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Sidecars Not just for motorcycles anymore By Michael J. Moody, MBA, ARM Last year’s mild weather and lack of any measurable catastrophe property losses in the U.S. was a welcome change from prior years’ activities. Despite grave warnings, 2006 will be remembered for a noticeable lack of hurricane activity, thus allowing the collective insurance industry to catch its breath. However, the industry remained wary about property risks last year, and 2006 was still a challenging year for non-coastal property coverage, and even more so for coastal property, which was extremely pricey. The lack of hurricane activity has certainly helped the pricing of the 2007 renewals, as has the additional capacity that has been attracted to the industry over the past few years. Today, there is even talk of the soft market extending into the general property area; however, few expect this to extend to cat-prone areas. Certainly the disappearance of retrocessional reinsurance has played a large part in the changing landscape for high layer cat covers. Another major factor has been the recalculation of the catastrophe models that insurers and reinsurers use to price their high layers of property coverage. In addition, most of the rating agencies have begun enforcing more stringent requirements on property reinsurers to maintain their ratings. Taken in total, these events have had a profound effect on the property insurance market, and they are ones that may last for some time regardless of the industry’s actual loss experience. Property coverage concerns The insurance industry has been trying for the past couple of years to find ways to reduce the effects of the 2004 and 2005 storms as well as future hurricane activity. One of the first actions was the formation of a number of new specialty property underwriters immediately following Hurricane Katrina. These new reinsurers have been able to provide some additional capacity, primarily out of the Bermuda marketplace. Additionally, increased interest has also been shown in the CAT bond market. Some believe that this may be the opportunity that the CAT bond market needed to finally be able to utilize the capital markets for additional capacity. However, it’s a new product offering, known as a “sidecar,” that is getting a great deal of attention today. The sidecar concept had been around prior to the “three sisters”—Katrina, Rita and Wilma—but in very limited use. Once the results of these three events had been tallied, interest in the sidecars grew rapidly. The basic concept of the sidecar is quite simple and easily implemented. In its purest form, the sidecar is a quota-share partnership in which a reinsurer becomes affiliated with a capital market source (frequently a hedge fund) that can provide a renewable source of capital. The capital market source forms a new reinsurer, typically in Bermuda, which sits alongside the existing, rated reinsurer that, in essence, functions as an underwriting manager. Brief history The past 18 months have seen a flurry of sidecar activity; however, most reinsurance experts believe that the concept actually started in early 1999. This is when a joint venture between State Farm and Renaissance Re (RenRe) lead to the formation of Top Layer in order to provide high layer, catastrophic property coverage for RenRe’s portfolio of property programs. Coverage was written on a quota-share, excess-of-loss basis for non-U.S. property risks. Income for both carriers was generated via an ownership stake in Top Layer. In addition, Ren Re also made a management and underwriting fee on the business written by Top Layer. Several similar structures were introduced following 9/11, with limited success. However, another Ren Re/State Farm entity, DaVinci Re, was by far the most successful. Here again, Ren Re provided the administrative duties on a management fee basis and State Farm provided the majority of capital. DaVinci’s business plan was to take a predetermined percentage of Ren Re’s catastrophic property business. Olympus Re was also established shortly after 9/11 by White Mountains; however, it lacked the single large investor. As a result, there were several investors who provided additional capacity for White Mountains’ general insurance and reinsurance business. The majority of the business of Olympus was written through quota share agreements with Folksamerica Re (a subsidiary of White Mountains). Another early effort to utilize sidecars was made by Montpelier Re. It established and capitalized a Cayman Island reinsurer called Rockledge. Rockledge was capitalized with $91 million, of which $10 million was an investment from Montpelier. For the insurance industry, the major appeal of these four operations was that they offered a chance to diversify the insurers’/reinsuers’ revenue stream by adding a fee-based element. This was of great interest to many underwriters who were tied to underwriting results during the 1990s soft market. The other additional factor was the desire by the capital markets that were looking for ways to get involved in the insurance business and had money to spend. The capital markets were looking for high rates of return as well as an investment that would diversify their portfolios. Post-Katrina XL was one of the first to take advantage of the sidecar concept following Katrina. In November 2005, they established Cyrus Re by capitalizing it with $500 million from several capital sources, but no direct investment from XL. Cyrus Re sits alongside the XL reinsurer and participates in high-level property coverage and a retrocessional book of property business under a quota share arrangement. After the storms, Montpelier Re quickly realized that it was going to suffer significant losses, to the tune of net losses for the third quarter of 2005 of an estimated $875 million. Those losses left the reinsurer in bad financial condition, and the subsequent ratings downgrades did not help at all. However, the management developed specific strategies that included entering into two CAT bond transactions, as well as launching an additional sidecar, Blue Ocean Re. Arch Insurance Company also started a sidecar, Flatiron Re, on December 29, 2005. The company was formed to take a 45% quota share of certain property and marine business that was written by Arch. Arch does not have any direct investment in the reinsurer but rather depends on investors developed by Goldman Sachs to secure the funds for Flatiron Re. White Mountains also launched another sidecar in the latter part of 2005. The sidecar, Helicon, will write up to 35% of White Mountains’ U.S. reinsurance for property business. Movement in the sidecar business has been hot and heavy since the hurricane activity of 2005. In addition to the above noted transactions, Validus Re has formed Petrel Re, and Renaissance Re formed yet another sidecar known as Starbound Re. Several additional sidecars were also rolled out during 2006. In addition, a number of other sidecars were in various stages of development as the 2006 underwriting year ended. But it is the introduction of a new sidecar in early 2007 that is attracting the most attention. This was a joint venture between Marsh, Inc., and ACE USA that was announced on January 11, 2007. The program was the first sidecar facility, named Marsh Risk Innovations (MaRI), specifically designed to provide additional catastrophic property capacity directly to corporate insurance purchasers. Another unique feature of this venture is that it combines the capacity of the capital markets and an A+ rated insurer that can offer admitted paper directly to Marsh’s corporate clients. MaRI’s purpose is to give corporate insurance buyers exclusive access to cat property capacity that can be used to fill gaps in their corporate property programs. Heretofore, sidecars had been reserved for retail insurers and reinsurers; however, now corporations can gain direct access to the capital markets, in much the same manner that captives allow corporate buyers direct access to reinsurance markets. Conclusion Obviously sidecars, just like CAT bonds, will never account for a high percentage of the reinsurance market. For example, Lehman Brothers estimated that sidecars accounted for only about $4 billion to 4.5 billion in 2006, while CAT bonds are expected to have about $4 billion in issuances during 2006. What is clear is that both of these capital market products should have a permanent place in the catastrophic property insurance coverage arena. Sidecars can provide additional capacity, which is sorely needed in today’s property market. The capital markets have been trying for years to beat down the door to enter the insurance arena. It is now painfully obvious that there will never be sufficient capacity within the insurance industry to survive the “big one.” And even a catastrophe that approached the losses possible from a “big one” could so cripple the industry, it would endanger its continued existence. Given that situation, prudent insurers and reinsurers should be exploring some of the innovative capital market ideas such as sidecar arrangements, so as to add capacity to the industry as quickly as possible. * |
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