Risk aversion

A spike in insurance premiums has led investors in Bermuda to favour a more flexible vehicle called a ‘sidecar’, which simplifies the relationship between reinsurer and investor. Charles Collis reports

With the 2006 hurricane season already under way, many US property insurers are facing a severe shortage of reinsurance capacity and are seeing a consequent spiralling of reinsurance premiums. This capacity crunch is being driven by the inability of the reinsurance market to provide cover, rather than by a lack of desire.

The hurricanes of 2005 served up a double blow to the worldwide property catastrophe reinsurance market. The storms themselves caused a record $60bn (£32.56bn) of industry losses. In December 2005 it looked as if the market would be somewhat stabilised by a huge influx of capital into Bermuda. Existing insurance companies raised in the region of $16bn (£8.68bn) in the weeks and months following Hurricane Wilma. In addition, around 15 new companies were formed in Bermuda over the same period with total capital and surplus around $16bn.

Despite all the new capital, many reinsurers were surprised by the relatively small increases in property catastrophe reinsurance rates during the 1 January 2006 renewal and a number did not bind as much business as expected. As a result, many insurance companies were unable to fill their desired reinsurance programmes.

Then came the second blow to the reinsurance market. As a result of their experiences from the hurricanes, the rating agencies increased their capital requirements for reinsurance companies writing property catastrophe business. As a result, many companies that thought they had additional capacity had to reduce the amount of cover they could offer to ensure that they maintained their ratings. As the 2006 hurricane season approached, there was an urgent need for new capital and a dramatic increase in reinsurance rates.

Hedge fund and private equity investors
The sharp increase in reinsurance premiums has attracted the attention of many hedge funds and private equity firms looking for high returns and diversification of investments. Many of these investors are only interested in investing in the property catastrophe risks, not the general diversified portfolio of most insurance companies.

In addition, they are not interested in assuming any legacy exposure from the 2005 hurricane season. Accordingly, the hedge funds want to invest in a new insurance company that only writes high-layer property catastrophe insurance business and, as the hurricane season started on 1 June, they needed the companies quickly.

Sidecars v cat bonds
The solution for these hedge funds was a Bermuda special purpose reinsurance company nicknamed the ‘sidecar’. A sidecar is not, as has often been described, a cat bond by another name.

Investors in a cat bond also tend to be hedge and private equity funds. In a typical cat bond transaction, a special-purpose vehicle (SPV) issues a protection contract to a single insured. Investors purchase limited recourse notes from the SPV rather than shares in its capital as they do in a sidecar structure. There are many advantages to the cat bond structure for investors. The minimum investment is usually quite small, often as low as $10m (£5.43m).

The use of bankers, modelling companies and rating agencies makes the cat bond very much a pre-packaged product. Investors wishing to diversify their fund by investing in an asset class uncorrelated with their existing portfolio and at the same time obtain a higher rate of return than a corporate bond with a similar rating may do so by investing in cat bonds.Investors can also opt to base their investment decisions on the probability of loss produced by the modelling company and the rating on the cat bond rather than their own assessment of the underlying risk.

What is a sidecar?
Sidecars are very different. There are no bankers, no modelling companies and no rating agencies. There is just an insurance company that wants a large amount of reinsurance protection and a lead investor with a couple of hundred million dollars to commit.

This allows all aspects of the sidecar transaction to be highly negotiated by the investors. Not only can the investors cherry pick the lines of business with the highest rates online, but 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 many respects a sidecar is similar to a traditional insurance company. However, there are a number of key characteristics that are unique. The sidecar only reinsures one cedant under a quote-share reinsurance agreement and that quote-share reinsurance agreement is fully funded and collateralised.

As the investors only want to participate while premiums are high, the quota-share agreements tend to be limited to a year or two. Should premiums remain buoyant for several years, there is often an option for the sidecar to renew the business for a few more years.

To encourage strong underwriting, the cedant is usually required to participate in the game either by investing in the sidecar, retaining a part of the business written, or both. One of the key elements of a transaction is returning the capital and surplus of the sidecar to the investors as quickly as possible after the end of the covered period’s loss, though losses on the underlying business may take years to finalise. The longer the capital is tied up in the + continued sidecar the lower the annual rate of return.

A number of different strategies have been developed to ensure as short a period as possible. Some sidecars are writing only in the upper layers, where claims will only be attached following an extraordinary event such as Hurricane Andrew or Katrina. In these cases, it is expected that the following years will be clear and that there will be no change under the agreement.

Many of the deals will also use a fixed commutation at a specified point in time. The commutation price is determined using actuarial estimates or audited loss reserve numbers.

The benefits for reinsurers
For a deal to work, the other side must also benefit. The Bermuda reinsurers receive a number of benefits from these transactions. On the one hand, there is usually an attractive profit commission for the cedant built into the deal. While, on the other hand, they get a large amount of additional capacity which can be offered to the clients at a time when little reinsurance is available.

Since November, seven or eight sidecars have been set up with total capital in the region of US$2bn (£1.09bn). There are more sidecars in the pipeline, many of which are expected to be up and running prior to the 1 July renewal date.

But just because these vehicles have a funny nickname, do not think Bermuda sidecars are just a passing fad.

It is likely that they will play an important role in the worldwide reinsurance market. The ability to set up and capitalise a Bermuda sidecar in a matter of weeks has assisted with easing the current capacity crunch.

All of the sidecars that have been set up to date have reinsured Bermuda companies for their property catastrophe exposures.

There is no reason why insurance and reinsurance companies in other jurisdictions should not have their own Bermuda sidecars and no reason for the risks to be limited to property catastrophe.

Any risk can be reinsured in to a sidecar, provided that the premium is sufficient to attract investors. The next time premiums for any line of business spike, as they are now for property catastrophe business, you will see sidecars used to fill the void. n
Charles Collis is a partner at Conyers Dill & Pearmancontinued #