What is a Reinsurance Sidecar
A reinsurance sidecar is a financial entity that solicits private investment in a quota share treaty with an insurance company. In the quota treaty the ceding company and reinsurer share premiums and losses according to a fixed percentage. Investors who take part in reinsurance sidecars share in premiums and losses from the underwritten policies. Profits and losses will be in proportion to the amount invested.
Typically, existing reinsurers will create sidecars as they try to spread the risk among third-party investors such as hedge funds and equity firms.
BREAKING DOWN Reinsurance Sidecar
Insurance companies usually set up reinsurance sidecar structures to underwrite some portion of their book of business. Reinsurance is insurance for insurers or stop-loss insurance for these providers. Through this process, a company may spread the risk of underwriting policies by assigning them to other insurance companies. The primary company, who originally wrote the policy, is the ceding company. The second company, who assumes the risk, is the reinsurer. The reinsurer receives a prorated share of the premiums. They will either take on a percentage of the claim losses or take on losses above a specific amount.
Reinsurers will create sidecars as they work to spread the underwriting risk they have assumed. As they can sell the sidecar to third-party investors, they may reduce the dollar amount of risk shown on their accounts. This reduction in claim risk will allow the reinsurer to assume additional risk from a ceding company. The 2005 hurricanes of Katrina, Rita, and Wilma caused insurance rating agencies, like A.M. Best, to set new reinsurer capital requirements. These companies created more sidecars to free up this capital, and the reinsurance sidecar market grew.
While sidecars can technically have any number of cedents, their relatively straightforward nature makes them appealing for individual companies as a way to raise capital and increase underwriting capacity. For third-party investors, sidecars offer the potential for high-yield investments with relatively limited risk due to their limited duration and flexible structure.
Risk Exposure in Reinsurance Sidecars
Reinsurance sidecars have risks and rewards similar to other quota share treaty agreements. Investor returns depend upon claim rates on the underlying policies covered by the sidecar. The lower the claim rates during the sidecar’s existence, the higher returns investors will see. This arrangement allows insurers to increase their underwriting capacity by selling a percentage of their risk portfolio of business to private or third-party investors.
Reinsurance sidecars appeal to investors because of the narrower scope of the book of business, or risk portfolio, underwritten. The smaller book limits an investor's risk exposure relative to the broader set of dangers, insurance types, or geographies generally present in an insurance company’s full book of business.
In practice, this allows investors with little or no experience with insurance underwriting to participate in the insurance market with an experienced partner. Investors can also seek out or negotiate the types of policies they underwrite, allowing them some flexibility in limiting their potential exposure. Since sidecars exist for an agreed-upon period, investors can take advantage of the reduced risk from the investment’s shorter tail.
Reinsurance sidecars generally limit investors’ exposure to their invested capital, since most require sufficient investment to cover claims which arise in the underwritten policies. This means the risk of loss typically equals no more than the amount invested.