Reinsurance Sidecars

The basic laws of demand and supply work in the reinsurance market just as they work in other markets of the world. This means that when the price is lowered, the demand begins to rise and when the price is raised, the supply begins to rise.

These laws are universal and also apply to reinsurance companies that are primarily dealing with the capacity to provide risk coverage to their policyholders.

Just like other markets, reinsurance companies also have their market cycles. There are certain periods of time when the cost of creating additional capacity for underwriting more insurance is very high. Such a market is called a hard market.

Conversely, it is also possible that the cost of creating additional capacity is quite low. Such a market is called a soft market.

Reinsurance companies have to ensure that they have spare capital which allows them to create additional capacity which can be used to provide reinsurance. Now, when a calamity or a natural disaster occurs, the reactions of insurers and the insured are very different.

Since insurers have paid out large sums of money as claims, they do not have the capacity to offer additional insurance. On the other hand, since policyholders have witnessed a loss, they want to insure as much of their exposure as possible. This creates a situation in which reinsurance companies do not have the capacity to provide reinsurance whereas, at the same time, there is a huge demand for such a service.

Over the period of time, reinsurance companies have come up with innovative ways which allow them to increase their capacity. Sidecars are one such innovative solution. In this article, the concept of sidecars has been explained in detail.

What are Reinsurance Sidecars?

A reinsurance sidecar is a corporate structure that is created to enable reinsurance companies to undertake more risks. Now, if they want to undertake more risks, they are required to have more capital. This capital is provided to reinsurance companies by financial entities such as hedge funds.

Hedge funds finance the operations of reinsurance companies. This means that they are willing to pay out large claims if a catastrophe occurs. However, at the same time, they want to pocket a large share of the reinsurance premium that is collected. It needs to be noted that sidecars are not permanent structures.

Such corporate structures are created for a short period of a few years after which they are dissolved. This is because hedge funds have a time limit on the funds that they have. Hedge funds are dissolved every few years and hence the partnership with the insurance company also needs to be broken and renewed every few years.

Also, the emergence of sidecars depends upon the state of the insurance market. If there is a shortage of capacity in the insurance market, then the sidecars are immediately created. However, in periods of abundant capacity, the sidecars are shut down.

How are Sidecars Structured?

Sidecar structures can be quite complex. However, an overly simplified illustration of the sidecar structure is as follows.

The reinsurance company needs to have an insurable interest at hand. This means that they must have identified the property which needs to be reinsured. They then contact a hedge fund that may or may not be in possession of their clients’ monies.

If the hedge fund agrees to participate in the transaction, they assume the risk. Hence, another reinsurance contract is drawn up between the reinsurance company and the sidecar. This reinsurance contract is more like a quote share contract wherein the companies assume a percentage of the risk in return for a percentage of the return.

The hedge fund investors obtain higher than market rate interest and dividends since they assume the high risk that such a contract entails. Hence, sidecars are structured as a contract between three parties viz. the reinsurance company, the sidecar company as well as the hedge fund investors.

History of the Sidecar

During the 1990s the global reinsurance market entered a difficult time. This is because of the colossal losses which were caused by hurricane Andrew. In the aftermath of the crisis, the world saw an increased shortage of reinsurance capacity. This is the period during which investment bankers and hedge funds stepped in and the concept of sidecars was first invented.

The increased destruction caused by hurricanes in the early 2000s also helped the popularity of sidecars.

It is estimated that hurricanes Katrina, Rita, and Wilma collectively caused a loss of close to $90 billion to the reinsurance industry. Once again, this created a shortage of reinsurance capacity and as a result, creating a conducive atmosphere for sidecars to thrive.

The fact of the matter is that climate change is causing an increased number of natural calamities in the world and sidecars are an important tool that is coming to the aid of the reinsurance industry from time to time.

Reinsurance sidecars have quickly risen to prominence in the reinsurance industry. Within a short span of time, reinsurance companies have come to rely on sidecars as a quick and convenient method to build additional reinsurance capacity when the market conditions demand so.

It is likely that the sidecar market will witness more innovation and will continue to provide better financial products to customers.