A sidecar is a special-purpose vehicle (SPV) created by an insurer or reinsurer, allowing them to offload some of their underwritten risks to investors. By doing so, insurers can free up capital for other purposes, while investors benefit from the steady income generated by insurance premiums. The sidecar structure is akin to a reinsurance contract, wherein the parent company retains control over underwriting decisions while sharing the risks and rewards with its sidecar partners.
In recent years, sidecars have become an attractive investment vehicle for institutional investors, hedge funds, and high-net-worth individuals seeking to take advantage of the relatively uncorrelated returns offered by the insurance sector. As a result, the sidecar market has witnessed significant growth, with an estimated global value of over $10 billion in 2021.
How do sidecars work?
Sidecars typically follow a five-step process from beginning to end.
First is the Formation, whereby an insurer or reinsurer establishes a sidecar by creating a legally separate SPV. The SPV is typically domiciled in a tax-efficient jurisdiction like Bermuda or the Cayman Islands.
Step two is Investment, where the sidecar raises funds from third-party investors, which then become shareholders in the SPV. The insurer or reinsurer may also invest capital in the sidecar, aligning their interests with those of the investors.
Risk Transfer is the third step in the process. At this point, the parent company enters into a quota-share agreement with the sidecar, transferring a predetermined percentage of its underwritten risks and premiums to the SPV. The quota-share agreement specifies the sidecar's share of both premiums and potential losses. The sidecar assumes its share of the risks and receives its portion of the premiums. Losses and expenses are allocated proportionally among the sidecar and the parent company. Any remaining profits are distributed to the sidecar's investors as dividends – this is the is Profit Distribution step.
Termination is the fifth and final step in the process. Sidecars are usually designed as short-term vehicles, with a predefined exit strategy. At the end of the sidecar's term, typically ranging from one to five years, the SPV is dissolved, and any remaining capital is returned to the investors.
Pros and Cons
The rise of sidecars can be attributed to several factors, including the growing interest of institutional investors in the insurance sector and the industry's ongoing search for innovative risk-transfer solutions. Moreover, sidecars can help insurers maintain their underwriting capacity during periods of market stress, such as following a natural catastrophe or a financial crisis.
Despite their growing popularity, sidecars are not without challenges. Regulatory scrutiny is a concern, as authorities seek to ensure adequate capitalization and risk management practices. Additionally, sidecars' performance is tied to their parent companies' underwriting expertise, which can result in considerable variation in returns.
Sidecars represent a dynamic and innovative risk-sharing mechanism that is reshaping the insurance landscape. By marrying traditional underwriting with capital market capabilities, they offer a unique opportunity for insurers, reinsurers, and investors to collaboratively navigate the complex world of risk management.
