High-velocity capital was crucial in 2005 and 2006. Hurricanes Katrina, Rita, and Wilma struck with unexpected consequences, and (re)insurers were left with a USD34 billion price tag. Balance sheets were drained, and the hunger for fresh capital was universal. Some replenishment did come from the dedicated capital of traditional reinsurance companies, but for the first time, alternative sources were prominent and accounted for a third of the cash coming into the industry. Sidecars effectively made their large-scale debut at this time, funneling USD13 billion onto carrier balance sheets.
Typically, sidecars generally have terms of one or two years. Thus, those issued following the 2005 storm season are beginning to expire. After two loss-free years, the capital from sidecars has been returned and interest in new sidecar capital has waned, leaving many to wonder if sidecars were anything more than a fad.
Though the first sidecars were introduced in 2001, the new risk management vehicle did not gain traction until after Hurricanes Katrina, Rita, and Wilma struck the Gulf Coast—with unexpected severity. The implications for (re)insurers were profound. Sidecars were quickly identified as tools that could attract capital quickly and help reinsurers manage risk carefully.
In 2005 and 2006, 17 sidecars were issued, ultimately accounting for 13 percent of the new capacity available to the market—approximately USD5 billion. In 2007, though, the use of sidecars dropped precipitously. Only seven were issued, for just under USD2 billion. In only one year, issuance declined by 60 percent. The situation may seem grim for this exotic risk transfer tool, but in reality the drop in issuances shows that sidecars have fulfilled a specific need. They were not intended to be perpetual sources of capital. In fact, sidecars are not as useful during periods with low levels of insured loss.
In a post-catastrophe marketplace, sidecars become important primarily because they deliver access to capital markets depth via a unique structure. These special purpose vehicles (SPVs) provide a conduit by which alternative investment capital (e.g., hedge funds and private equity funds) can participate in relatively uncorrelated returns. Instead of taking this cash onto its own balance sheet, the (re)insurer creates a separate entity—a sidecar—which addresses a specific set of perils, typically involving a collateralized quota share applied to a particular portfolio.
This mechanism is clearly designed to make the inflow of capital as smooth as possible, while minimizing expenses. As a result, sidecars offer a cost-effective alternative to newly formed start-up reinsurers that tend to appear following a mega-catastrophe. A new firm requires the development of a reinsurance infrastructure, which necessarily entails an investment in the start-up of operations. Sidecars, on the other hand, use their issuing reinsurers for such matters as accounting and claims administration. Since less capital has to be committed to overhead, more can be committed to the business of managing risk.
The advantages resulting from the sidecar structure are clear. Thus, it may seem perplexing that fewer are being issued and that many are being left to expire. This trend makes perfect sense. Traditional reinsurance rates have declined, and carriers have ample capital to address their needs. Sidecars have been rendered unnecessary by market conditions. Rather, in benign loss years, there isn’t much of a role for sidecars.
But, this could change quickly and almost without notice.
The next mega-catastrophe will return sidecars to relevance. As carriers survey the damage and determine how much capital they will need to return to business as usual, sidecars will likely supplement the traditional reinsurance and catastrophe bonds that are stabilizing to the (re)insurance community. Once the industry’s balance has been restored, sidecars will again recede. So, sidecars aren’t dead right now—they’re just resting.
*Securities or investments, as applicable, are offered in the United States through GC Securities which is a division of MMC Securities Corp., a US registered broker-dealer and member FINRA/SIPC. Main Office: 1166 Avenue of the Americas, New York, NY 10036. Phone: (212) 345-5000. Advice on securities or investments in the European Union is provided through GC Securities Ltd., authorized and regulated in the U.K. by the Financial Services Authority. Reinsurance products are placed through qualified affiliates of Guy Carpenter & Company, LLC. MMC Securities Corp., GC Securities Ltd. and Guy Carpenter & Company, LLC are affiliates owned by Marsh & McLennan Companies. This communication is not intended as an offer to sell or a solicitation of any offer to buy any security, financial instrument, reinsurance or insurance product.