Two highly active storm seasons have sent retrocession into hiding, explains Phil Zinkewicz.

The worldwide retrocession market, especially in the catastrophe arena, has dwindled in recent years in terms of the number of players and available capacity. Once considered a relatively safe way for new players to enter the reinsurance business, retrocessionaires have come to the tough realisation that the market can be a particularly volatile one. That point was driven home in 2005 when Hurricane Katrina and her sinister siblings wreaked havoc along the southwest coast of the US.

"Katrina demonstrated very clearly that retrocession reinsurers can suffer serious losses when a major catastrophe occurs and the damages that ensue burst through to the upper layers of reinsurance," says Andrew Barile, president of Andrew Barile Consulting. He explains that before Katrina, most retrocession reinsurers didn't realise they could get hit that hard. Years ago, retrocessionaires got into the business for strategic purposes. If they wanted to write reinsurance business in the US, they sometimes had to wait four or five years to get the business. So, they would write retrocession as a means of breaking into the reinsurance market. Bermuda started out as a retrocession market. Lloyd's was big on retrocessions as were Swiss Re, Munich Re and General Re.

Premiums were relatively small because no one expected significant losses to reach those upper layers. Today, rates have gone up dramatically and the number of retrocession reinsurers has diminished. "Retrocessions are no longer something upon which you want to build your business," says Barile. "It's just too volatile a market."

Clint Harris, vice president for property and casualty research at Conning Research and Consulting, says that, based on anecdotal information, all signs point to a shrinking market. "Basically, the retrocession market has been shrinking since the late 1990s when retrocession reinsurers took a couple of big hits," says Harris. "The market dwindled even more noticeably in 2004 after the series of hurricanes and then declined even further after Katrina." The reinsurance market as a whole has become strained and many primary carriers are retaining large portions of their risks because pricing has become prohibitive. "One thing is certain," adds Harris. "Retrocessions are not driving the reinsurance marketplace as they did in the early 1990s."

Rise of cat bonds

Both Barile and Harris point out that, as an alternative to retrocession reinsurance, many reinsurers are employing cat bonds or entering into sidecar arrangements. These arrangements are really quota-share agreements whereby a reinsurer takes funds from outside investors who have agreed to tie up their funds for two or three years. The sidecar usually has no staff of its own and the reinsurer does the underwriting, sharing some of the risk and taking some of the premiums earned by the sidecar. The capital comes from private equity investors and hedge funds looking to take advantage of the higher premiums that accompany a hard market.

These new sidecars coming into the reinsurance market may be a welcome relief during the current retrocession capacity crunch, but they also need careful monitoring. At a Standard & Poor's panel discussion earlier this year, Brian O'Hara, president and CEO of XL Capital, said that the proliferation of sidecars and catastrophe bonds as ways to gain strategic capacity had been "amazing to watch".

Also during that panel discussion, Edward Noonan, chairman and CEO of Validus Re, one of the "Class of 2005", said sidecars are still untested and that they could add basis risk. "Sidecars can provide the strategic capacity companies need to have to make the market work," he said, adding that "the market will have to work through how best to use them without adding risk."

It is estimated that some $3bn has been invested in sidecars since late last year. Recent investors in sidecars, according to a Reuters report, include Boston-based hedge fund management firm Highfields Capital and Seattle-based private equity firm Farallon Capital Management LLC. If this year's hurricane season turns out to be relatively benign, sidecar returns could be 20% to 30%, according to Reuters. However, if the hurricane season mirrors 2005, investors could get burned.

Some analysts also fear that sidecars could end up being "dumping grounds" for reinsurance companies. Such a scenario occurred in the US in the 1980s when New York established its own insurance exchange to compete with Lloyd's of London. The syndicates on the New York Insurance Exchange were made up primarily of insurance companies, many of which used their syndicates to underwrite the bad risks they didn't want to put into their own companies. As a result, the exchange closed before the end of that decade.

- Phil Zinkewicz is a freelance journalist.