Moody's Discusses How To Rate Sidecars

With catastrophe reinsurance rates softening as a result of the expansion of the Florida Hurricane Catastrophe Fund, reinsurance sidecars may suffer, according to Moody's Investor Service.

For concerned investors the rating agency set out five principles in rating sidecars.

Sidecars are a mix of both catastrophe modeling done by computers and business done by human beings, the rating firm noted.

In rating a sidecar, Moody's said it likes to put itself in the mind of the sponsoring insurer examining factors such as what the ceding commission says about the underlying portfolio and why the sponsor prefers a particular treaty structure.

Moody's said the features that regulate sidecar behavior are traditional insurance business rules like operating leverage, reserve leverage and reserve development.

While regulators perform this task for traditional insurance, in sidecars such constraints can be topics of negotiation between sponsor and the investors, Moody's suggested.

The firm said sidecars and catastrophe bonds are not the same when it comes to risk.

Sidecars and cat bonds have different ways of responding to the moral risk that the sponsor may resist limiting losses through either relaxed underwriting or loose claims settlement practices, Moody's advised.

Sidecars can mitigate this risk by using a quota share structure, according to the rating firm. It said that for catastrophe bonds, moral hazard may be mitigated by having the sponsor retain a percentage of losses in the reinsured layer.

For both indemnity cat bonds and sidecars, the wording of the net retention clause is critical, Moody's counseled, especially limitations on what reinsurance the sponsor buys on its retained share, to ensure it has enough "skin in the game."

Moody's noted that risk of change in premium levels affects sidecars. A pricing squeeze directly impacts sidecars, but not cat bonds, while loosening of terms and conditions impacts both.

Catastrophe models, Moody's cautioned, contain inherent uncertainties which must be reflected in the rating of a sidecar through a series of steps known as calibration, conservatism, comparison and composition.