Origins

The sidecar is a special purpose reinsurance vehicle developed as a by-product of recent natural disasters, in particular Hurricane Katrina and Hurricane Rita. The losses suffered in the hurricane seasons of 2004 and 2005 have had a serious impact on the balance sheets of reinsurers.

In addition, there has been a sharp increase in reinsurance rates and a shortage of reinsurance capacity, mainly for reinsurers' property catastrophe exposures. Hence, these sidecars are being set up by reinsurers to maintain or expand capacity.

It is widely acknowledged that the sidecars originated in Bermuda, with the earliest being set up in the 1990's, although one or two have been set up in the Cayman Islands, including Thunderbird Re (on behalf of Lloyd's of London).

• Rockridge Reinsurance (for Montpelier Re)
• Cyrus Re (for XL Capital)
• Flatiron Re (for Arch Re)
• Helicon Re (for Olympus Re)

Purpose

Sidecars have been formed to provide reinsurance cover to specific Bermudian reinsurance companies and are an alternative to the traditional means of raising capital through equity or catastrophe bonds. Their aim is to provide a healthy return on the capital for both sponsors (existing reinsurance companies) and investors in them.

In other words, the main use for sidecars is that the reinsurer can write more business than it could have written without raising more capital.

Essential Ingredients

So, what is required in order to mix a tasty sidecar?

• Well, first you take a (re)insurer that wants a large amount of reinsurance protection;
• Secondly, you need an investor(s) with a few million dollars who wish to participate in the risk without the need to invest in either existing reinsures or new reinsurers. The investors are usually hedge funds, investment banks or private equity funds with relatively little exposure to the insurance sector (other than their sidecar investment) who are looking for high returns;
• Finally, you need a separate corporation that operates as the side vehicle to the larger (re)insurance company mentioned above.

Once these have all fused together you should be left with a refreshing, compact and reliable vehicle.

"Feel Good" Effects

With the right blend of sponsors and investors a number of advantages can be experienced.

Firstly, the sidecar is a simple structure and a 'quick fix'. This is because it provides the cover that the market requires but it does so by using other people's money (private equity and hedge funds). This in turn means the reinsurer can write more business as there is a large amount of risk-bearing capacity available.

Setting up a sidecar vehicle is relatively straightforward and does not require the need for cumbersome administration. In effect, the entity only reinsures one cedant under a quota share agreement which is fully funded and collateralised. Under this quota share agreement, the (re)insurer agrees to cede to the quota-share reinsurer a percentage of all premiums arising from a book of business in exchange for the reinsurer bearing the same percentage liability for losses. Consequently there is the attraction of both ceding commission and profit commission for the cedant.

There are no bankers, modelling companies or rating agencies needed in the process which means that it is relatively inexpensive to put in place. Another cost benefit is that a sidecar requires little or no staff. In addition, as the sidecar does not have any underwriting capability it does not represent any competition for the reinsurer.

Sidecars typically have a limited life of about two years. As a result, the investor usually has a short-tail exposure to catastrophe losses but benefits by taking profits during a high premium environment. The investor can then exit once the capacity returns to the market.

Finally, there is a speedy regulatory approval process in Bermuda, where most of these sidecars have been established, and any risk can be reinsured into a sidecar provided the premium is sufficient to attract investors.

Are there any potential "Side Effects"?

It is fairly easy for investors to move their investments away from any sidecar and invest elsewhere should opportunities arise in the future. The sidecar is also susceptible to what has been described as a 'blow-out.'

An example of this can be seen with Olympus Re, a sidecar that was formed in December 2001. The sponsor announced in June 2006 that it was increasing its pre-tax 2005 loss estimates by a further US$203m. Of this, US$143m should have been ceded to Olympus Re but this would have finished the sidecar. Instead the sponsor bailed out Olympus Re by paying almost all of the losses.

The Verdict

Sidecars are still proving popular in Bermuda and beyond and, as long as there is private equity and hedge funds eager to have a reinsurance element in their portfolio, combined with a relatively calm 2006 hurricane season, there will be a number of parties eager to taste the sidecar.

Celebrating the success of your Sidecar

With the potential profits to be made from investing in a reinsurer sidecar, you could toast your success with the cocktail that shares its name with this special purpose reinsurance vehicle!

Ingredients: 

• 2oz brandy (cognac)
• 1oz cointreau
• 1oz lemon juice

How to serve:

Shake with ice and serve into a cocktail glass, decorate with a twist of lemon. Enjoy!!