As property catastrophe reinsurance companies suffer losses stemming from Hurricanes Katrina, Rita and Wilma,many have raised capital in the public markets to allow them to underwrite for 2006 renewals.The traditional means of raising capital include the issuance of equity or catastrophe bonds through public offerings. A company might also reduce its property catastrophic writings but thatwould require the reinsurer to give up position in the market,and thus reduce its ability to take advantage of any improved rates and terms post-Katrina.An alternative structure that offers certain advantages over traditional offerings is known as a "reinsurance sidecar."
Four sidecars have been established post-Katrina: Cyrus Re, Flatiron Re, Rockridge Re and Blue Ocean Re. All of these sidecars are Bermuda insurance companies established with funds raised in private placements to third-party investors. The newly created sidecar is intended to reinsure risks from an established reinsurance company and rely on the underwriting capabilities and market position of the established reinsurance company. For instance, Cyrus Re reinsures property catastrophe business of XL Re and Flatiron Re reinsures property catastrophe and marine risk of Arch Re. The investors in sidecars have primarily been hedge or private equity funds such as Highfields Capital, Farallon Capital and West End Capital.
The primary use for sidecars, from the perspective of the established reinsurance company, is that the reinsurer can write more business than it could have written without raising more capital. The reinsurer does not have to increase its level of long-term debt or undertake a dilutive equity offering. The reinsurer assures itself of the creditworthiness of the sidecar by requiring the sidecar to post a letter of credit or establish a collateral trust with funds commensurate to the projected risk of the ceded business.While the reinsurer loses some of the upside connected with the higher premium environment, it absorbs less downside risk and can negotiate with the sidecar for the payment of ceding and profit commissions. In addition, since the sidecar is a limited-life vehicle (two years typically) and has no underwriting capability, it does not represent competition for the reinsurer. In some structures, the reinsurer also has no governance or managerial responsibility for, or stockholder control over, the sidecar or exposure to losses experienced by the sidecar.
From an investor’s perspective, the sidecar allows them to take direct exposure to a particular segment of the reinsurance market that is not possible through the purchase of the equity securities of a diversified reinsurer. This exposure is related to a catastrophe risk and therefore its returns are not directly correlated to interest rates, the equity markets and other economic factors. Compared to a catastrophe bond, a sidecar offers equity-like returns and is not limited to a specified yield. Investors’ exposure is usually to short-tail, catastrophe business in a limited life vehicle which allows the investor to take profits during a higher-premium environment and to exit their investment once capacity returns to the market.
Investors in a sidecar can also leverage their return by borrowing against its pool of equity and accumulated premiums. This leverage, however, does not expose the reinsurer or policy holders to risk as the obligations of the sidecar to its lenders are subordinate to its obligations to the reinsurer.
Compared to establishing a new reinsurer (such as Ariel or Harbor Point), a sidecar needs little or no staff, no underwriting department, little management oversight and faces a comparatively quick regulatory approval process in Bermuda. Since all sidecars are established offshore, the sidecar is not considered to be conducting a trade or business in the United States and therefore, offers tax savings for certain kinds of investors.
Sidecars have been subjected to two contradictory objections; some suggest that sidecars are dumping grounds for undesirable risks; others compare them to the "baby syndicates" of Lloyd’s that were made up of favored players and received favorable risks.The answer to both objections is that sidecars generally take a neutral slice of the reinsurer’s business by way of a quota-share treaty.The reinsurer is bound to cede a share of a line of its business (without cherry picking) and the sidecar gets to piggyback on the reinsurer’s underwriting skill. To the extent the reinsurer makes good or bad underwriting decisions, the sidecar will benefit or suffer proportionately.
A reinsurer might also be concerned that the sidecar is skimming the profits that would otherwise be earned by the reinsurer. In the case of a reinsurer whose balance sheet is sufficiently strong to take all new business, there is no need for a sidecar. For those reinsurers who would otherwise have to retreat from the market, it allows them to maintain market share and to earn a significant ceding and profit commission on all risk assumed by the sidecar. The reinsurer can avoid increasing its risk exposure and capital requirements but also increase earnings through the ceding commissions.
Sidecars are a byproduct of recent natural disasters and are designed to be formed relatively quickly to take advantage of the favorable premium environment. They are flexible, shortterm investment vehicles that offer targeted catastrophe exposure for investors and an effective short-term solution for reinsurers to maintain market share and profitability.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
