Hiscox Syndicate 33 recently became the first Lloyd’s syndicate to enter into a sidecar transaction. This highlights the growing prominence of the sidecar as a capital-raising vehicle for property catastrophe risks. This article sets out the principal characteristics of reinsurance sidecars and highlights the key points for both parties, including the importance of thorough due diligence and the need for the sponsor to be satisfied that the quota share reinsurance agreement protects its interests.

  • How did the sidecar emerge?
  • What is a sidecar?
  • Advantages for the sponsor
  • Advantages for the investor
  • Disadvantages
  • Comparison with catastrophe bonds
  • The future

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Introduction

Hiscox Syndicate 33 recently became the first Lloyd’s syndicate to enter into a sidecar transaction. This highlights the growing prominence of the sidecar as a capital-raising vehicle for property catastrophe risks. This article sets out the principal characteristics of reinsurance sidecars and highlights the key points for both parties, including the importance of thorough due diligence and the need for the sponsor to be satisfied that the quota share reinsurance agreement protects its interests.

How Did The Sidecar Emerge?

The huge losses from last year’s hurricane season caused a substantial capital shortfall to many global reinsurers and increased premium rates. Rating agencies consequently required reinsurers to put up increased capital if they were to continue to underwrite property catastrophe risks. These factors meant that reinsurers had to obtain additional risk capacity so that they could meet the demand for catastrophe risk protection and capitalise on the "hard market".

Investors such as hedge funds have stepped in to provide reinsurers with the needed capital and risk capacity via "the sidecar", a vehicle in return for which investors stand to receive potential profits from the high premiums and catastrophe bonds.

What Is A Sidecar?

A sidecar is a reinsurance company that is created and funded by investors, such as hedge funds, to provide capacity to a single reinsurer in respect of its catastrophe business. That reinsurer is commonly referred to as the "sponsor".

The structure of the sidecar is a reinsurance company that is set up to provide quota share reinsurance protection to the sponsor via a quota share reinsurance agreement. The sidecar assumes a percentage of the sponsor’s catastrophe risk in return for which the investor receives a percentage of the premium. The sidecar pays ceding commission to the sponsor, the amount of which may increase in proportion to the expected profitability of the business. The sidecar accepts premiums and pays claims as a normal reinsurer would, but it also distributes interest and any dividends to the investors. The sidecar usually has a limited lifespan of only one or two years.

Bermuda and the Cayman Islands are currently the main base for sidecar transactions. Many sponsors have been located in Bermuda, which enjoys a regulatory regime that facilitates the rapid establishment of sidecars. The Cayman Islands has strong links with the hedge fund industry.

Advantages For The Sponsor

  • The sponsor acquires additional risk capacity by which it can maintain or increase its market presence without the need to restructure its capital base.
  • Zero credit risk. The investor will either issue a letter of credit or set up a trust containing funds equal to the risk that is ceded.
  • Sidecars can be set up quickly and cheaply to adapt to prevailing market conditions.
  • Their flexibility allows the sponsor to renegotiate terms during the transaction.
  • The sponsor can retain an interest in the sidecar.

Advantages For The Investor

  • The defined lifespan and flexibility of the sidecar affords investors with opportunistic access to a new market. Typically, the arrangement will also provide for an exit strategy if rates start to drop.
  • The sidecar is an "off–the shelf" vehicle, meaning the investor does not need to establish underwriting systems. Investors can therefore react quickly to market conditions.
  • Catastrophic risk is uncorrelated with returns on traditional stock market investments, thereby offering portfolio diversification to investors.
  • Investors do not face exposure to the whole business of the sponsor.
  • In a good year, sidecars can generate comparatively excellent returns (20- 30%).

Disadvantages

For investors, a recurrence of the 2005 hurricane season would cause huge losses. Equally unattractive would be the lower returns that would result from a "softer market". Investors also stand to lose out if the sponsor does not underwrite properly and profitably and it is clearly important for investors to conduct suitable due diligence in this regard.

For sponsors, weak negotiation of the ceding commission may cause sponsors to lose out on some of the benefits of the high premium environment. However, the most obvious danger for sponsors lies in a failure to ensure that their risks are suitably protected under the terms of the quota share agreement. Given the enormous sums of money in issue, the speed with which sidecars can be implemented should not be at the expense of receiving legal advice upon the adequacy of the scope of cover proposed, especially if it is intended to use a "standard" quota share agreement, the terms of which may be inappropriate for a particular transaction. Typically, disputes tend to arise from the interpretation of the stated class of business and financial and geographical limits of cover.

Comparison With Catastrophe Bonds

Catastrophe bonds are similar to sidecars in that they are both mechanisms by which investors can transfer catastrophe risk from sponsor to investor, thereby providing increased reinsurance capacity.

The sponsor will typically liase with an investment bank to create a special purpose vehicle which issues a catastrophe bond. Investors then purchase the bond. If there is no catastrophe, the investor achieves a high interest return on its investment. If, however, a catastrophe occurs, the catastrophe bond is said to be "triggered" such that the sponsor need not repay the investor and can use the invested money to pay off its claims. The catastrophe bond will be rated by agencies (using catastrophe models) according to the probability of default due to the catastrophe occurring.

A key difference between a catastrophe bond and a sidecar lies in their structure. Sidecars employ a quota share reinsurance agreement while catastrophe bonds generally utilise a more complicated indexed contract. Further, sidecars carry the advantage of being quicker and cheaper to set up because the negotiation is directly between investor and sponsor without the involvement of bankers and modelling agencies.

The Future

Reinsurers may increasingly regard the sidecar as a "capital management tool" that can be used to manage other lines of business outside of catastrophe, such as casualty. It remains to be seen whether the benign 2006 windstorm season encourages more hedge funds to participate. On the other hand, the renewals in January 2007 may reveal lower premiums, making investment less attractive. If sidecars continue to operate, sponsors would be wise to conduct thorough due diligence and obtain suitable advice upon the adequacy of the wording of the quota share reinsurance agreement.

This article was written for Law-Now, CMS Cameron McKenna's free online information service. To register for Law-Now, please go to www.law-now.com/law-now/mondaq

Law-Now information is for general purposes and guidance only. The information and opinions expressed in all Law-Now articles are not necessarily comprehensive and do not purport to give professional or legal advice. All Law-Now information relates to circumstances prevailing at the date of its original publication and may not have been updated to reflect subsequent developments.

The original publication date for this article was 20/12/2006.