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By Jonathan Kent

Bermuda has become accustomed to waves of new reinsurance capital washing up on its pink shores in the aftermath of major disasters. After insurers paid out about $116 billion in catastrophe losses last year, it's happening again. Only this time, it's different.

Insurance-linked securities, particularly catastrophe bonds, are booming. Some $4.7 billion of ILS have been listed on the Bermuda Stock Exchange, all within the past three years. Sidecars, which sprang to prominence after Hurricane Katrina, are also back in vogue.

At the same time, big players in the hedge fund industry are getting involved. Daniel Loeb of Third Point LLC, Steve Cohen of SAC Capital Advisors, and John Paulson of Paulson & Co., have all set up reinsurance operations in Bermuda this year, with combined capital approaching $2 billion.

For years, industry experts have talked about the growing convergence between the capital markets and the reinsurance industry, but now it is really apparent. For investors, it offers potentially high returns, very low correlation to financial markets and a clear exit plan. For reinsurers, it's an effective means of tapping the capital markets for extra capacity.

For buyers, this is good news. Indications from midyear property-catastrophe reinsurance renewals are that the nontraditional capital has helped to stunt the development of any hard reinsurance market that might have been expected after last year's losses. John Berger, CEO of Third Point Re, one of the new hedge fund-connected companies, noted this trend.

"People are saying for the first time this past June that they really saw these alternative sources of cat capacity take from the traditional marketplace and the pricing reflected that," Berger said.

Indeed, analysts at Keefe, Bruyette & Woods suggested in their midyear renewals report that nontraditional capacity could now make up as much as 10 percent of the market and was influential in pricing.

Ed Noonan, CEO of Bermuda reinsurer Validus Holdings, said he had seen a similar impact on pricing, particularly in Florida renewals.

"My sense is that we're reaching that point of convergence between the capital markets and catastrophe risk that everybody has talked about for so long," he said.

"It feels like it's coming to that level of maturity where it's a real factor in the market and looks like it will remain one."

Validus has embraced convergence, particularly through sidecar AlphaCat Re, which has helped the firm utilize third-party capital in the retrocessional market. Also, Validus handles underwriting operations for PaCRe, a joint venture with Paulson & Co., which manages the investments. The new entity launched this year with $500 million of capital.

The first half of 2012 saw a flurry of ILS issuance, including the biggest ever catastrophe bond transaction, in which state-run Florida Citizens Property Insurance gained $750 million of hurricane coverage through a Bermuda-based vehicle, Everglades Re. The initial target was $200 million, but the strength of demand allowed the bond sale to more than triple in size, with investors willing to take the risk of seeing their principal wiped out in exchange for a 17.75 percent coupon.

The preferred offshore home for catastrophe bond listings was until recently the Cayman Islands, but Bermuda has been claiming an ever-increasing share of the market since the Bermuda Monetary Authority, the financial regulator, created a new classification of "special purpose insurer" in late 2009, providing a regulatory framework for collateralized reinsurance products.

Bermuda Stock Exchange CEO Greg Wojciechowski said ILS listings had gone from zero to nearly $5 billion in less than three years and the pace was increasing, with $1.2 billion of that coming in the first half of this year.

"Intuitively, it makes sense for ILS to be here," Wojciechowski said. "Bermuda has decades of experience underpinning its ability to provide the support and services the reinsurance market needs.

"For convergence to happen, you need to have the plumbing between the capital markets and the reinsurance industry. What I mean by that is the infrastructure -- the regulatory framework, the legal system and the stock exchange.

"ILS is an evolution in the market and Bermuda is embracing that challenge," he said.

The $3.6 billion in global ILS issuance in the first half of this year was double that of the same period in 2011. According to Swiss Re Capital Markets, there is more in the pipeline, as capital pours in from investors who increasingly include yield-hungry pension funds, which see catastrophe bonds as an alternative investment that can help juice returns to meet burgeoning future liabilities.

There are a number of Bermuda firms specializing in investment opportunities in insurance-linked products, including the pioneer, Nephila Capital, established in 1998, which manages more than $5 billion of investments. CatCo Investment Management, ISIS Fund Services and the Armour Group have more recently started to service this market.

Reinsurance industry veteran Don Kramer, who founded Tempest Re in 1993 and Ariel Re in 2005, has spotted the expanding opportunities in ILS. His latest Bermuda-based venture is investment firm ILS Capital Management, which seeks to offer investors portfolios of diversified risks, to achieve more reliable returns than could be obtained from buying into a single catastrophe bond.

"We're taking insurance risk capital and turning it into yield, but obviously with risk," Kramer said.

"Instead of us being a reinsurer earning interest on our assets and a return on our underwriting, we're giving the underwriting return directly to the investor with a short-duration, high-yield, high-risk security. As a small addition to a conventional portfolio, it helps to compensate for some of the loss of investment income elsewhere."

Kramer sees nontraditional sources of capacity continuing to boom, partly because the economics of reinsurance have changed, with low interest rates having severely squeezed investment income and having made it unattractive to establish traditional companies.

"When I started Ariel, in my first year I had $65 million to $70 million in investment income," Kramer said.

"If I started Ariel tomorrow, I would have less than $12 million of investment income. Rates have not gone up sufficiently to compensate for this loss. So the margins have declined significantly.

"Insurance is an expense for corporations, who are under pressure. They're not suddenly going to pay 20 percent more in premiums because you're not getting that investment income any more. Neither are they," Kramer said.

Noonan believes the key development in the fruition of convergence is growing investor demand from funds that have learned the value of catastrophe bonds as an alternative investment.

"They're only going to be investing a small percentage, but when you think of the trillions of dollars in pension funds and endowments around the world, it doesn't take much to have very big impact on the amount of capital coming into the catastrophe business," Noonan said.

Just about the only people setting up new reinsurance companies in Bermuda right now are hedge fund managers. And they come into the industry with a different focus than conventional reinsurers, said Third Point Re CEO Berger.

Traditionally, reinsurers have put their assets into "safe" investments, to balance the volatile risks on the underwriting side. Third Point Re adopts the opposite approach.

The company, which opened its doors for business in January this year with $750 million of initial capital, is building a conservative portfolio of underwriting risks. All of its investment assets are being managed by Loeb's hedge fund, which employs an event-driven strategy.

Berger, the former CEO of Harbor Point Re and ex-reinsurance CEO at Alterra, said he found it liberating.

"When opportunities aren't there, we don't have to pursue them, because we're relying on the investment side so much," Berger said. "It gives you the ability to just write deals that make sense."

Armed with an A- rating from A.M. Best and based in offices on the Hamilton harbor waterfront, Third Point Re wrote about $150 million of premium in the first half of the year in lines including multiperil crop reinsurance, nonstandard auto, standard auto and workers' compensation.

Other hedge fund-linked reinsurers are pursuing a different strategy. SAC Re will underwrite some catastrophe risk, as will PaCRe, which will focus on the top layers. Noonan stressed that PaCRe's underwriting strategy was at "the extreme of conservatism" and would take on only one-third of capital in catastrophe risk in absolute terms.

"In an extreme scenario, if any reinsurance contract were fully exhausted, two-thirds of the capital remains and everybody still gets paid," Noonan said.

For the hedge funds, there are two particular attractions for starting a reinsurer. First, investors cannot easily pull out their money, protecting fund managers from the kind of mass redemptions that plagued many of them during the 2008 financial crisis. Secondly, the tax treatment of returns is beneficial.

"Our investors can't say 'give us our money back,' because we're a privately held reinsurance company," Berger said. "Their liquidity will come the day we have an IPO. That is probably the biggest factor driving this right now."

Investors will be able to cash out by selling their shares at the stock flotation, booking it as a capital gain, subject to lower U.S. tax rates than if they had invested the money in the fund. Clearly, a successful IPO is key for Third Point Re's investors. Berger hopes to be ready to float by the end of the year, but said it will only happen only when conditions are right.

"We need three things to happen," he said.

"We need the market to get back to some normal valuation, as the average price-to-book value is very low, so it makes no sense to have an IPO now. Then we need our investment manager Third Point to have good results and we need to do a good job on the underwriting side to get a good return on equity.

"When those three things align we'll be an attractive IPO," he said. "The timeframe on that is really determined by the marketplace."

Berger said the Third Point hedge fund had not invested in the reinsurer. "Dan Loeb personally has put money in -- not the hedge fund's money -- so he's a major shareholder and on the board," he said.

"Other than that, it's an arm's length investment management contract."

As was evident by the impact on pricing this midyear, convergence could be seen as a threat to the traditional reinsurer model. Noonan understands that argument, but sees no reason why different forms of capital should not successfully co-exist.

"In our own case, we raised third-party capital to give investors access to our underwriting and modeling capabilities, so our feeling is that convergence doesn't need to be a strategic threat, it can be part and parcel of our business," Noonan said.

"To some extent, it will shrink the pool of available business to the traditional reinsurance market. It will also tend to reduce post-event pricing spikes, because you have sources of capital that are infinitely larger than the industry's capital. It becomes a risk and capital management strategy and I think the returns can still be absolutely fine."

Ultimately, quality underwriting will still be required to deploy the capital and that is where differentiation between reinsurers will continue to show, just as the remarkable range of performance among market players illustrated last year, said Noonan. The ongoing evolution of the reinsurance market should hold no fears for Bermuda, he added.

"Bermuda is the undisputed center of catastrophe risk management in the world," Noonan said.

"I look around the island and see very well managed, smart companies. And some of the biggest players in the convergence spot are located here too, so I would expect Bermuda to thrive in this business."

JONATHAN KENT is a Bermuda-based financial writer and editor.

August 22, 2012

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