As reinsurers replenished their coffers following 2005's record hurricane losses, private equity and hedge funds were a principal source of capital. A substantial portion of their funds flowed into innovative vehicles known as reinsurance sidecars.
A sidecar is a special purpose insurer of limited duration formed to reinsure specific risks underwritten by a single reinsurer. The sidecar has none of the infrastructure normally associated with an insurance company (including employees), and instead relies on its reinsurance partner for marketing, underwriting and claims management and on a third party management company for other aspects of its operations.
For investors, a sidecar offers a pure insurance play, typically limited to specific categories of underwriting risk (e.g. wind risk in a particular geographic location). Investors commit their capital on the expectation that their returns will be dependent entirely on the underwriting (and, to a significantly lesser extent, investment) performance of the sidecar. This contrasts with an investment in a traditional insurance startup, where underwriting performance is an important element in determining investment return, but the price/earnings multiple on an initial public offering or sale of the company is the most significant driver of investment performance.
There are a number of factors that have contributed to the development of the sidecar market:
Access to management. The scarcity of management teams that are both strong and unengaged creates a limitation on the number of attractive insurance start-up opportunities. Sidecars provide a vehicle for new investment in reliance on a management team at an established insurer, without exposing investors to its historic business.
Ratings advantage. The record hurricane losses have caused an industry-wide reassessment of catastrophe risk models, including by rating agencies. In order to maintain favorable ratings, many insurance companies have had to limit wind and other high severity exposures on their books. A properly structured sidecar allows its insurance company sponsor to underwrite a higher volume of volatile business in the sidecar without an adverse ratings impact, while sharing in positive underwriting results in the sidecar through the payment of a performance-based underwriting fee.
Demand for capital. The post-2005 contraction has made reinsureds receptive to alternative sources of coverage. While there is reason to wonder whether the new private equity and hedge fund capital infusing sidecars will dry up if the current round of investment does not perform well, more stable sources of capital are simply not available in the current market.
High rates. These same market factors have led to a steep increase in insurance rates. Rates on line – the relationship between premiums and policy limits – are reportedly as high as 25 percent to 40 percent in certain risk classes, even at relatively high attachment points. The search for yield has caused a number of hedge funds that have not traditionally invested in the insurance sector to view sidecars, which offer high rates of return and relative liquidity, as attractive investments.
Quick execution. Sidecars can be formed in response to dislocations in the insurance marketplace in very short order, because they do not need to recruit a management team, find office space in the very difficult Bermuda real estate market, put in place information technology systems or do any of the myriad other tasks that face a start-up insurer. By the same token, their business can be wound down quickly. Sidecars are therefore vehicles that are well adapted to the needs of the highly cyclical insurance market.
Structuring a sidecar
Although sidecars are customized to meet the requirements of their sponsors and investors, there are common structuring issues for all sidecars.
Corporate form. The sidecar insurer is typically organized as a wholly-owned subsidiary of a Bermuda or Cayman company, which issues securities to investors. This permits borrowings in the holding company which can be downstreamed as equity capital to the insurer, increasing its underwriting capacity.
The formation of a Bermuda sidecar insurer requires submission of an application, including a business plan, to the Bermuda financial services regulator. Conditional approval can be obtained in as little as a week.
Market facing or not? As indicated above, sidecars may write reinsurance coverage for third party insurers directly on their own paper, may write retrocessional coverage (reinsurance of reinsurance) for policies written on the paper of their insurance partner, or may do both. This is principally driven by commercial rather than legal considerations. Where the sidecar is a direct writer of reinsurance, it will enter into an underwriting agreement with its insurance partner, which will have the authority to bind the sidecar to any policy that meets prescribed underwriting guidelines.
A market facing sidecar may need to obtain a financial strength rating in order to compete for many types of business. If the sidecar simply stands behind reinsurance policies written on the paper of its insurance partner, it will enter into a quota share reinsurance policy pursuant to which it will share a percentage of the premiums and risks on each policy written by its insurance partner that conforms to the underwriting guidelines set forth in the quota share agreement. In either event, the sidecar is ultimately reliant on the underwriting prowess and claims settling capabilities of its insurance partner.
Alignment of interests and adverse selection. The sidecar's dependence on the insurance partner requires from the standpoint of the sidecar investor that the economic interests of the sidecar and its reinsurance partner are aligned with respect to the policies written by the sidecar. Without such an alignment, the sidecar could be used by the insurance partner as a vehicle for placing less profitable business or for granting an accommodation to an existing client in order to garner more favorable terms on business that will not be ceded to the sidecar. This alignment is generally accomplished in several ways.
First, the insurance partner may be required to share (generally a minority interest) in each risk written by the sidecar. The insurer may also or instead make an equity investment in the sidecar itself. Second, in the event that the sidecar is writing insurance directly, the insurance partner/underwriter should be barred from competing with the sidecar with respect to business that meets the sidecar's underwriting guidelines. Similarly, the quota share reinsurance agreement should provide that any business that meets its underwriting guidelines which is written by the insurance partner is automatically subject to sharing under the quota share, so that the insurance partner does not have the discretion to retain a disproportionate share of the most profitable business. In either event, the sidecar must receive its share of any business that meets the underwriting guidelines. Finally, the insurance partner's commissions under the underwriting agreement or quota share agreement largely will be based on the profitability of the sidecar in each policy year, and may be subject to clawback or loss carryforward provisions.
Collateralization and ratings
Sidecars typically write business on a fully- or highly-collateralized basis. Equity capital provided by investors and premiums paid by reinsureds are deposited into a trust account which may be used to collateralize each policy written by the sidecar up to the full limits of the policy or on a probable maximum loss basis. Alternatively, the sidecar may be permitted to fund the collateral trust with a letter of credit or financial guaranty by a creditworthy institution.
Collateral determinations will generally be driven by commercial considerations, principally the desire of the reinsured (either the sidecar sponsor or another insurer in the case of a market-facing sidecar) to avoid any funding risk if payment is required under its reinsurance policy. In addition, collateralization to limits may reduce an otherwise steep capital charge for rating agency purposes that would to some extent mitigate the benefit of obtaining reinsurance through the sidecar.
Exit and distributions
Highly dependent on hedge fund capital, sidecars are designed to provide opportunities for short term liquidity, since hedge funds are subject to investor withdrawals. This has many implications. First, sidecars are typically one to three year deals. Second, the business assumed by the sidecar generally involves low frequency ?short tail? catastrophic risks, such as hurricane risk. Therefore, there is a probability of no losses during the life of the sidecar, and if a loss event occurs, the insurer knows of it immediately and quickly receives claims, permitting a reasonably informed determination of the approximate size of the loss (and the need to reserve capital) shortly after the end of a policy year.
Sidecars are, however, still insurance companies, and so the ability to return capital is limited by the need for adequate reserves, including possible regulatory and ratings constraints. As a result, the interplay between reserving and collateralization requirements, including the timing and methodology for establishing reserves and releasing collateral on the one hand, and the availability of capital to be returned to shareholders on the other, is highly negotiated in most sidecar transactions.
In addition to regular dividends to investors whenever capital is available for release, many sidecars allow for early exit opportunities in the form of redemptions. Deals may provide for voluntary redemptions periodically or upon certain trigger events that would cause investors to want to cease partnership with the insurer, such as loss of license, insolvency, material breach of the transaction documents or change of control. Investors also typically have book value redemption rights at the end of the term of the reinsurance arrangements. This may be coupled with the right to force a commutation of the reinsurance agreement (a termination of the agreement along with settlement of any outstanding losses) to provide for liquidity to enable the redemption. A critical mass of investors may have the right to extend the reinsurance agreement for an additional term with non-participating investors given redemption rights.
The financial performance of the first generation of sidecars and, in the short run, the continuation of the current hard market cycle is likely to determine whether sidecars become a fixture of the reinsurance market, but their long-term viability may also depend on their evolution from a highly-customized product with attendant transaction costs to one that is more commoditized.
Andrew Sommer and Stephen Hertz are partners and Michael Devins is an associate with the law firm Debevoise & Plimpton LLP.