Reinsurers Seeking Sidecars to Ride Out Next Big Storm

By | September 10, 2008

As Hurricane Ike takes aim at the Gulf of Mexico, triggering memories of 2005’s devastating storms, reinsurers see temporary underwriting vehicles as the solution to their capital needs in the event of “the Big One” — a disaster costing them tens of billions of dollars.

These temporary vehicles, known as sidecars, are set up by a reinsurance company using funds from outside investors, who agree to tie up their funds for a period of two or three years.

Sidecars have drawn in over $7 billion of new capital since 2005’s major storms and offer attractions to reinsurers, who share some of the risk and take some of the premiums earned, as well as providing good returns to investors.

In the past major disasters such as the World Trade Center attacks in 2001 or Hurricane Katrina in 2005 — the world’s two most expensive disasters to date — triggered a flood of fresh capital into the reinsurance industry.

Over a dozen new firms were set up on the tax haven of Bermuda following those two catastrophes for example, as investors backed new ventures set up by veteran underwriters and managers to exploit the skyrocketing prices on offer.

But industry players say this model has now lost its lustre, in part because of tougher capital markets.

“I’m not sure the old model that, after a big event, new companies like Flagstone would form, will be repeated in the future,” David Brown, CEO of Flagstone Re — set up in the market turmoil caused by Hurricane Katrina — told Reuters.

“We now have a new model, which is that following a big event you will raise money through sidecars,” said Brown.

SIDECARS THE FUTURE

Sidecars have been set up by underwriting firms such as Hiscox to exploit the dislocation in the catastrophe reinsurance market following a major disaster.

A sidecar has almost no staff of its own, and the reinsurer that sets it up does all of the underwriting. It is designed to shut down when the market returns to normal.

The fact that many sidecars, such as Hiscox’s Panther Re venture with investor Wilbur Ross, have now closed, while the capital flowing into new entities has slowed to a relative trickle, is a sign of their success, not failure, said Brown.

“The right thing to do was to close the vehicles down after the hard market ended and return the capital to the investors, who have made a 25 percent return on that capital. Everyone’s happy,” said Brown.

Despite the fact that hedge funds and institutional investors are nursing wounds from the credit crisis, reinsurers are confident these investors will queue up to put capital into the reinsurance market following a big disaster through sidecars, because the terms of the investment are clear.

As “concertina capital” vehicles, sidecars expand and contract according to demand for cover and the returns on offer. When the returns are no longer on offer, investors can pull their capital quickly.

In contrast, Bermuda is home to a crowded market of reinsurers, many of whom were set up after 2001 or 2005, who are now jockeying for business while prices fall.

“Of the reinsurers in Bermuda, most do all the same things. You don’t need that many. One or two big ones would be enough,” Hannover Re CEO Wilhelm Zeller said.

Investors in those new firms have seen their values sink in line with the insurance sector, where firms trade at or below their book value, thanks to the sell-off in financial stocks and sliding insurance profits, as investment returns sink in turbulent markets.

“The nice thing about sidecars is that they don’t rely on a company’s share price or its investment results, they’re a pure play on Acts of God, which have little correlation with the financial markets,” said Brown.

(Additional reporting by Jonathan Gould)

(Editing by Richard Hubbard)

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