The reinsurance side-car market is becoming an increasingly desirable way to spread risk, explains Alan Murray.

Reinsurance side-cars – or special-purpose reinsurers – are an innovative development in capital and risk management for insurers and reinsurers, and one that may be poised to become an integral component of business and risk management strategies.

Catastrophe-battered insurers and reinsurers have been seeking ways to stabilise capital, to avoid excessive underwriting risks, and to ease earnings volatility. Special-purpose reinsurance vehicles, such as side-cars, offer a conceptually simple, yet versatile, alternative (or a complement) to the traditional reinsurance marketplace. Moreover, the reinsurance side-car structure looks directly to the capital markets for its insurance risk-transfer capacity.

At their simplest, these new instruments are designed to assume underwriting risk from ceding insurers or reinsurers, typically via a quota-share reinsurance contract. This contract is one in which the side-car assumes a percentage of the ceding company's underwriting risk in exchange for a similar percentage of the associated premiums.

The side-car's capital is, in most cases, funded by a combination of equity and debt financing at a newly created holding company, with the equity financing usually provided by private equity investors, such as hedge funds. Proceeds from securities offerings, as well as premium and investment income revenues, are transferred to a collateral trust, which invests the proceeds and disburses funds to the ceding insurer or reinsurer in order to pay claims, or to the new holding company in order to service debt obligations and shareholder dividends. In this regard, the side-car structure is very much based on the use of standard reinsurance contracts, and corporate and capital structures.

That said, side-cars do tend to be differentiated by such characteristics as a defined risk period and finite lifetime (usually not a “going concern”), capital needs shaped by modelled risk, and the lack of an active administration.

The side-car structure is basically an off-the-shelf template. Given the speed at which market conditions can change, quickly assembled side-cars offer rapid-response reinsurance and corporate capital. This clearly accelerates the ability to exploit new opportunities – a seductive lure for private equity investors.

Moody's also expects that this structure will eventually find utility in parts of the insurance and reinsurance /retrocessional marketplace other than property/catastrophe risk, such as casualty, life, health, and financial-guaranty risks.