Reinsurance vehicles differ in design, but all provide form of risk transfer

Reinsurers will turn increasingly to sidecars, catastrophe bonds and industry loss warranties to obtain more capacity, but no single vehicle has taken a dominant position in the alternative sector, say observers.

While each option has its supporters, the capacity boosters actually used will depend on the reinsurer's particular needs, experts say.

"I'm not sure that any one of those vehicles is going to be more dominant across the entire industry," said Patrick J. Denzer, president and chief executive officer of reinsurance intermediary John B. Collins & Associates Inc. in Minneapolis.

"I think they all serve a purpose, and they will all be viable alternatives to certain types of buyers that have a certain type of objectives," he said.

The various products all provide some form of risk transfer (See box).

"Whether you're transferring the risk for natural catastrophes through sidecars, or whether backing it with equity or buying it in a cat bond, buying a fixed income asset, or you're selling protection through an ILW, it's all in effect the same thing. It's just the form is different by which you're participating," said Judy Klugman, managing director and head of distribution at Swiss Re Capital Markets in New York.

Pete Thomas, executive vp and managing director for Willis Re Inc., who is based in McLeansville, N.C. agreed. "It's a question of which is most appropriate," he said. "They're all intended to spread risk" and allow investors different ways to manage their exposures.

James Veghte, Stamford, Conn.-based executive vp and chief executive of reinsurance general operations for Bermuda-based XL Capital Ltd., said he sees a mix of the three options. "If you look at the spreads in the cat bonds and the way they've moved over the last five months, they clearly have reacted to ILW pricing, for example, which has skyrocketed over the last nine months," he said.

"I don't think one will emerge over the exclusion of other instruments. It depends on the individual company" and what they are trying to achieve, "but I clearly see" all of these instruments "having an active involvement in the business," Mr. Veghte said.

Industry estimates of the size of these vehicles vary. According to Chicago-based Fitch Ratings, through September, $2.4 billion of cat bonds had been issued and five new sidecars, with roughly $2 billion of capital, were formed.

According to Collins, while the size of the ILW market is hard to determine because many deals are done on a private placement basis, there is an estimated aggregate of $3 billion to $4 billion in force.

Hedge funds, private equity funds and investment banks have been active in supporting alternatives, as well as in making equity investments with reinsurers, say observers.

Stephen K. Bolland, president of reinsurance intermediary Gill & Roeser Inc. in New York, said sidecars "are the perfect opportunity for a hedge fund. It has an expected maturity of one or two years, and it expects to liquidate after that time," he said. "It's very easy to start them up and it should be fairly easy to shut them down and get your money out," which is what hedge funds want.

"I think sidecars will be the 'vehicle du jour,' so to speak," said John Gwynn, managing director at Memphis, Tenn.-based Morgan Keegan & Co. They can be set up "on fairly short notice with a good-sized chunk of money."

Sidecars "are the way to get capital into the market when capacity's constrained, and they are the way to get capital out of the market when the returns are no longer commensurate with the risk," said Mark Rouck, senior director at Fitch. "In theory, vehicles like that should help kind of smooth out the cyclical nature of the rate environment in reinsurance."

Sidecars "probably offer equity returns that are larger, and you're not as tied to one particular risk" which is the case with cat bonds, said Gary Martucci, a director at Standard & Poor's Corp. in New York. "With a sidecar, you're more following the fortune of the reinsurance company."

John L. Ward, CEO of Cincinnati-based Cincinnatus Partners L.L.C., an advisory firm that specializes in the insurance industry, said, "I think the ideal investment platform of choice will be to continue to back existing underwriting teams with new sources of capital. In my view, the sidecar plays most effectively to that," he said.

It "allows existing underwriting teams to reload and continue to make investments in the market, and the expertise and the knowledge of the market is a skill that's in great demand," Mr. Ward said.

Paul Karon, CEO of Benfield Group Ltd.'s U.S. division in Minneapolis, also said sidecars will be the most often-used option. "Cat bonds are good for risks that occur once every 100 years," he said. Sidecars "tend to play lower down, closer to the loss."

However, sidecars' growth may slow because of the number that have already been created, suggested J. Paul Newsome, vp and senior equities analyst at A.G. Edwards & Sons Inc. in St. Louis.

"Recently, there was just an enormous wave of the creation of these sidecars post-Hurricane Katrina, and at this point there are so many of them there it's hard to find a significantly sized Bermuda reinsurer that doesn't have one," he said.

Other industry watchers said cat bonds will see great use.

"Cat bonds are transactions which are tailor-made for the issuing reinsurer," then distributed in a "fairly standardized, conventional bond market form" to investors, said Morton N. Lane, president of Lane Financial L.L.C., an independent reinsurance consultant in Wilmette, Ill. "But because they have to conform to certain bond market forms, sometimes they're not as flexible as the issuers would like."

However, Christopher McGhee, managing director at MMC Securities Corp. in New York, an affiliate of reinsurance intermediary Guy Carpenter & Co. Inc., said, "I think it is likely that you'd have a more stable, long-term cat bond marketplace than you would a sidecar marketplace."

Diane Coogan-Pushner, a portfolio manager with Philo Smith & Co., a Stamford, Conn.-based investment banking firm, said she expects cat bonds will be a bigger subsector of the market than sidecars five years from now "because they're simpler structurally than sidecars, and they're more transparent and, therefore, more desirable to investors."

ILWs also have their own distinctive attractions. Reinsurers may not be able to perfectly hedge their risk with ILWs because a reinsurer's particular experience may not correlate with the industry's, however, the speed with which ILWs can be arranged is an advantage. "It's a good way to get things done more quickly," said Mr. Martucci.

"There's always going to be people that prefer that method of execution because you can call up your broker and have an ILW done that same day if you want," said Paul Schultz, president of Chicago-based Aon Capital Markets.

"However, I think in terms of just the size of capacity, I would say sidecars and cat bonds will exceed that of the ILW market," Mr. Schultz added.

Chris O'Kane, London-based CEO of Aspen Insurance Holdings Ltd. said, for instance, that while there could be a $100 million cat bond, "ILWs probably have to build up in little units" of $5 million or $10 million and the terms of the individual ILWs may be nonconcurrent.

Over the past several years, alternatives to conventional reinsurance and retrocessional coverage have emerged and are taking up an increasing portion of the market. The three most popular alternatives are: sidecars, catastrophe bonds and industry loss warranties. Observers say that each of the alternative vehicles has its own attractions and uses depending on what the buyers and sellers of the coverage want to achieve.

Sidecars are special-purpose vehicles often capitalized by hedge funds that provide capacity to existing reinsurers by assuming risk, typically through mutiyear quota-share reinsurance contracts. The sidecar assumes a percentage of premiums in return for assuming a percentage of the risk, which is generally property catastrophe reinsurance.

Catastrophe bonds are risk-based securities that provide coverage once defined losses exceed a certain limit. Capital market investors can participate in the reinsurance market through the purchase of the bonds.

Industry loss warranties are financial instruments that are tied to an index of industry losses. The coverage is triggered once the loss figure for the entire industry surpasses the amount agreed upon for each contract. Through ILWs, reinsurers may trade risk capacity among themselves or purchase it from others, including hedge funds or investment banks.