Hedge funds once confined their wagers to stocks, bonds and interest rates. Now that their latest investment craze is betting on hurricanes, are the hedge funds straying too far from their expertise?

The biggest hedge funds in this market include Chicago?s Citadel Investment Group LLC, Nephila Capital Ltd. of Hamilton, Bermuda, and CooperNeff Advisors Inc., a unit of French bank that runs several hedge funds.

Nephila Capital partner Greg Hagood says the fund has concentrated on reinsurance, particularly catastrophe coverage, since he and co-founder Frank Majors started the firm in 1997 as part of insurance broker Willis Group Holdings Ltd.

Over the years, ?we?ve seen a lot of people consider ways to crack into the market,? Mr. Hagood says. Representatives for Citadel and CooperNeff wouldn?t comment on their strategies.

The returns for the hedge funds can be juicy. In a typical deal, a hedge fund will agree to make a $10 million payout to a reinsurance company if the reinsurer faces losses topping a certain threshold. The hedge fund could charge as much as a $3 million premium for such a one-year contract or even a lesser amount to protect the reinsurer from a single event such as Hurricane Ivan.

With Ivan threatening the US, the hedge funds are crossing their fingers that the damage won?t be too costly. But as long as things aren?t too bad, the hedge funds can do well. Generally, some hedge funds limit their allocations to 5% or so of their overall capital to such deals, trying to keep a cap on any possible losses and allowing them to generate big gains by reducing the amount of money they have to set aside to pay off possible claims. But some worry that the trend is a sign that too much money has come into the hedge-fund world, forcing managers to come up with a new way to make money. This strategy could lead to losses in the event of a serious catastrophe such as a hurricane that is worse than expected. And some funds that specialise in the business have been allocating more than 5% of their funds to one type of catastrophe, such as Florida hurricanes.

Moreover, the risks are higher than with so-called catastrophe bonds, which pay slightly above comparable corporate bonds and usually sustain losses only if a rare, very damaging event occurs. Now hedge funds are getting involved in offering protection from events that could have a 5% to 20% chance of happening in a year, but provide a much higher payoff.

For now, hedge funds play a small part of the overall reinsurance market. Specialists say they are less than 2.5% of the market for providing backing for reinsurance companies. But more hedge funds are getting into the market, with some starting reinsurance units and going on a hiring splurge to find insurance veterans to run their operations.

In contrast to catastrophe bonds, in which investors are essentially passive investors, buying risks that already have been selected, priced and chopped into bonds, hedge funds are providing the coverage directly, establishing special reinsurance units, typically offshore, where minimum-capital and other regulatory requirements are lighter, according to reinsurance brokers and insurance-industry executives. Hedge funds are ?looking to be more like traditional reinsurance companies ... they have become more and more active and interested in calling us,? says Bert Golinski, who helps arrange such coverage from hedge funds as head of the Bermuda office of Guy Carpenter, Marsh & McLennan Cos.? reinsurance broker.

Hedge funds played little or no role in the reinsurance market five years ago, according to reinsurance brokers, but now some say hedge funds account for as much as half of the capital available for some forms of this coverage, such as protecting against a single storm.

Hedge funds, loosely regulated investment vehicles, offer protection that is attractive to some reinsurers because it allows these companies to hedge themselves with help of an entity that isn?t another insurance company, which could be safer if the industry takes a hit on a big catastrophe. The hedge funds avoid having to register as insurance companies because they aren?t technically offering insurance, but rather a form of protection, specialists say. Alternatively, some do set up thinly funded reinsurers offshore, then back those entities with letters of credit or other collateral.

At the same time, the market has embraced the hedge funds because capacity in the reinsurance market ? or the amount of reinsurance available ? has been on the decline, says George Reeth, chief executive of US reinsurance operations for insurance broker Willis Group Holdings Ltd.