The surprising return of the sidecar
In a recent report by Willis Capital Markets & Advisory, Bill Dubinsky, the company’s head of insurance linked securities, described 2014 as pivotal for sidecar market growth on the back of 2013 when there was “considerable sidecar activity despite the softening market conditions.”
Sidecars first emerged following 9/11 and became a crucial part of the financing of reinsurance after hurricane Katrina in 2005. Sidecars are short term financial structures (typically one to three years in duration) that allow investors to participate in the performance of a portfolio of policies written by a reinsurer and share in the profit (or loss) that is generated by that business.
They were first launched by traditional reinsurers as a way of taking advantage of temporary market dislocations by writing more business than their balance sheets would allow. After the record losses caused by Katrina, the sidecars of 2005/2006 contributed more than $5 billion of temporary capital to the reinsurance industry, in addition to the $7 billion of permanent equity capital that was raised.
The complexity of these structures means that many of the investors come from the more sophisticated private equity firms and hedge funds that have specific insurance expertise. These types of investors typically have return targets that are significantly higher than the pension fund investors that have funded much of the recent growth in the insurance linked fund sector.
High premium levels and a period of benign losses meant that investment in these early structures performed extremely well. At the time, commentators predicted that the capital in these vehicles would increase several times by 2008 making them a large part of the reinsurance landscape. But in 2008 the market suddenly dried up.
Two necessary conditions for sidecars were disrupted by the financial crisis – leverage and the prospect of investment returns. Both were needed to achieve the target returns of sidecar investors and both disappeared. In addition, market conditions were softening, which caused modelled returns to fall. A significant driver of this was a decision by the State of Florida to dramatically expand the size of the reinsurance protection offered by the Florida Hurricane Catastrophe Fund.
But in recent years, despite the reduction in reinsurance rates, the sidecar market has made a surprising comeback. Over $1 billion of sidecar capacity was raised in 2013 and further investment is expected in 2014. New vehicles included a fully-collateralised reinsurance sidecar with $370m capacity launched by Everest Re and Munich Re’s $63m capacity Eden Re sidecar.
These followed several sidecar launches last year including Atlas Reinsurance X, a $55.5m capacity vehicle launched at the end of 2013 by French reinsurer SCOR, and Aspen’s Silverton Re sidecar. These are in addition to regular launches of annual ventures from the likes of Ren Re, Validus and Markel.
What has stimulated this sudden burst of activity? One factor is the intense pressure that is being felt by the management of reinsurance companies to produce a considered response to the rise of the insurance liked fund model. Sidecars are a good way for reinsurers to access investors because of the inherent alignment of interests – whilst other structures can create the perception of conflicts of interest.
But the new sidecar market is qualitatively and quantitatively different to the post Katrina market. While a large number of vehicles have been launched, they are on average less than half the size of those in 2005/2006. And in many cases, a significant portion of the funds has been provided by the sponsoring reinsurers.
There are both supply and demand side pressures that have been capping the scale of sidecars. Returns are significantly less than in the past, meaning that private equity firms are less likely to deploy large amounts. Additionally, many reinsurers are overcapitalised and are able to write all the business that they need using their own balance sheets.
Sidecars are able to use their association with their reinsurer sponsors to access types of risk that are inaccessible to many insurance linked funds but a process of constant innovation is crucial if the asset class is going to continue to be differentiated from the fund management model.
With no end in sight to the intense competition for new capital, the new wave of sidecars are likely to remain an important tool for reinsurers in their fight for the hearts and minds of investors.
Posted: Monday, March 3rd, 2014