Katrina Created a Banner Year for Sidecars

After the 2005 hurricane season -- when hurricanes Katrina, Rita and Wilma caused about $57 billion in insured losses -- fresh capital poured into the insurance industry in the form of new companies and a renewed interest in alternative vehicles, including sidecars and catastrophe bonds.

The insurance market has traditionally seen new companies form to take advantage of the hardening market after major events, such as after the terrorist attacks of Sept. 1, 2001 and after Hurricane Andrew in 1992. However, the rush to form sidecars after 2005 was a new trend.

"There was a shortage of capital post-Katrina," said Markus Schmutz, head of insurance-linked securities structuring and origination for Swiss Re. "Some companies had lost capital and had to reduce their writings. A lot of insurance companies found themselves short of capacity, while reinsurers saw this opportunity: rates were high and capacity was scarce. It was a great moment to raise capital to write more business."

Sidecars are limited-purpose companies funded by investors, often hedge funds or private equity, who in essence provide capital to reinsurers. They in turn provide the investors their underwriting skills. It's a way for a reinsurer to share risk and write more business, while the investors can enter the insurance market quickly, and usually will exit at book value. This allows the investors to achieve a return that typically is driven by the underwriting result, not dependent on public equity market conditions.

About 20 sidecars carrying a combined $4.5 billion in initial capacity were launched in 2006 -- in the wake of Katrina, Rita and Wilma, according to A.M. Best's Review & Preview 2007. After the capacity crunch in the market subsided, there was less demand for the usually temporary vehicles. "The good thing about [sidecars] is they can go away seamlessly once the opportunity goes away," Schmutz said.

Thanks in part to the cash infusion the sidecars brought to the market, insurance companies "recovered, rebuilt their equity cushions, were able to adjust their equity and risk appetite," Schmutz said.

Sidecars had been around since Renaissance Re started the concept with the formation of DaVinci Re, which was formed as a strategic joint venture between RenaissanceRe, State Farm and other investors to provide new capacity to the property catastrophe reinsurance market following the events of Sept. 11, 2001.

DaVinci's business is underwritten by Renaissance Underwriting Managers using the same underwriting discipline and systems as RenaissanceRe, and DaVinci's business is underwritten side-by-side with RenaissanceRe's existing property catastrophe books of business. So DaVinci's risk exposure profile is comparable to that of RenaissanceRe's property catastrophe portfolio, according to BestLink, which provides online access to A.M. Best's Global Insurance & Banking Database.

Unlike other sidecars, which have faded away as market conditions led to less robust returns, DaVinci has become a permanent company, said John Lummis, who retired as chief operating officer of RenRe in 2006, but remains active as an industry consultant.

"Even in the sidecar structure, there are different variations. Some are longer lived," Lummis said.

Sidecars "make sense after a big event. They are most effective in responding to the acute needs for reinsurance capital." Lummis said. Sidecar investors are willing to enter the investment at book value and exit at book value, so that return is driven by the underwriting result and is not sensitive to the valuations in the public equity markets, Lummis said.

The real question is who is going to run the business. "The logic of the sidecar is it will leverage the skill of the existing sponsoring reinsurer or insurer. The hard part isn't forming a legal entity, it's creating the management team, the underwriting and risk management systems and so forth," he said.

Should another Katrina strike a city like Miami, it could produce far greater insurable losses than Katrina and threaten the solvency of some companies, said Dan Glaser, chairman and chief executive officer of Marsh Inc.

A few side cars have continued to pop up recently, but nothing like the wave of sidecars created after the 2005 hurricane season. On the other hand, the cat bond market has continued to thrive -- except for the stall in the market caused by the financial crisis in the fall of 2008.

The dollar amount of cat bond issues doubled from 2005 to 2006, growing to $4.6 billion from just less than $2 billion, and jumped again in 2007 to $6.9 billion, the best year ever for cat bonds, according to Guy Capenter. The financial meltdown had a chilling effect on the market in 2008, with just $2.7 billion in cat bonds issued, none in the last quarter. But 2009 saw the market thawing out again, with $3.4 billion of risk capital issued through cat bonds, a 25% increase over 2008, making 2009 the second-busiest year for cat bonds since 2007. The first quarter 2010 has already outpaced cat bonds issued in the first quarter of 2009.

(By Meg Green, senior associate editor, BestWeek: [email protected])