SIDECARS

Rough Notes, Mar 2007 by Moody, Michael J

Not just for motorcycles anymore

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.