Weather risk investors breathing sigh of relief

Aug 28, 2006 @ 12:01 am

By Gary S. Mogel

NEW YORK - As we mark the one-year anniversary of Hurricane Katrina this week, hedge funds and private-equity firms that invest in weather risk are giving thanks for the benign - at least so far - Atlantic hurricane season. But there is still plenty of time for the boom to turn into a bust, industry observers said.

It's not too late for wealthy individual investors and institutions to get in on the potential profits from a calm hurricane season, according to industry experts. Advisers may consider such investments for clients who can spare at least $1 million for a high-risk - and possibly high-reward - opportunity.

"Investors can still get in, because the hurricane season is far from over," said a managing partner of an $800 million fund that specializes in insurance-linked securities, who preferred not to be named.

"That's because the peak of the hurricane season is in September. The funds are betting that there won't be another Katrina this year," he said.

"Major hurricanes can occur well into October and beyond, so investors should not be overly optimistic," said Christopher McGhee, managing director of MMC Securities Corp., the investment bank affiliate of New York-based reinsurance broker Guy Carpenter & Co. Inc. "Depending on the rules of the specific fund, there may still be time for new investors to get in."

New ways are developing for investors to participate in weather risk.

Last week, HedgeStreet Inc. in San Mateo, Calif., introduced an online retail market for speculating on the economic impact of hurricane and tropical storm damage.

One contract's underlying value is based on the total estimated losses from hurricanes and tropical storms that cause at least $25 million in insured damages during the 2006 hurricane season. The last trading day will coincide with the last day of the hurricane season, Nov. 30.

At press time, Tropical Storm Debby was slowly gaining strength in the Eastern Atlantic.

Big rewards, risk

Although returns are high, these bets can be a gamble.

Interest paid by catastrophe bonds - a common way to invest in weather risk - can be extremely high, often up to 5% or more over the London interbank offered rate, depending on the degree of risk, the experts noted. The three-month Libor rate has recently been about 5.4%.

Cat bonds are issued by insurers and reinsurers, which don't have to pay back the principal - which is kept in a trust - if there are a certain amount of losses or a catastrophic event of designated magnitude within the bond period. But the catastrophe threshold is so high that even last year's hurricanes didn't trigger them.

It would probably take a Category 5 hurricane directly hitting downtown Miami to trigger a bond, according to Andrew Sterge, principal of AJ Sterge Investment Strategies LLC in Berwyn, Pa.

"The bonds generally pay more interest than corporate bonds with the same rating," he said.

Last month, Mr. Sterge was hired by Magnetar Capital LLC in Evanston, Ill., which has $3 billion in assets under management, to build its reinsurance platform.

While only a small number of hedge funds invest in reinsurance, those that do may have up to 25% of their assets in these types of investments, industry observers say.

Reinsurance alternative

After traditional reinsurance capacity retreated following property damage from last year's Hurricane Katrina, and other storms in the Caribbean and along the U.S. Gulf Coast, many hedge funds, as well as some private-equity firms, stepped in to provide the needed capital.

They also sought to benefit from drastically higher property insurance premiums, some of which more than doubled in Louisiana and other hard-hit states. Investment managers are counting on the statistical improbability of a repeat of last year's devastation, estimated by most catastrophe modeling firms at $60 billion to $80 billion.

Many investment managers like to have weather-related risk in their portfolio, because it isn't correlated to most other asset classes. About $23 billion has been pumped into reinsurance vehicles - mostly from hedge funds - according to the Reinsurance Association of America in Washington.

As potentially lucrative as these vehicles seem, investors must be prepared to lose their entire stake.

"These are for very experienced, high-net-worth investors seeking diversification and who won't panic if things go bad," said Diego Wauters, chief executive of London-based Coriolis Capital Ltd., a hedge fund that manages $300 million.

Investors can sometimes even benefit from a catastrophe within the bond period, as that can lower the bonds' prices and drive up yields. A bond's value can decline by 20% or more when a hurricane is off the coast, Mr. Wauters noted.

A bond issued by Zurich American Insurance Co. in New York lost 35% of its value after last year's storms.In addition to cat bonds, hedge funds and private-equity firms can invest in sidecar agreements, and finance new reinsurance companies in Bermuda and other offshore tax havens.

Sidecars permit investors to participate in a segregated portfolio of reinsurance business written by an existing reinsurer. But there is a lot of risk: This year, a sidecar set up by White Mountains Insurance Group Ltd. in Hamilton, Bermuda, was almost wiped out from higher-than-expected losses.

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