The special-purpose reinsurers known as side-cars are likely to become increasingly important in insurer and reinsurer business strategy, a rating service is predicting.
Moody's Investors Service in New York said in a report that such operations represent an innovative capital- and risk management development.
The firm noted that side-cars are a recent innovation in the "catastrophe-battered insurance and reinsurance industries, whose managements are seeking solutions to stabilize capital and to reduce earnings volatility."
Moody said it knew of four side-car arrangements that have been established recently, all of which have been set up by–and provide coverage exclusively to–Bermuda reinsurers. It listed Rockridge Re (with cedant Montpelier Re), Cyrus Re (with cedant XL Re), Blue Ocean Re (with cedant Montpelier Re) and Flatiron Re (with cedant Arch Capital).
A side-car structure, Moody's explained, typically comprises a newly-created licensed reinsurance company (for example, Side-car Re) that assumes risk, collects premiums from and pays claim losses to the ceding insurer or reinsurer via a quota-share reinsurance agreement.
The side-car's capital, Moody's said, is typically funded via equity and debt financing at a newly-created holding company (for example, Side-car Re Holdings) provided by private equity investors–usually hedge funds and other institutional investors.
Proceeds from the securities offerings, as well as premium and investment income revenues, are then customarily transferred to a collateral trust, which invests the proceeds and disburses funds to the ceding insurer or reinsurer on behalf of Side-car Re to pay claims. Funds are also disbursed to the holding company, via Side-car Re, to pay interest on debt and dividends, if any, to shareholders.
According to Moody's, side-cars offer a "conceptually simple but versatile alternative, or at least complement, to the traditional reinsurance marketplace–and one that looks directly to the capital markets for insurance risk transfer capacity."
The firm said further that the side-car reinsurers' prospects will be linked to the cyclical dynamics of the insurance industry.
The report discusses the side-car market's development and structural characteristics, as well as Moody's analytical approach to rating the side-cars reinsurers.
"For private equity investors, the side-car structure is an attractive alternative to start-up and traditional corporate-reinsurance entities," said Alan Murray, a senior credit officer in Moody's insurance group and an author of the report. "These investors are keen to capitalize on short-term opportunities offered by disruptions in the insurance and reinsurance marketplaces."
He added that "in their simplest format, these new instruments are established to assume underwriting risk from ceding insurers or reinsurers."
The means by which they assume underwriting risk, he noted, "is typically via a quota-share reinsurance contract. This contract is one in which the side-car assumes a percentage of the ceding company's underwriting risk–underwriting losses and related expenses–in exchange for a similar percentage of the associated premiums."
Moody's said it expects that reinsurance side-car structures will likely be aided by improved computer-based tools that should help to more easily evaluate underwriting and credit risks, as well as by the relative simplicity of the side-car structures.
The firm found another driver behind the side-car structures' expansion is a heightened sensitivity on the part of insurers and reinsurers to the financial and business consequences of assuming an excessive underwriting risk burden.
It added that an additional push is a keener investor appetite tempted by the establishment of an investment-grade market for catastrophe-related structured debt.
"We also expect that this structure will eventually find utility in parts of the insurance and reinsurance/retrocessional marketplace other than property-catastrophe risk, such as casualty, life, health, and financial-guaranty risks," he said.
The report is titled "Reinsurance Side-Cars: Going Along for the Ride."
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