Hathaway Inc. (NYSE: BRK.A)(NYSE: BRK.B), Munich Re, and Swiss Re on the basis of their strong balance sheets. In this case, Berkshire Hathaway Inc. (NYSE: BRK.A) (NYSE: BRK.B) is not a hedge fund, but does own re-insurers.

One of the pioneer hedge funds to step into the reinsurer business was David Einhorn’s Greenlight Capital Re, Ltd. (NASDAQ:GLRE). David Einhorn established the Greenlight Re in the Cayman Islands. TP Re was recently founded by Dan Leob of Third Point Offshore Investors Ltd (LON:TPOE) (LON:TPOG), with an initial investment of $500 million.  Third Point went public in 2007, by raising $525 million.

Another major hedge fund, Paulson & Co., is going to kick start a reinsurance business by the name of PaCRe in Bermuda. Man Group Plc (LON:EMG) has owned 25 percent of Nephila, a reinsurance broker, since 2008. Man Group Plc (LON:EMG) went public back in 2007, with 9.7 million shares priced at $30. Bill Ackman’s Pershing Square Capital is also considering an IPO in the upcoming year, the fund will be able to generate permanent capital from the public offering, while its peers Greenlight Capital and Third Point, invest in reinsurance.

Mitchell also observes that any reinsurer who wants to succeed in the market, will try to invest their capital in highly liquid assets, while operating at modest leverage. Reinsurers will also strive to improve their grading from major credit ratings agencies, and also their claims paying ability ratings from AM Best.