Lloyd's of London is following in the footsteps of Bermudian reinsurance companies by setting up sidecars in order to take advantage of huge price rises and a shortage in capacity for US coastal cover.
So far, Global Reinsurance has counted 18 of these alternative risk transfer entities, which are mostly registered in Bermuda, with a smattering also set up in the Cayman Islands. They are funded by investors and only do business for their parent or sponsor company. The idea is to take risk off the parent's books to allow more business to be written.
Many of the post-Katrina "Class of 2005" Bermuda start-ups have used sidecars in order to write more business. Among those to have sidecars include XL Capital (Cyrus Re), Montpelier Re (Rockridge Re) and Harbor Point (Bay Point). See page 19 for a concise list of post-Katrina sidecars.
There seems to be no stopping investors' appetite to fund the ventures, with bankers finding hedge funds and private equity still willing to put up the money for future companies while demand is up and capacity is down. This means that many of the new sidecars are now owned, in part or altogether, by hedge fund managers or their clients.
Many of the new sidecars have a limited lifespan, which has led to them being tagged "disposable reinsurers" by some. Sceptics are concerned about the real value of sidecars to the industry and their capacity to deal with a series of catastrophic events which could empty their coffers and leave the parent company having to foot the bill. But dissenting voices are few and the enthusiasm for sidecars has travelled across the Atlantic to London. Last month Lloyd's confirmed it had set up Thunderbird Re in the Cayman Islands, while Hiscox Syndicate 33 (which intends to relocate to Bermuda) announced it was setting up a new vehicle, which has no name as yet.
"We've been looking at sidecars for a while," said Bronek Masojada, chief executive of Hiscox. "We see as much opportunity to write business in London and sidecars are a way of supporting this business. I think we are the first one in Lloyd's to do this and maybe others will follow." Masojada said that while its plans were not final, they were in advanced stages of discussion. "At the moment, we have in a sense, a mismatch from the demand from our customers and our own risk appetite," he said. "The demand from our customers is greater than our own appetite for retained risk and this is a way of getting our customers a product they would like to buy, whilst maintaining Hiscox's overall risk tolerance. The investors in sidecars are a group of people who specifically want exposure to this area, and so we find a way of bringing it in and providing it to them."
Earlier this year Brit Insurance said it would continue to explore the potential for establishing a catastrophe retrocessional sidecar vehicle, but at the time of going to press a spokesperson told Global Reinsurance that while the venture was still in the works, it was not expected to happen before 2007.
Lloyd's joint head of underwriting, Bob Stevenson, said at the time of the announcement of Thunderbird Re, that reinsurance availability and price for US cat risk, the entry of new insurers and the increased interest shown by capital market investors had created a fascinating market dynamic. "Insurers, including syndicates at Lloyd's, are obliged to explore alternatives that access capital markets to supplement traditional sources of reinsurance supply," he said. "These alternatives range from so-called reinsurance sidecars to securitisation through the issuance of catastrophe-related bonds and everything in between."
But Masojada and others in the industry say they are well aware of the limitations of sidecars, which was highlighted by the implosion of one of the first-ever special purpose vehicles in June this year. Bermuda-based Olympus Re was set up in 2001 by White Mountains to take advantage of the post- September 11 price hikes, but massive losses from the 2005 storms wiped out the sidecar's funds and White Mountains was forced to bail the company out. Under the terms of its reinsurance agreement with Olympus Re, White Mountains was supposed to recoup $143m of storm losses. But despite recapitalising the sidecar with funds from a new set of investors in January, Olympus Re would have gone bust if its parent had not stumped up the cash. To avoid wiping out the investors, White Mountains agreed to reimburse up to $137m of the losses, effectively taking the whole loss itself.
But Masojada said that despite what had happened to Olympus, sidecars were still worth the investment. "They are very good for the specific purpose that they are set up for but they are not the solution for every insurance need," he said. "I mean, they are a special purpose vehicle for a very defined special purpose, but I don't see them replacing broader insurance vehicles as some people believe they will. From speaking to investment bankers there is still a lot of interest in them."
John Berger, CEO of Harbor Point, said they set up sidecar Bay Point to take advantage of the opportunities in US catastrophe reinsurance. "We see some opportunity to write more business, and that is an important role (for Bay Point)," he said. He added that raising capital had not been that difficult, but had attracted a very different form of investor from the end of 2005, when money had been raised to transition Chubb Re to Harbor Point post-Katrina.
Keeping an eye on the storms
Brenton Slade, a senior manager at another post-Katrina start-up, Flagstone Re, which set up sidecar Monte Fort Re, said there had been proposals for sidecars that had come to nothing.
"There have been a lot of vehicles and a lot of sidecars that have flooded the market in the past few months," he said. "They have come into the market and they were not capitalised." And he pointed to a wariness of some capital providers to stump up the cash, a view echoed by Masojada, who said he doubted any investors in sidecars would raise the capital until the hurricane season was nearly or completely over.
Not surprisingly, ratings agencies have been taking an interest in sidecars. AM Best said it was going to publish issuer credit ratings and/or debt ratings, where appropriate, on all sidecars and their corresponding debt, if any, back in June. Moody's said that hedge funds continue to see sidecars as a wise investment and saw "no abatement" in the steady march of the insurance special purpose vehicles. "Sidecars are a response to a hard and limited retrocession market and are set up by reinsurers to maintain or expand capacity," said Bruce Ballentine, senior credit officer at Moody's. "They are a sign of creativity and adaptability by existing reinsurers."
Fitch, in its special reinsurance report in September: "Cycle management - A bumpy ride ahead" also gave them the thumbs up. "Fitch views sidecars as an alternative source of capital for the reinsurance sector, albeit a temporary and opportunistic one, and thus generally considers sidecars' emergence as positive for the sector," said the report. "Additionally, Fitch believes that sidecars can be used to isolate risks and more appropriately match risk tolerances and return requirements." The report went on to say that from a cedant's perspective sidecar usage was considered a form of reinsurance leverage and depending on the specifics involved, it could be comparatively low-risk reinsurance leverage, since premiums paid to sidecars were often used to collateralise sponsors' potential recoverables.
Fitch also said that since sidecars typically don't accept underwriting risk from parties other than their sponsor, they are less likely to experience deterioration in credit quality from an unforeseen source. But they are not considered the be-all and end-all for everyone. In June at a panel discussion at Standard & Poor's recent "Insurance 2006: Rethinking Risk" conference, Ed Noonan, CEO of Validus Re, warned they were still untested and sounded a note of caution that they "could add basis risk". He said that with so much capital now needed to start a reinsurer, this had become a less viable option for raising capital. Sidecars can provide the "strategic capacity companies need to have to make the market work", but added that "the market will have to work through how best to use them without adding risk."
A temporary solution?
In September Chris Waterman, senior director at Fitch, said: "The sidecar model is a positive one, helping to fuel competition which may in turn influence rates." But he added that he does not expect the run on sidecars to last and that he expects them to be wound up as the market begins to soften.
It will be interesting to see if sidecars would remain as blindly popular after a couple of large catastrophic events. One sceptic is Don Kramer, who set up Ariel Re in the wake of Hurricane Katrina. He is against them now and vows not be using them in his new venture. "If the sidecar blows, you are suddenly naked for the second event," he said. "So when you get into that it becomes very difficult." Kramer points to the problems experienced by Olympus Re. "Look what happened to White Mountains - and they are supposed to be smart guys. This is Jack Byrne, the genius of the business! The sidecar blew and they are now making up the losses for the sidecar because if they don't the sidecar doesn't have the capacity to cover them on the other stuff. Which only shows there was never a free lunch here." Kramer also believes that starting a sidecar is not a good ratings arbitrage because ratings agencies know that they have taken additional risks. He added: "I see it as defensive risk-reduction. I don't see it as an aggressive derivative to leverage the capital of the industry."
- Lloyd's confirms Cayman sidecar Thunderbird Re
- Hiscox to create Bermudian sidecar
- Lexington to cede to Concord Re
What are sidecars?
In their simplest form sidecars are reinsurance companies, often sponsored by existing reinsurance companies that receive the majority of their capital from investors other than their sponsors. These investors are often hedge funds, investment banks or private equity funds with comparatively little exposure to the insurance sector beyond their sidecar investments. Because they are often intended to capitalise on favourable market conditions with an uncertain duration, many sidecars are designed so their operations can be unwound relatively easily. Most of the sidecars that have been formed to date are domiciled in Bermuda, which is also typically their sponsor's country of domicile.
Sidecars have been formed because they provide capital-efficient return opportunities for sponsors and investors. Typically the sponsor and the sidecar enter into a quota-share reinsurance contract under which the sponsor transfers a portion of its underwriting risk (and related required capital) and corresponding return to the sidecar in exchange for a commission. Additionally, although they differ from typical sidecar arrangements, sponsors and sidecars may also enter into management contracts in which the sponsor provides fee-based underwriting and management services for the sidecar, but does not accept underwriting risk. These arrangements enable the sponsor to deploy its underwriting and management capabilities while using the sidecar's capital.