What Is A Sidecar?

Sidecars are special-purpose entities set up by a sponsoring entity to reinsure a book of business to investors who have provided capital to support those liabilities. Sidecars gained popularity among U.S. property/casualty insurers in the early to mid-2000s after some major hurricanes. However, it took more than a decade for them to spread to U.S. life insurers.

The growing need

The need for significant capital relief arose in the industry when the National Assn. of Insurance Commissioners adopted Actuarial Guideline 48 in late 2014, dramatically increasing reserving requirements for certain types of business. At the time, life insurers primarily sought that relief by moving business offshore to affiliated captives, rather than setting up sidecars.

As insurers contended with uber-low interest rates for more than a decade, derisking the balance sheet became a priority. Insurers started selling small parts or blocks of their operations that were no longer integral to their overall strategy, resulting in a surge in block reinsurance transactions. New players entered the arena, which had been dominated by a handful of traditional life reinsurers, including private equity players with their asset management capabilities. The emergence of sidecars provided additional competitive capacity by attracting on-demand third -party capital, possibly at lower cost.

The current state

The structure of sidecars, or offshore reinsurance vehicles , runs the gamut from fully owned captives, to ones where the ceding insurer only holds a minority equity stake, to seemingly independent insurers, where the sponsor has zero ownership in the sidecar. However, the degree of control or influence that the sponsor has on the sidecar may be higher than its ownership stake may suggest. Contract provisions between the sponsor and the sidecar, the staffing of the sidecar's executive team and its board of directors, or other less formal mechanisms may effectively give the sponsor control or a high degree of influence over the sidecar's operations, even without outright ownership or a majority equity stake.

External investors in sidecars may include sophisticated money managers that manage institutional and sovereign wealth funds, high-net-worth investors and family offices, employees of the sponsor, etc. While ownership structure and control provisions may vary, we expect companies to maintain solid governance by having a well-diversified investor base and avoiding any single-investor concentration.

Benefits

Setting up a sidecar or an offshore reinsurance vehicle could benefit the primary insurer by allowing access to third-party capital (possibly at lower cost), thereby expanding the insurer's competitive limits. Some sidecars also offer companies the ability the use third-party equity capital without diluting equity for existing investors.

Setting up a sidecar also allows the company to either participate in larger transactions or add more volume by transferring a portion of its risk to another entity, without straining its own capital strength. For companies that regularly acquire large blocks of business from other insurers, accessing on-demand third-party capital can also limit the capital volatility that comes with the lumpy nature of block acquisitions.

These structures often have one or more investors with solid asset management capabilities to manage the sidecar's assets for a fee. This convergence of investment management and liability management allows each party to focus on their own core competencies in managing a block and ultimately unlocking its return profile.

Ratings Implications

Whether a sidecar enhances or weakens the overall credit profile of the primary insurer depends on numerous factors and may be different for each entity. Any ratings implications on the primary insurer that establishes a sidecar may be based on:

• The sidecar's track record: How long has it existed? How much business has gone into it? What is its liability profile?
• Counterparty risk: Is the sidecar a rated entity? Otherwise, we may view it as reinsurance exposure to an unrated entity.
• Risk management and governance: What is the ownership profile? Who are the key decision makers? What is the exit strategy?
• Clarity of financial performance: How clear are dividend, capital target, and return expectations?
• Capital strength: How strong is consolidated or stand-alone capital?
• Investment strategy: What is the allocation to structured, alternative, and high-risk assets?

Some key considerations

Primary insurer's control and influence:  An important consideration as we analyze sidecars is the level of control the primary insurer has over these vehicles. As mentioned above, although the ownership structure may differ and the primary insurance company may not have any equity stake in the sidecar, it may still exhibit strong control through its involvement in decision making, investment management, risk management etc.

Insurers and sidecars also exhibit a strong vendor-supplier relationship--the primary insurer may be the sole vendor/supplier to attract new business or clients, leaving the sidecars heavily dependent on the primary insurers. As such, despite having minority or no ownership at all, we may still consider a sidecar to be part of the same group as the primary insurer.

Capital strength:  It is important for S&P Global Ratings to understand a sidecar's current capital strength, as well as the management teams' broader capital management and dividend strategy for the entity. We could evaluate sidecars' capital using our proprietary criteria and methodology on a stand-alone basis or take a consolidated view (i.e., consolidate it with the primary insurer) to assess if the combined capitalization is commensurate with the insurer's ratings.

Permanence of third-party capital is another key area, because the long-term nature of the liabilities require a longer-term capital commitment. Sidecars often have a call feature whereby investors can monetize their investment based on set time frame--typically 10 years.

When ceding blocks of policies to offshore entities, insurers will often structure these transactions on a funds withheld basis. In other words, liabilities are transferred to the sidecar, but the primary insurer retains the assets on its balance sheet and periodically passes the assets' net experience to the sidecar. The sidecar then sets up reserves, sometimes with some level of overcollateralization (holding more capital/reserves to support liabilities), which can be viewed as an added layer of protection.

Risk management:  We also examine a primary insurer's broader risk management approach and, more specifically, around the use of sidecars to understand if this is a true transfer of risk. We expect companies to have a clear exit strategy and recapture provisions to avoid any brand/reputational risk. We also watch for counterparty risk exposure, especially if the sidecar is unrated. We expect both parties to have and remain within well-defined risk limits and tolerances.

Based on our early observations, in a block reinsurance transaction involving a sidecar, most primary insurers simply transfer a vertical slice (or a portion) of the block to the sidecar based on a pre-approved quota share agreement, rather than utilizing it to transfer risker pieces of the block.

However, as these structures evolve and companies look at acquiring larger blocks, this could lead to product/liability concentration at the sidecar if they are not well governed or fail to operate within their risk limits. For example: if a primary insurer cedes 50% of a large block to its sidecar such that it utilizes the bulk of the sidecar's capital, the sidecar is left with a highly concentrated product/liability profile.

Domicile:  The domicile of the sidecar plays an important role in the overall management of capital and can potentially offer tax advantages. Offshore reinsurance entities could benefit from a friendly tax regime, although changes to U.S. tax laws in recent years have shut down some of these opportunities.

Most sidecars are set up in Bermuda, mainly because of its qualified and reciprocal jurisdiction and its reserving approach, wherein qualifying reinsurers are not required to post additional collateral when reinsuring U.S. risks. Companies may also consider the Cayman Islands, Barbados, and the Bahamas. However, several regulators are reassessing and enhancing their capital frameworks to capture evolving asset allocation strategies, which may include higher allocations for alternatives and structured assets.

Although U.S. life sidecars are in an early stage of development, they are growing fast and they are transforming. With the evolving competitive landscape of the U.S. life insurance sector, we expect more and more companies to assess if a sidecar fits with their core strategy. As such, we expect this growing side of the industry to garner a lot of attention in the next few years.