Historically, capital markets have intersected with the insurance industry at the level of “re-reinsurance” (which is actually called “retrocessional reinsurance”), buying the risk that reinsurers carry, Karon says. Now they “typically play behind reinsurers,” but not always. He sees the convergence with Wall Street evolving so that more often, hedge funds or investment banks buy risk directly from insurers.
“It’s potentially a competitive threat to us,” he acknowledges. “We have built out an investment-banking division called Benfield Advisory that’s been active in this. So on a net basis, it’s been good for us, because we just view this as another market for us to place business in.”
Lately, the weather bets of hedge funds and other investors have paid off handsomely. In 2004, four named hurricanes hit Florida, Karon says. Then Katrina and Rita struck the Gulf Coast in 2005. Reinsurance money became scarce, and the price for it went up. This meant bigger potential returns for anyone willing to assume what Karon calls “wind risk” and gamble that the big winds wouldn’t blow in 2006.
No named hurricanes struck the U.S. mainland in 2006. Primary insurance companies posted record profits. Reinsurance companies, cat bond holders, and other “risk securers” saw double-digit returns. As of late October, 2007 also has been a quiet year.
But hedge funds will remain interested in cat risk only so long as the potential returns remain attractive. If 2007 ends without a major loss, reinsurance prices will drop, Karon says. The “convergence” phenomenon won’t go away, but it will slow.
