Hedge funds as risk reducers

We all know how insurance companies work. They collect a premium from policy holders and in exchange agree to pay out a large sum whenever some predetermined event occurs. While the payout to any given policy holder may be well in excess of the premiums paid, the insurer collects premiums from many policy holders and as long as the correlation among payouts remains small, the insurance business remains profitable.

What happens if the correlation among payout events becomes high? For example, what if there was a homeowners insurer who only operated in Florida? As soon as a major hurricane swept through, the insurer would face a slew of claims, possibly driving them out of business. If the homeowners don't get paid on the insurance policies, they cannot rebuild, and suddenly the area hit by the hurricane is in a permanent economic depression.

In real life, insurance companies work hard to diversify various elements of their insurance portfolio. One means of doing this is through re-insurance. Today, many hedge funds are in the re-insurance game through so-called side-car investments. These investments allow insurance companies to off-load the risk of certain events occurring, and allow the hedge fund to reap returns in the 20-30% range should those events not come to fruition. The linked article from the WSJ talks about side-cars done to protect against hurricane damage, but one imagines these vehicles could be used for any type of risk.

The side-car is risky. If there were to be a large number of hurricanes, then the hedge funds would suffer steep losses. But let's think about who really wins when risk is spread out. If we have insurance companies better suited to pay claims in the event of a disaster, and if the risk of a disaster is spread among a wide range of investors rather than a single insurance company, the whole system is better off.

A lot of time is spent talking about how hedge funds may or may not be contributing to systemic risk. Here is a clear example of hedge funds reducing systemic risk.