Casting one’s mind back to the heady premium days of post Katrina / Wilma, life for the reinsurance market, including the nascent ILS market, was good. It was what in the industry is called a ‘hard market’, a market where terms are hard i.e. high premiums combined with narrow coverage scope. Premiums had sky-rocketed and capacity remained fairly scarce. Once they had put to work their own capital, enterprising reinsurers pondered how to continue to capitalise on this boom time. Coming from the reinsurance industry they knew what they really needed was further quota share capacity on which they could charge a healthy commission to put someone else’s capital to work in the space. Only all reinsurance capacity was being used. They needed a new source of capital and therefore turned to the capital markets. They would create a separate special purpose reinsurance company that would be financed by investors and would in turn provide quota share capacity to the reinsurer – everywhere the reinsurer’s portfolio would go, the quota share would assume a corresponding share – a little like a sidecar going everywhere the motorcycle went. Hence the ‘reinsurance sidecar’ was born.
It made perfect sense for those investors who did not have any other way to access the market. For various reasons it made much less sense for ILS funds such as Solidum to invest this way.. The market had never paid so much for risk transfer and, through a temporary vehicle linked to a reinsurer, the investors could easily access the risk and have it vetted. Alignment of interest with the reinsurer was structural and all that remained was to reasonably remunerate the reinsurer. Finally, as the market cycle changed and capacity became more plentiful resulting in falling premiums, it would be easy to ‘detach’ the sidecar, refund the investors and allow the reinsurer to ‘go it alone’ shrinking the book of business to be supported by the own capital. This was flexible capital management that made total sense.
As the market softened, i.e. premiums fell and capacity became more available, these early sidecars were shelved, as had been the design, and all but disappeared.
A Hard Market Product in a Soft Market
The market continued to soften over the years; 2011, with the Christchurch quake (New Zealand) the Tohoku quake (Japan) and the Thailand Floods, merely slowing the softening but not reversing it. It was therefore a surprise to many when sidecars started to pop back up in the market around 2012-13. This did not tie in with the original purpose of the sidecar, to capitalise on a market with a lack of capacity and correspondingly high premiums. In 2012-13 there was sufficient capacity in the market and premiums were considerably lower than their highs from 2006. Could it be that the reasoning behind the sidecars had changed?
From the Reinsurer’s Point of View
The basis of risk-taking for a reinsurer is its equity-funded capital, further supported by reinsurance. Although reinsurance is annually renegotiated, reinsurance is built for a long-term mutually beneficial ongoing relationship. Any reinsurance buying will carefully cultivate relationships and will desire that it is fair to both parties. Premiums should be reasonable and if there are losses paid, there is generally the desire to make the reinsurer whole over the following years. This ‘traditional reinsurance’ thinking is different to the ’deal-by-deal’ approach of the capital markets. As an example of the latter the sidecar is explicitly opportunistic capital with no ties, no relationships and no comeback.
To a casual observer it would appear that the reasoning behind the sidecar, at least from the reinsurer’s point of view, has changed. In return for a fee, the reinsurer is loading risk onto the sidecar, rather than onto its own balance sheet and therefore its equity-holders and reinsurance panel. It would appear that the only logical explanation is that: (i) the risk is priced such that it is no longer terribly attractive to take it for their equity; (ii) it is more attractive to generate fee income for its equity by writing to the opportunistic capital of the sidecar; and (iii) the reinsurer can keep its (equity) ‘powder dry’ whilst awaiting the next large event, which will always occur at some point. Then, following the event, the reinsurer can cut loose the sidecar (it is not obliged to offer investors the ability to reload capital and continue) and write the ongoing book at post-event rates using its own equity. Indeed it would appear that the reasoning behind the sidecar has turned on its head.
From the Investors Point of View
If, in the current market, reinsurers are indeed creating sidecars as naïve capacity on which to write, this will most certainly not be mentioned to the investors. It is also unlikely that investors are being sold the line that premiums are high and that this is a great time in the market cycle to write business. It is more likely that they are being sold the underwriting prowess of the reinsurer, which they get access to. Also, possibly, that they will be able, after a hefty reloading, to participate in the market post-event, although this is unlikely to be contractual and whether it actually happens remains to be seen.
Investors will also almost certainly be sold alignment of interest with the reinsurer. Whereas alignment of interest is always important, one must ensure that it truly exists; in the days when CDOs were booming it was not uncommon for the structurer of the deal to assume the equity and point to that as ‘alignment of interest’, however, upon closer inspection, the fees being earned amounted to more than the equity. If the equity failed the structurer of the deal would merely make a smaller profit. This is not alignment of interest.
Sidecar Fees in Comparison to Fund Costs
For the investor to better understand the reinsurer’s motivation, the fee structure must be analysed. It may also be beneficial to do the calculation to covert the sidecar fees to a fund’s fee structure. Investors understand this well and can therefore easily make a comparison between the sidecar and other investments in their portfolio.
The actual fee structure will vary but may contain the following (figures are recent market figures for a 1-year transaction):
Placement Fee: 1.75% of assets invested
Underwriting Fee: 5% of gross premium = 5.56% net premium (prior brokerage)
Profit Commission: 15% of profits
Running Expense: 0.27% of assets invested
Closing Expense: 0.67% of assets invested
Est. Net Ceded Premium: 50% of assets invested
This fee structure translates to a fund charging 5.4% base fee and a profit commission of 15%. No hedge funds, unless they are true alchemists turning lead into gold, could get away with these fee amounts.
At this fee level the reinsurer is most certainly supporting its ROE by writing for the sidecar investors. If, per chance, no loss occurs the reinsurer equity has an enhanced return from the profit commission, whereas, in the event of a loss event, – the loss that the reinsurer sustains will in part be offset by (i) underwriting a lesser amount (because the sidecar is writing in its place); and (ii) receiving generous fee income from the sidecar.
Profit Commissions in a Reinsurance Environment
Reinsurance is all about spreading risk. Over time the premium charged must be sufficient to cover the losses that one would expect to arise over the long term as well as a return on the capital which (i) assumes the risk; and/or (ii) finances the loss.
Take a contract providing protection against a 1 in 10 year loss event, it averages out to 9/10 years profit and 1/10 years loss. If we lose 1 in the loss case and charge 0.1 (=10%) per annum (for each of the 10 year) over time we are even, however we have charged nothing for the capital and potential loss financing (if the loss happens in year 1 and not year 10). We therefore need to charge more premium to pay for the capital.
Say we charge 12% per annum instead of 10%, over the 10 years we have charged 1.2 and paid out 1 i.e. we have earned 20% on our collateral over the 10 year period, assuming we collateralized the limit.
A return of 20% over 10 years, or 2% p.a., is clearly not enough for the reinsurer, but this single contract would form part of a diverse portfolio. It could well be that the reinsurer only allocates 15% of the limit as capital, the remainder being leverage. The annual return on allocated capital, after the expected loss (i.e. annual 10% in this case), would therefore be 13.3%. This 13.3% Return on Capital (“RoC”) is not spread equally over time: for 9/10 years we are returning 80% RoC (=12% of limit) and 1/10 years we are returning -587% RoC (=a loss of -88% of limit).
A major problem arises for the risk taker if we factor in a profit commission. Say we pay a profit commission of 15% we would now have a 9/10 years returning 68% RoC (=10.2% of limit = 12% less 15% profit commission) and 1/10 years we are returning -587% RoC (=a loss of -88% of limit i.e. no profit therefore no profit commission payable). Over the period our long-term RoC is 2.5% (= average return on limit is 0.38% pa), a far cry from the 13.3% pa average RoC prior to the application of the profit commission. This effect becomes further exacerbated as premiums become tighter (i.e. the market further softens), to the point that the expectation, after profit commission and over time, may be negative.
In reinsurance, economically speaking, profits in any given year should not be actually perceived as ‘profits’ but should be divided into 2 parts: (i) loss financing; and (ii) profits. The loss financing component is by far the larger of the two and is not a profit, merely money to hold for when the loss occurs. Profits therefore are very much smaller than those actually perceived by the market outsider.
Investors should always carefully consider what is going on in any situation. To coin Warren Buffet, when you sit down at the poker table and you don’t know who the patsy is, it’s you!
With this particular game of poker – sidecars specifically and not ILS in general –the patsy has changed over time. This table has 3 players: the reinsured, the reinsurer and the sidecar investor. At this particular poker table it is unlikely that the reinsurer will ever be the patsy – he owns the house and generally calls the shots – don’t look to him to play patsy if he can avoid it. Post 2005, the patsy was the reinsured – he could barely find the capacity he needed and only then at a massively inflated price. He had no choice but to play the game – he has no real alternative to buying reinsurance.
This decade however the cedent is no longer the patsy – capital is plentiful and prices low – the cedent has the pick of the bunch, most certainly not the patsy. If it were merely a game for 2, the reinsurer would have to be the patsy, but he has opened the table to for someone else (make no mistake, this game is controlled by the reinsurer). This new addition, the sidecar investor, can only be being brought in as the patsy!
This picture is clearly simplified – one should not forget that investors also stand behind the reinsured and the reinsurer in the form of equity-holders, so for example one can state that the reinsurer equity investors are not the patsy. Also, although this stands true for sidecars, ILS funds are a different matter. They sit in the place of the reinsurer and their investors are equivalent to the reinsurer’s equity investors. The ILS fund investors pay their manager to ensure that they are never the patsy at a ‘deal table’. If however an ILS manager invests in sidecars at this time, their investors should maybe carefully question their manager.
Commissions, in particular profit commissions, do not always lead to the same results for all types of investments. ‘Profit’ is not profit in reinsurance; much of it is either pre-loss financing by, or post-loss repayment to, the reinsurer. Investors should be aware of this when offering profit commissions in the reinsurance sector.
When entering into sidecar investments, it likely pays to ‘convert’ the commission stream to the ‘2-and-20’ format used by hedge funds and PE funds to make a sensible comparison with what investors are paying their other managers – the reinsurer of a sidecar is nothing more than an investment manager of a somewhat esoteric asset class.
One final comment when considering the fees; the fact that the reinsurer, and through them their equity, earn fees out of the transaction, the financial position of the equity investor vis-à-vis the sidecar investor is altered. They are not in the same boat (or the sidecar coupling is loose and threatening to come apart). The problem arises when considering the management of the reinsurer and to whom they owe a duty of care. It is clear that they owe a duty of care to the equity investors, however they do not owe the same duty of care to the sidecar investors, and to the extent that the results of the equity and sidecar are no longer properly aligned, the reinsurer will act to protect their equity investors over the sidecar investors.
It is most important to note that investors investing in an independent ILS fund (i.e. one not owned / managed by a reinsurer) are owed a duty of care by the managers of the fund, in the same way that the reinsurer equity investors are owed a duty of care by the management of the reinsurer. As such a knowledgeable and experienced ILS fund manager, such as Solidum, will protect its investors from being the patsy in any transaction and seeking the best and safest return at the desired risk level.
As a summary, one can see that investing in reinsurance sidecars has a further parallel to the motorcycle variety: If you want to enjoy your ride in the sidecar, make sure that the weather is fine before setting out!