Vehicles for success
23 October 2006
Sidecars are like a traditional reinsurance company, except that they only reinsure one cedant under a quota-share reinsurance agreement that is fully funded and collateralised. They provide dedicated capital to supplement an insurer's ability to offer catastrophe capacity over and above its own risk appetite.
Sidecars are an attractive vehicle for the capital markets to participate at the underwriting level on highly volatile business for a limited timeframe (usually a couple of years while premiums are high). Unlike cat bonds, which tend to be a pre-packaged product, sidecar transactions can be negotiated by investors.
Not only can the investors cherry-pick the lines of business with the highest rates online, they can also negotiate the form of the reinsurance contract, as well as the amount and investment strategy of the collateral held by the ceding company.
In addition, the rating agencies have changed their standards by adding pressure to upgrade the quality of capital for (re)insurers. By reinsuring the most volatile risks of a company's overall book to a sidecar, this raises both the quality and the profile of the (re)insurers' retained risk profile and makes maintaining their rating more feasible. By parcelling out some of the worst of the volatility, the (re)insurers try to mitigate possible repetitions of the consequences of the patterns of the past two years.
A further attraction of the sidecar is that it enables (re)insurers to access additional capacity without diluting shareholders' equity. And through a fee income earned from the arrangements, it is hoped that it will produce higher stock price multiples. Since November, a number of sidecars have been set up with total capital in the region of $4bn (£2.14bn).
Sidecars as an investment vehicleSidecars can also be used as an investment vehicle, through which the capital markets can participate at the underwriting level on a whole account basis of a cedant that suddenly requires additional underwriting capacity, either to allow it to continue writing its current book of business at these higher rates or to write more business. By participating on a whole account basis, as opposed to on only certain specified lines of business (as would traditionally be the case on a normal sidecar arrangement or a cat bond), the investor gets the benefit of a diversified risk portfolio of the cedant.
The appeal to the Lloyd's marketThis should have particular appeal to (re)insurers participating in the Lloyd's market. Despite its stringent and complex agency-related rules, this has proved to be a successful insurance market, surviving for more than 300 years.
In the present climate, where regulators and rating agencies are demanding higher-quality capacity and diversified business to be written by (re)insurers, the Lloyd's market is particularly attractive because it provides a diversified platform for its syndicates. This has contributed to the Lloyd's market being able to withstand the losses caused by the 2004 and 2005 hurricanes.
In recent months we have also seen a marked upswing in the interest from institutional investors. The hedge funds, as well as the private equity industry, are now interested in investing into the Lloyd's market.
One of the major benefits of operating within the Lloyd's market is the cheaper cost of capital, as has been demonstrated in a comparison of the Lloyd's market, Bermuda and the EU. To exploit this benefit, however, the Lloyd's market will have to become more flexible, in particular in how it relates to the raising of capital to increase underwriting capacity, so that its syndicates are in a competitive position to react to market forces.
The current regulations surrounding this aspect and supporting the annual venture basis by which Lloyd's operate has resulted in an inflexible environment that makes it difficult for syndicates to adapt or react to market demands.
By way of example, a mixed syndicate made up of a number of traditional names and different third-party capital providers cannot increase its stamp capacity after the commencement of the relevant underwriting year of account without the consent of all the names and third-party members participating on the syndicate for that year of account. This can be a long and sometimes unfair process, with the possible anomalous outcome that a minority of members on a syndicate is allowed to decide the fate of the majority of the members on the syndicate or to hold out for unrealistic demands as recompense for not being able to participate.
Not being able to revisit its capacity means that the active underwriters of the syndicates, in preparing their business plans for the following year of account, are under pressure to gauge the capacity requirements of the syndicate for that year. A task that over the past two years has proven difficult because the coming-into-line date at the end of November and the commencement of the new underwriting year occur so soon after the end of the hurricane season. There is the added difficulty of trying to anticipate market sentiment and rate movements which could impact on the mid-year renewals the following July.
The inability of a syndicate to react quickly to market conditions puts them at a disadvantage to their company market and Bermuda counterparts. For this reason, more and more syndicates are becoming integrated Lloyd's vehicles (ILV), with the managing agency group owning or controlling all the underwriting capacity on a syndicate in order to achieve this flexibility. This does, however, limit the opportunities for investors to participate directly at the underwriting level through the provision of third-party capital. Consequently, it also affects their ability to raise additional capital to support an increase in underwriting capacity occasioned by a spike in (re)insurance rates.
To raise such additional capital, ILVs would either have to borrow the funds or issue shares, which would further dilute shareholders' equity. In many circumstances, this may not be possible anyway, due to the uncertainty of the ILV's exposure to major losses. Any investor buying into the shares of the ILV will indirectly be exposed to the legacy of the past losses of the syndicates operated by that ILV, defeating the rationale of investing into a hardening rate cycle after a major catastrophe. nAndrew Holderness is head of corporate insurance and Dion Williams an assistant solicitor at Clyde & Co
the reinsurance industry has started to use a relatively new business model - the sidecar. But
what is its impact likely to be on the Lloyd's market? Andrew Holderness and Dion Williams investigate