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New Cartesian Business Finds Visibility in the Eye of the Storm

In a world of uncertainty, Cartesian Capital Group is betting on one thing it knows  hasn’t changed: natural disasters. This week the firm launched operations for its new catastrophe reinsurance business, called Iris Reinsurance. The business will be led by Chase Toogood, formerly with Credit Suisse and ACE Capital Re, and Schuyler Havens, formerly of Freestone Capital Management.

Cartesian Capital, which typically makes investments of between $40 million and $125 million, contributed to Iris Re with capital from its first fund, alongside contributions from outside investors. Cartesian Capital’s private equity operations continue to invest from its first fund, Pangaea One LP, a $1.05 billion pool closed in 2007 that is 55% deployed.

Cartesian may be the first buyout firm to fulfill a year-end prediction from Reuters that private equity firms would flock to the reinsurance business for private equity-like returns of around 20%. I spoke with Cartesian Capital’s Managing Partner and co-founder, Peter Yu (who also founded AIG’s private equity business) about why he expects to outperform that estimate, what private equity has in common with reinsurance, and the industry’s true market dislocation.

What’s the attraction of a private equity firm to something as specific as the reinsurance business?

The easiest way to explain the opportunity is in context of our overall strategy. Before starting Cartesian, I started the private equity business at AIG. Going on 14 years now, we’ve had the same strategy: to capitalize on long term continuities and to take advantage of dislocations. For example, we were active in Asia in ‘98, in telecoms in ’01, in airlines in 2002 after 9/11, and in 2003 in Latin America.

Since the collapse of Lehman Brothers and AIG, we have continued to focus on dislocations. But to do so requires understanding just how the world has changed since September 15. The way I think of it, we’ve moved from a world of risk to a world of uncertainty.

You have to ask where do we have visibility? Where in the economy are models of value and valuation still intact? There aren’t that many places, by asset class, industry, or geography. The entire global economy was affected by the financial crisis.

The natural world was the one area that wasn’t affected by the financial crisis. No matter how many banks fail, or industries need bailouts–it doesn’t make a natural catastrophe more or less likely. The value of that risk is based in the probability of its occurrence and that’s one of a very few probabilities that didn’t change as a result of the financial crisis.

So it’s a very theoretically interesting situation. The underlying risk isn’t affected by the crisis but the pricing risk of that risk is affected. Insurance companies had significant investment losses and some casualty losses in 2008. Their demand for reinsurance increases. But the capital markets that historically funded that risk have contracted. In short, we have increasing demand and decreasing supply.

This then is a true dislocation: a separation between value and price.

Does the reinsurance business have anything in common with private equity?

Well that depends on what you mean by “private equity.” If you mean LBOs, that was never our focus. Iris Re is really is about providing capital to address a market need when a true dislocation is going on. For me that’s what private equity is about.

What size is the investment opportunity for catastrophe reinsurance, and is it a crowded market?

In previous situations, like the period following Hurricane Katrina in 2005, you saw a number of private equity firms and hedge funds enter the reinsurance markets. We haven’t seen that this year, and I’m not sure why, but we do believe the size of the opportunity is quite substantial.

In December Reuters wrote that more private equity firms would enter the reinsurance business, and the story said a firm could get 20% returns on their investments, which rival the private equity asset class. Is that in the ballpark of what Iris Re is targeting?

Certainly our target returns are north of that. To be clear, we are not focused on traditional reinsurance, but on a very specialized kind of reinsurance called industry loss warranties (ILW). Think of it as an investment contract. For example, an insurer is concerned about its exposure to a major hurricane in Florida. In an industry loss warranty, the insurer and its reinsurer agree to contribute capital to a segregated trust. The insurer may put in $2 million and the reinsurer contributes $8 million. The trust is governed by contract. Then, if a certain event occurs, say a $40 billion hurricane, then the $10 million is paid to the the insurer. If the hurricane doesn’t happen, then the money is paid to the reinsurer.

I think it’s the right product for today’s market, because it addresses the major concerns coming out of the financial crisis. There’s no counterparty risk because it is collateralized. There’s high transparency because it is not tied to a particular insurer’s losses, but to the total size of the storm. And it is a short-term contract so it is relatively liquid.

Other than Blackstone Group, which started Aspen Insurance back in 2001, have you seen other private equity peers recently enter reinsurance investing?

In recent quarters, we’ve seen a number of asset management firms try to raise capital for this purpose but not many of the traditional private equity firms.