In the wake of the 2005 Atlantic hurricane season’s record-setting catastrophic loss year and in response to the increased demand of capital adequacy and requirements, sidecars gained popularity in the (re)insurance market as an important strategic tool. They have since transitioned from an instrument created to cope with the impact of large-scale catastrophic losses, to an efficient quota-share capacity instrument used by (re)insurers to leverage their relationships with capital markets.
A respected handbook of operational risk defines a reinsurance sidecar as a financial structure created to allow investors to take on the risk of a group of (re)insurance policies, written by a (re)insurer, and to receive the risk and return that results from that business. Figure 1 shows a simplified sidecar structure in which the (re)insurer (A) creates a sidecar holding company (B) to cede the premiums associated with the policies written to the sidecar.
Figure 1. A simplified sidecar structure. (Source: AIR)
The holding company sells its debt and equity to investors (C), who, in turn, make sufficient investment in the sidecar to ensure that claims can be paid should they arise. Any proceeds arising from the sidecar are put in a trust (D), which pays interest and profits back to the holding company. The holding company owns 100% of the sidecar and the liability of the investors is, essentially, limited to the capital they have invested. As a result, sidecars are a purposeful financial mechanism because (re)insurers are able to underwrite additional business without decreasing their financial and underwriting capacity, and capital market investors are able to participate in a market tool with the potential for high returns.
Reinsurance sidecars are unlike traditional reinsurance tools; they are privately financed, their risks are limited and have a defined risk period, and they are typically limited to a single cedent.
1) Privately Financed
Sidecars are attractive tools not only because they alleviate the need for (re)insurers to maintain high capital levels, but also because they appeal to private investors seeking high-yield, short-tailed investments. According an article in Forbes, the potential returns of sidecar investments are in excess of 30%, thus serving as attractive investment mechanisms. Private investors do not generally have underwriting experience and look to (re)insurers for their professional expertise.
If the underwritten policies have low claim rates while in the possession of a sidecar, investors will make higher returns. However, if the policies incur a loss, they will lose funds proportionately; if losses are large enough following a major catastrophe like Hurricane Katrina, they stand to lose all funds. As the loss is limited to the invested capital and profits can be substantial, sidecars are extremely appealing to investors in the private market.
2) Limited Risks
Unlike other insurance-linked security instruments covering an array of perils for a long-term period, sidecars are strategic, limited-duration instruments designed as opportunistic investments that can be terminated quickly. The risks of a sidecar are limited to the associated policies written to that sidecar.
As a result, funds are typically raised by investors in anticipation of the associated policies for the specific purposes of a sidecar as opposed to covering a defined set of pre-existing exposures, a broad array of perils, or a variety of geographies as with other tools such as catastrophe bonds. The structure and types of policies written to a sidecar are heavily influenced by the investors.
3) Defined Risk Period
In addition to limiting the associated risks, sidecars are typically of limited duration. Normally, sidecars are structured with periods of 1–3 years; however, some sidecar structures are more permanent and require the policies associated with them to be underwritten at each renewal season. The re-underwriting of policies is dependent on the capacity of the (re)insurer, the size of the sidecar, and the raised investments. Additionally, some sidecar structures grant investors further flexibility with an option to exit the investment mid-term.
4) Single Cedent
Cedents are increasingly attracted to sidecar mechanisms, as they are typically the sole cedent in the structure and thus able to leverage additional value and surplus relief. Structuring a sidecar reinsurance agreement is a relatively straightforward process and, unlike raising capital through such processes as public offering procedures to increase capacity, a sidecar provides the cedent with immediate access to additional capacity.
The cedent also has built-in flexibility because capital is typically provided for a short and finite period, and on the maturity of the sidecar may be restructured in a subsequent deal. As a result, the cedent has additional underwriting capacity that allows them to take advantage of other profitable opportunities they might previously have been constrained from undertaking.
Overall, reinsurance sidecars are valuable strategic (re)instruments, with more than USD 5 billion of capital raised.
Following Hurricane Katrina in 2005 and the insurance industry’s hard market conditions, reinsurance sidecars rose in popularity. Their defining characteristics, which include being privately financed—having limited risks, a defined risk period, and typically a single cedent—are attractive structural features that continue to appeal to investors seeking high-yield, short-tailed investments.