Sidecars: back in vogue
Traditionally sidecars have appeared following specific market dislocations and a definite need for additional short-term capacity. The latest iterations however, appear to be driven—at least in part—by a desire to write more business off the balance sheet, with the help of third party capital. Such an approach leverages re/insurers’ underwriting expertise and draws in associated fee income, while satisfying investors’ desire for short-term plays with generous return profiles.
As Fitch outlined in its Bermuda 2013 Market Update, Bermuda players are increasingly “transforming [themselves] into risk asset managers” as they seek to marry investor interest in the space, with a desire to pep up their own returns. While funds and insurance-linked securities (ILS)-type structures will satisfy some of this interest, a number of markets have opted for sidecar capacity. Here, Bermuda Re speaks with three Bermuda players with sidecars in the market—two old heads and one new entrant—about motivations behind the move and the state of play for such vehicles.
Another spike
The recent spike in sidecar activity has been driven by a combination of factors, with investor interest and a desire to write business off the balance sheet appearing to be the motors of growth. As Jed Rhoads, president and chief underwriting officer at Alterra Bermuda indicated, with investors such as hedge funds, private equity funds, sovereign equity funds and pension funds all growing increasingly accustomed to a new low return investment environment, many are exploring “the idea of low or uncorrelated natural catastrophe exposure as a way to improve their overall returns”. And considering the size of the wider capital markets, “even a very small percentage of capital market allocation in the property catastrophe reinsurance space represents an overwhelming amount of capital”.
Re/insurers are looking to act as the home for this additional capacity, with those active in the sidecar space asking “if this new capital is coming into the industry and somebody is going to be managing it for them, why not us?”, said Rhoads. Mark Gibson, head of alternative risk markets at Argo Group, explained that “If there is someone else prepared to put up that capital, to write that business and pay a fee to do so, it makes a lot of sense to write that business. As a reinsurer you face fixed overheads and if someone wants to help you make some virtually risk-free returns through fees, the relationship is a win-win.” As such, re/insurers are increasingly taking on the role of ‘risk asset managers’, employing sidecars and other vehicles to satisfy investor demand in the space.
While much has been spoken about rising investor interest in the space, not everyone is convinced that the interest is as buoyant as is often portrayed. Gibson argued that he had heard enough anecdotal evidence to suggest that for some reinsurers attracting investor interest in their sidecar offerings has been an uphill struggle. Reinsurers have, in some instances, been obliged to actively seek out investors and “even after experience of similar transactions”, it would appear that the picture of investor confidenceis somewhat mixed. What does seem apparent is that there is the potential for investor interest—and something of an uptick—even if reinsurers must continue to convince interested parties of the merits of sidecar capacity.
Added value
Reinsurers are evidently looking to draw together their own and third party capital to construct off-balance-sheet vehicles that can extend additional peak peril capacity to the market. As Gibson explained, “If there is more business coming through the door, there are friendly investors in place and you know it’s good business, establishing a sidecar represents a strong opportunity to make a decent return on that business.” And with reinsurers having faced generally soft market conditions for some years, the ability to complement existing revenue streams is attractive.
"There is potential for investor interest-- and something of an uptick-- even in reinsurers must continue to convince interested parties of the merits of sidecar capacity."
Rhoads argued that there is little reason not to leverage the underwriting expertise present in bricks and mortar reinsurers to write this kind of business, as both reinsurers and investors seek to build out their presence in the third party capital space. The trend is part of a broader move “towards developing a risk management business on a broader scale”, said Paschal Brooks, executive vice president at Validus and portfolio manager for its AlphaCat funds, with reinsurers creating platforms to manage and deploy investor capital off the balance sheet, rather than adding shareholder capital to their own balance sheets.
Fee income is proving an attractive component of the sidecar play. As Gibson explained, “For some the sole motivation behind their sidecar is fee income. A number of markets are using their balance sheet aggressively to generate fee income, with sidecars helping to increase their bottom line returns, without increasing their bottom line exposure.” Rhoads added that fee income has become a “meaningful part of returns for some companies”, and that although such capital will naturally ebb and flow, it will become a component of many markets’ income going forward.
Sidecars form part of reinsurers’ efforts to build out complementary business, said Brooks, with such capacity “expected to be less volatile and able to provide a steadier earnings stream than the peaks and troughs associated with traditional peak peril underwriting”. Reinsurers are increasingly looking to create a balance of income streams, he said—from traditional underwriting, investment returns and third party capital—with such an approach likely to help improve reinsurer valuations, which in many instances have been below book value.
Much will, however, depend upon whether reinsurers pursue opportunistic or strategic involvement in the space. Players that develop a long-term strategy can expect to be the main beneficiaries in terms of improved valuations, said Brooks, while more opportunistic plays may bring more limited benefits.
Their latest iteration
Driven by a desire to write additional off-balance-sheet business and satisfy increasingly diverse investor interest in the space, the risk:returnprofile of third party capital is also changing. Investors have traditionally sought 15 percent-plus returns from the space, said Brooks, but present iterations are offering investors a broader array of risk:return profiles. As Rhoads explained, “There’s no doubt hedge funds are targeting different returns and return periods to pension funds ... each are looking for returns that suit their individual investment goals.” This has led to a ‘barbell’ distribution of vehicles, with sidecars satisfying the traditional peak peril returns at one end of the spectrum, and funds offering lower risk:return profiles at the other.
While less risky vehicles do now form part of the third party reinsurance offering, the “traditional spot of sidecars on the risk:return spectrum will mean their primary investors will continue to be macro hedge funds”, said Brooks. “Those types of investors tend to be more focused on specific dislocations in the market, which is why sidecars are frequently structured as short-term focused one or two year vehicles.”
Such vehicles continue to represent the mainstay of the high risk:high return section of the market, but the profile of third party capital and investors is evidently changing. As Brooks outlined, “If you look at the broader fund management product offering, there is greater interest from a wider set of investors looking for funds structured as longerterm vehicles and designed to be long-term allocations to the sector.” As Gibson outlined, “Investors can now participate in the reinsurance arena through funds, sidecars or traditional reinsurance companies.” And they really are spoilt for choice.
Vehicles proliferate
In response to investor interest and a desire to leverage in-house expertise, reinsurers are establishing a range of vehicles to tap into the third party space, with sidecars being just one such permutation. Cat funds, ILS and quota share arrangements are all attracting interest, although from different sections of the capital markets. Dedicated cat funds are more easily understood by the capital markets, explained Rhoads, with such vehicles “similar to what they are used to investing in”. As such they are attractive to the market, even if “most of those entities do not employ the level or quality of underwriting quality that exists in the traditional market”, said Rhoads.
Sidecars, for their part, attract slightly different investors, who recognise that it is in such vehicles that “the real underwriting expertise resides”, said Rhoads. “They don’t want people deploying their capitalat any cost just to earn income; they want their money deployed as and when the market allows and accommodates it.” Sidecars are a perfect fit for just such an approach. Such nuances have meant that there is no one size fits all approach; rather there has been a proliferation of cat funds, ILS and sidecars all looking to satisfy market needs.
It seems likely that reinsurer involvement in the third party space will continue to develop apace. Addressing the ramping up of its own AlphaCat business, Brooks said that Validus designed the platform to be an “investment manager house within the overall reinsurance company”, with the fund able to “source capital beyond traditional shareholder sources”, while offering a broader product line offering to insurance clients.
Rhoads spoke in a similar vein concerning New Point V. “Sidecars are very sticky once you put one together. And Bermuda companies aren’t simply establishing sidecars, but are setting up segregated cell funds, cat bonds, ILS and quota share arrangements as they develop their involvement in managed cat.” Reinsurers are evidently exploring all iterations as the alternative space develops.
A permanent adjunct?
With their popularity having picked up in recent months, are sidecars set to become a more permanent adjunct to the market? In the case of sidecars formed in response to particular market dislocations, “the answer will lie in their results and experience in the natural catastrophe space during a time when the interest rate environment is low and the investment environment is uninteresting”, said Rhoads. How quickly such capital departs the market will be dependent upon experience, he said, but absent major losses, investor interest is likely to remain. Brooks concurred, adding that sidecars will likely remain a “part of the toolkit, but will wax and wane dependent on the returns available at that moment”.
Brooks said that investors in the space have had positive experiences from their investment in such vehicles, recognising the “benefits of diversification in their portfolios”. The deciding factor will however be the health of absolute returns, as “the investment base has minimum return requirements”. So long as these are achieved, interest in the space will be sustained, he said. However, reinsurers need to be upfront with investors as regards expected returns and potential pricing developments.
Investors may well remain with reinsurers through the vagaries of the market cycle, but they need to have their eyes open as regards likely returns, said Brooks. For sidecars, their short-term nature should make such discussions a simpler task. For funds and more permanent vehicles, outlining the likely course of the cycle will be significant in securing long-term commitment from investors.
And it isn’t only market conditions that have the potential to drive reinsurer interest in sidecar plays. As Gibson made clear, sidecar formations could also be sparked by rating agency restrictions on capital. “It may be that rating agency or regulatory pressure will encourage reinsurers to write some of the more volatile business on someone else’sbalance sheet rather than their own. This could prove a driving factor to create and use more sidecar entities.” With regulatory and rating agency scrutiny only likely to deepen following the financial crisis, the motives behind sidecar deployment may yet strengthen still further.
An alignment of interests
While sidecars tend to be relatively similar in their structure and function, the proportion of business ceded by the reinsurer varies considerably between vehicles. As Gibson explained, the “alignment of interest” of reinsurers with third party capital provides telling insights into how core the ceded business is to the reinsurer. The less core the business in the sidecar, “the more third party investors will demand an alignment of interest and the more ‘skin in the game’ needed to attract third party capital”.
Current versions average around 30 percent of capital being extended by sponsor reinsurers, said Gibson, although participation varies from less than 10 percent to around 60 percent. A cursory examination of the current crop of sidecars provides some indication of the level of reinsurer buy-in in each vehicle.
AlphaCat 2013: $230 million of capacity, $45 million of which has been provided by Validus—20 percent participation from Validus
Harambee Re: Argo Group 100 percent third party participation
Mt Logan Re: $250 million of capacity, $50 million of which is from Everest Re— 20 percent participation from Everest
New Point V: $247 million, $75 million of which has been provided by Alterra— 30.4 percent participation from Alterra
Saltire Re I: $250 million, $33 million of which has been provided by Lancashire—13.2 percent participation from Lancashire
Reinsurer buy-in also reflects how opportunistic the play is— whether it is in response to particular market or pricing dislocations, or whether it is an extension of the reinsurer’s existing underwriting strategy and/or portfolio. The current crop appears to be a mix of both approaches, but it will be interesting to see whether more vehicles emerge as extensions of traditional portfolios, rather than as opportunistic pop-up plays.
