Christopher Klein, Global Head of Business Intelligence
The popularity of sidecars seems to have ended. The availability of traditional capital and access to insurance-linked securities (ILS) and other alternatives simply has made sidecars less attractive. But, reinsurers know that the market can harden at any time, with one mega-catastrophe creating near-immediate demand for fresh capital. Low overhead and an inherent exit strategy are likely to help these vehicles regain prominence in the next hard market—with investors and reinsurers alike.
Sidecars are nothing more than special purpose vehicles (SPVs) that facilitate the entry of capital into the reinsurance market. The SPV is usually fuelled with capital from non-traditional sources (e.g., hedge funds and private equity funds) to supply additional reinsurance and retrocession capacity. Sidecars have even been used for supplemental insurance capacity, as with Concord Re’s Lexington vehicle. Almost USD5 billion of capacity was supplied in this form in 2005 and 2006 to provide needed capacity for the US renewals that immediately followed Hurricanes Katrina, Rita and Wilma.
Sidecar mechanics are fairly straightforward. Instead of carrying capital on its own balance sheet, an insurer or reinsurer creates a separate entity (the SPV) and finances it with the incoming capital. The SPV is used to cover a specific set of perils, usually through a collateralised quota share of a selected portfolio of risks. In exchange for a pro rata share of premium, the sponsoring entity accepts the risk of a pro rata share of losses.
The Evolution of Sidecars
The evolution of alternative reinsurance capital is punctuated by the three mega-catastrophes of the past 20 years: Hurricane Andrew (1992 and 1993), the terror attacks of September 11, 2001 and Hurricanes Katrina, Rita and Wilma (2005). More than USD60 billion of new capital found its way into the insurance and reinsurance market following the three largest catastrophes of the past two decades. But, the manner in which capital entered the market has changed over this period.
Through each period, capitalization techniques matured, providing both carriers and investors with a growing set of alternatives. Traditional equity capital better-suited to investors seeking medium or long-term positions has been supplemented by cat bond and sidecar capacity, with the latter favoured by shorter-term investors.
In 1992 and 1993, the capital that followed Hurricane Andrew came almost exclusively in the form of equity investment. More than USD10 billion was raised in the two years that followed the storm. Balance sheets bled by insured losses were replenished, and companies expanded. The funding of start-ups led new firms—such as IPC, PartnerRe and RenaissanceRe. Investors were left with initial public offerings (IPOs) as the prevailing exit strategy, though this was compromised by the soft market that followed.
The absence of market-changing losses in the later 1990s bore down on revenue and returns. Several of the post-Andrew start-ups consolidated. Names such as CAT Re, Tempest Re and Mid-Ocean Re disappeared as they merged with (or were absorbed by) competitors. For equity investors, the timing was not propitious. The prevailing exit strategies—IPO and acquisition by a public reinsurer—were limited by the soft market’s effect on valuations.
The terrorist attacks September 11, 2001 were the catalyst for the next capital infusion, as investors anticipated a post-loss reinsurance boom. More than USD16 billion of new capital entered the market, again mostly in the form of traditional equity capital to recharge depleted balance sheets or to form new underwriters such as Axis, Arch and Endurance.
Alternative capacity did emerge in the form of cat bonds, representing 14 percent of the capital raised. The first sidecar was funded as well. Olympus Re was capitalised with USD495 million to provide capacity for Folksamerica Re and represented 3 percent of the capital raised in this wave.
The trend toward alternative capacity resumed in the wake of Hurricane Katrina. Approximately USD34 billion of new capital was raised in 2005 and 2006. Twenty percent flowed into catastrophe bonds, while sidecars absorbed another 13 percent. Alternative capacity vehicles, such as sidecars, were neither exotic nor trivial at these rates. Combined, sidecars and cat bonds accounted for nearly a third of post-Katrina reinsurance capital.
Sidecars grew in number as well as volume after Hurricane Katrina. An estimated 16 sidecars took to the road to provide additional capacity to existing and new traditionally structured reinsurance and insurance companies. The ease of start-up, low cost of management and built-in exit strategy made sidecars quite attractive to both insurance industry and outside investors, as evidenced by hedge fund and private equity fund activity at the time.
Investors, particularly those from outside the insurance industry, sought to capitalise on an expected and sharp rate increase, along with more favourable terms and conditions. However, experience after September 11, 2001 suggested that in the absence of another major catastrophe loss, rates would quite quickly fall back from the levels that provided substantial, but short-term returns. The ease and speed by which sidecars could move capital into and out of the reinsurance market via sidecars provided a ready solution to post-catastrophe market softening.
For sponsoring carriers, there are several benefits to using sidecars. The infusion of capacity enables the rapid expansion to exploit the post-loss hard market. Also, sidecars can be used defensively, helping carriers to protect market positions where damage to the balance sheet precludes expansion. Insurers and reinsurers can use sidecars to avoid additional infrastructure expenses and garner extra risk-free income from fees charged to the sidecar (by the sponsoring cedant) for underwriting and other management services.
Carriers can lower credit risk and reinsurance recoverable capital charges, as the reinsurance or retrocession cover provided by a sidecar is fully collateralised. Basis risk tends to be lower as most arrangements are on a quota share basis, with the sidecar following the fortune of the sponsor cedant. Finally, the sidecar avoids the disruption to an insurer’s or reinsurer’s balance sheet that can arise from an infusion or withdrawal of capital.
Sidecars offer several attractive features for investors, particularly those of a short-term disposition. First they are quick and relatively easy to set up. Staff, premises and the other impedimenta of a traditional company are not required as underwriting and other management functions are handled by the sponsor cedant. A rating is not normally required except in cases where the sidecar may have a debt-funded catastrophe excess of loss cover to take out peak risks.
Further, the sidecar vehicle can take a tightly defined portfolio or slice of risks that can reduce uncertainty for the investor. Finally, the sidecar provides a pre-determined exit plan for the investor with options to extend or shorten the cover in harmony with market conditions. This avoids the market and timing risk to which an IPO-type exit is exposed.
The Future of Sidecars
Modest losses from the 2006 and 2007 wind seasons have ended the favourable market conditions which were the catalyst for most sidecars. Rate softening and a surplus of traditional capacity militate against the high returns that investors seek from fully collateralised capacity. Consequently, several sidecars have not been renewed.
Montpelier Re’s sidecar Blue Ocean Re, formed at the end of 2005 to assume its sponsor’s retrocession book, did not take up new equity commitments that had been secured for 2007. Validus Re did not renew the 75 percent collaterised quota share retrocession of marine and offshore energy reinsurance risks provided by its sidecar Petrel Re that was established in 2006. Instead, Validus Re has placed the cover with an alternative carrier.
Recent sidecar closures actually demonstrate the utility of the vehicle as a source of capacity. When needed, sidecars delivered. Since the current market has sufficient traditional capacity, sidecars have waned, and it would be imprudent to perceive this development as a lack of confidence in sidecars. Having served their purpose, the sidecars have come to a conclusion … for now.
Despite evident scepticism from some quarters following Hurricane Katrina, recent experience suggests that the value of sidecars in making capital available to the market. Sidecars are not intended to be permanent, neither individually nor as an asset class. Instead, they arise from specific market conditions to address capacity shortfalls. Sidecars fade when capital surpluses become the norm and facilitate the quick and easy entry and exit of capital without the cost, time and disruption associated with more traditional equity-based solutions. When the next mega-catastrophe strikes, sidecars may become the preferred vehicles for both investors and risk-bearers.
Christopher Klein, Global Head of Business Intelligence