While sidecars temporarily parked in Bermuda may soon ride off into the sunset as property-catastrophe rates keep falling, the basic idea remains sound and investors will likely fuel new facilities with fresh funding whenever the next capacity crisis emerges, capital markets experts contend. "It is a fundamentally solid concept that will continue," predicts Paul Schultz, president of Aon Capital Markets in Chicago.
Mr. Schultz directed his remarks at the basic framework of a sidecar–one that allows reinsurers and insurers with proven underwriting expertise in specialized lines to bring investors in alongside them to take advantage of market opportunities.
The opportunity spurring the creation of most sidecars over the last two years was property-catastrophe reinsurance, Mr. Schultz said, noting that those opportunities are waning–meaning that few, if any, sidecars are likely to form during the balance of 2007. But "the concept will survive," he said, adding that the temporary nature of the sidecar capital is beneficial for the markets in which they participate.
A sidecar is essentially a limited-life special-purpose vehicle in which third-party investors–such as hedge funds or private equity funds–collaborate with an underwriter to provide additional capacity to existing sponsor insurers or reinsurers, usually for short-tail lines of business.
"The fact that sidecars are flexible enough to be in existence for a year or two and then be run off or commuted" makes them "a very efficient way of managing capital in a cyclical business," Mr. Schultz said. "If you raise capital on a more permanent basis…to take advantage of a window of opportunity, then you must decide what you do with that capital once the opportunity goes away."
Robert DeRose, assistant vice president for Oldwick, N.J.-based rating agency A.M. Best, also gives high grades to the sidecar movement. "If the vehicles are used in a very rational way–which I think they have been–it's going to be good for the market. It provides capacity at a time when capacity is needed, [and] it certainly didn't erode underwriting or pricing discipline." In fact, investors in sidecars clearly benefited from those disciplines, he said.
Rob Bredahl, president of Benfield Inc., said sidecars were the difference in getting reinsurance deals done at midyear 2006. Referring to a sidecar set up with RenaissanceRe in late May mainly for Florida wind, he said, "If we did not have that extra capacity, we would not have been able to successfully place all our covers."
Mr. Bredahl, who spoke to NU from a catastrophe summit his firm was hosting in Florida, said the main topic on the agenda was recently passed legislation in Florida which will likely kill off any talks about new sidecars for now–and nearly assure the closing of existing ones.
A central provision of the law doubles the size of the state's hurricane catastrophe fund to $16 billion. "The state of Florida will be providing reinsurance not at market prices, but at loss costs–a fraction of market prices," he said.
"To put it in perspective," he added, "we think the total amount of cat cover bought in the United States is about $55 billion, plus Florida is the peak exposure for all reinsurers, so it was the highest priced."
"We think government intervention is going to really push down rates–and not just in Florida. Cat capacity everywhere is going to come down in price," he said.
"So for now, the sidecar market is probably close to dead," he added, noting that reinsurers will want to keep more of the premium that they're able to write instead of retroceding it to a sidecar. Plus, "we may be moving down to rate levels that no longer interest hedge funds."
John Laubach, senior financial analyst at A.M. Best, noted that record reinsurer results meant investors had better-than-expected returns from the sidecars in 2006.
"When will that ever happen again?" he asked. "I think a lot of investors are going to take their money and run when this is over instead of throwing it out again for another year and gambling."
The accompanying list of 20 Bermuda-based sidecar-type vehicles compiled by NU from various sources includes some that technically don't fit the definition of a "true sidecar" as A.M. Best defines it.
According to Mr. DeRose, a true sidecar writes no third-party business. "It only accepts business through a reinsurance mechanism from a specified sponsor," he said–noting that Olympus, a vehicle for Folksamerica that also wrote other business directly, was not a true sidecar.
Also falling short of the definition is Harbor Point's vehicle, New Point Re, which is more aptly described with the term "market-facing sidecar," Mr. Schultz said. "Harbor Point isn't quota-sharing business to New Point." While Harbor Point provides underwriting expertise, "New Point is the vehicle that essentially writes the business for [other reinsurance company] clients. It's not first written for Harbor Point and then ceded to New Point."
That particular structure is similar to the earliest vehicle on the list–Blue Ocean Re. And while New Point is one of several entities very recently set up to write third-party retrocessional business (sidecar Norton Re and Aeolus Re, a full-fledged reinsurer are others), most experts do not view this as significant trend.
Experts also didn't read anything into the fact that two recent sidecars–Concord Re and MaRI–were formed to provide insurance rather than reinsurance capacity.
The only clear trend these experts described involved changes in the motivations of companies that participated in sidecar formations. The earliest sidecars helped sponsors manage their exposures and lower catastrophe aggregates, they said; later ones were more opportunistic.
Timothy Gardner, managing director for the property practice of Guy Carpenter in New York, said the early sidecars "allowed reinsurers to stay still rather than advance," explaining that many were created to meet elevated rating agency requirements.
Referring to these as "defensive sidecars," he said reinsurers recognized they were overexposed based on the new criteria and sought to lay off some existing business.
Those participating in "offensive sidecars" responded to the property-catastrophe market opportunity in Florida. Rather than using their own capital exclusively to leverage that, they sought out investors who also recognized the opportunity.
Now, with the state of Florida poised to replace property-catastrophe reinsurance capacity and record earnings from 2006 buoying reinsurer capital to levels sufficient to take back much of the exposure ceded to sidecars last year, experts not only predict a slowdown in new vehicles, but the wind-up of old ones–at expiration or even before.
"Given market conditions, will the hedge funds commute the deals early? The question is already being asked," said Mr. Bredahl. "I think there will be discussions."
Over the longer term, he said the reinsurance market continues to be cyclical–and having sidecars as a "release valve" to take out some spikes and valleys is helpful.
"If there's another big event, or the reinsurance market goes the other way, I think that the hose opens up again and more capital comes in," he said.
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