Sidecars: timing is everything
Following a slew of catastrophe events in the first quarter of 2011—in Australia, Japan and New Zealand—US tornado losses, and memories of the Chilean earthquake and Deepwater Horizon, global reinsurance capacity has been significantly reduced and the appetite for further risk markedly foreshortened. As Marty Becker, president and chief executive officer of Alterra Capital, put it: “If we were meaningfully overcapitalised at the start of the year, clearly we are not today, given the magnitude of losses that have taken place through the first quarter cats.” And it is this destruction of capital that has prompted the re-emergence of sidecars, vehicles that haven’t really made an appearance since the events of KRW back in 2005.
Motivations for deployment
The new capacity is being directed at the retro market, with three Bermuda players having raised significant capital in recent months to deploy in the space. Alterra’s sidecar, New Point IV, has loaded up with $200 million of capacity; Lancashire’s sidecar, Accordion, with $250 million; whilst Validus’s sidecar, AlphaCat Re, has a further $180 million of capacity. Interest began early in the year, with Jonny Creagh-Coen, head of investor relations at Lancashire Group, indicating that this rose markedly following Fukushima, with brokers approaching Lancashire following a “restriction in supply and an increase in demand, which together helped to create a new pricing equilibrium”. Discussions with “senior retro brokers” led Lancashire to believe that there are “significant opportunities out there” in the retro space, particularly following recent events and the impact of RMS 11, Creagh-Coen said. “The market is on the cusp of hardening following all the capital that has been pulled from the market,” he said, adding that having “something in place pre-windstorm...a contingent vehicle that can grow with the needs of the market” was sensible.
Andrew Cook, executive vice president—business development at Alterra Capital Holdings, said that Alterra’s early move into the retro sidecar space was due to the company’s desire to be “in the market before the January 1 and July 1 renewals—which include the main renewals for Florida-exposed property catastrophe reinsurance, so that our New Points clients and the market in general knew that we had capacity available”. Addressing motivations behind the move, Cook said that cat events and RMS model changes were the major drivers of interest, with “demand for retro cover having come increasingly to the fore” in recent months. He added that “reinsurers as a group are trading at approximately 85 percent of book value, which means that raising common equity capital would prove to be expensive. In this environment, the purchase of retro coverage is a very efficient way for companies to raise short-term capital.”
Addressing the psychological impact of events during the first quarter, Charles Mathias, group underwriting operations director and chief underwriting officer at Lancashire, Bermuda, said that whilst it was clear that there had been losses, the “market doesn’t just trade off numbers, but also off emotion. The repetitious nature of nonpeak losses started to effect underwriters, putting bad numbers up internally.” This created something of “an atmosphere of fear” that encouraged firms to seek additional coverage in the retro market, he said. And it is in satisfying this desire for additional coverage that sidecars such as Accordion have come about.
Just-in-Time Re
After a protracted soft cycle and suggestions that the reinsurance sector was meaningfully overcapitalised, the ability to draw down funds from the capital markets using sidecar vehicles holds evident allure, with Cook describing New Point IV as “Just-in-Time Re”.
Alterra has drawn down its first tranche of capital, Cook said, with further deals likely if they “meet our economic expectations for New Point”. This drawdown facility makes the vehicle “very capital efficient for us and our fellow New Point investors”, Cook said.
Addressing its sidecar, Mathias said that “Accordion is—in a way— Lancashire writ small”, with the close capital management of the vehicle reflecting the strategic values of Lancashire. He added that Bermuda sets itself apart from other markets in its high levels of capital management, with Lancashire “at the higher end of that scale” and sidecars being the most obvious expression of this close attention. Addressing Accordion, Mathias said that the sidecar “is pulling capital into the business where we think it can be best deployed to get the best return”, and it is in this capital efficiency that sidecars can really prove their worth. Creagh-Coen added that “since we retain a part of the risk and we are an investor in Accordion, we won’t accept any risk that we aren’t happy to have in the Lancashire portfolio. And this comes back to the sidecar’s drawdown facility—we don’t have to put any of the capacity to work if the rates aren’t right”.
It is this drawdown capability, enabling firms to respond in timely fashion to the needs of the market and deploy capital when needed, and not before, that make sidecars such an attractive proposition in the current reinsurance environment.
A second birthday, anyone?
Lancashire’s Accordion is set to be a “rolling vehicle”, Creagh- Coen said, with “the vehicle in place and able to be expanded with the help of existing or new investors” going forward. Lancashire envisages deploying around 25 to 30 percent of capacity by January 1, with Accordion having an open-ended lifespan. Mathias added that Lancashire “sold more at June 1 and July 1 than we expected”, with some expectation that retro demand at January 1 and for the rest of 2012 could be strong, although much he admitted will depend on the US wind season. “If the wind blows”, however, then the facility will be ready, Creagh-Coen said.
Alterra’s New Point IV, for its part, is set to be a one-year vehicle, with the sidecar being the latest incarnation of three previous such vehicles. New Point I and II were both one-year vehicles, whilst New Point III was “segregated into three separate underwriting years”, Cook explained. New Point IV is set to return to the single-year formula, with a definite end-date envisaged for the sidecar. Cook said that the company’s one-year vehicles “generally meet the demands not only of clients, but also investors”, adding that “we believe that the one-year vehicles are the way to go”. Nevertheless, Cook agreed that there was potential for multi-year vehicles with “more of a funds structure”, which have “essentially unlimited life spans as investors come in and out of the fund”.
Signposts to a turn
Asked if sidecars are indicative of a potential hardening of the market, or rather an unwillingness to add additional capital into reinsurers’ general pool of capital, both Cook and Creagh-Coen agreed that it was a bit of both. Cook said that recent sidecar activity and chatter in the market “suggest that there is a general perception that the market is hardening”. But he added that “given where we are in the equity marketplace and our valuations, a number of companies in Bermuda have raised preferred equity—there’s been three offerings so far—so you can see people do need to raise capital, but are reticent to raise primary equity capital given where our multiples are right now as a group”. With stocks trading in “the mid-80s as a multiple of book value”, raising additional primary equity capital is both “expensive and unwise”, with sidecars proving the obvious alternative to fulfilling capacity.
Creagh-Coen added that “unquestionably, we have seen some hardening”, with the industry “frightened” by the unexpected nature of losses in the first quarter. He said that such concerns have made investors wary of investing in underperforming firms or establishing a new class. Instead, they have turned to those firms with a consistent track record in the space, with sidecars representing the perfect vehicles for the capital markets to get involved in the reinsurance field.
Back in vogue?
Finally, addressing whether sidecars are now back in vogue, Mathias said he did not expect to see a “great avalanche of new formations; rather capital will be attracted to those players with a good track record”. As always, it will remain “difficult to call the market”, he said, with further formations possible, but dependent upon the whim of events. Cook added that sidecars “didn’t go away”; rather on the property cat side post-KRW, things had been “fairly quiet from a loss standpoint”, meaning that “demand for sidecars has been less robust”. In the next few months, he said that the emergence of new vehicles will be “driven by the market and whether there is enough retro capacity to fulfil market needs and client demands”. It seems that it will be a case of ‘watch this space’ going forward. Sidecars are, at the very least, back on the menu.
