In the previous article, we have already studied about the concept of reinsurance sidecars. We now know what reinsurance sidecars are and how they are structured. We know why insurance sidecars have revolutionized the reinsurance industry. However, it is equally important to know what are the pros and cons of reinsurance sidecars so that a decision can be taken regarding whether or not a reinsurance company wants to use this structure to raise funds.

Pros of Reinsurance Sidecars

The concept of reinsurance sidecars has been gaining significant popularity in the recent past. This is because of the fact that there are some significant advantages which are associated with the idea. An indicative list of some of the advantages are as follows:

• Short Term Structure: A reinsurance sidecar is an ideal structure for hedge fund investors who are willing to take a high risk for a short period of time. Hedge fund investors typically notice the capacity shortage in the reinsurance industry and know that good returns can be made. However, they cannot really open and operate their own reinsurance company since they want to invest only for a short period of time. Also, investing in a reinsurance company can be a complicated transaction as well.

  The reinsurance sidecar gives them the perfect opportunity to invest in the industry only for a short period of time when the situation is favourable to them. Hence, reinsurance sidecars are a temporary structure which can provide support to the industry when needed and can then be dissolved.

• Higher Than Market Returns: During periods of capacity shortage, reinsurance service is not easily available. As a result of this shortage of supply, premiums rise sharply when compared with the risk that is being assumed. This creates a situation wherein hedge fund investors can lock in a high rate of return in the form of interest and dividends. In the short history that reinsurance sidecars have existed, hedge fund investors have made above average returns when they have invested in the same.

• Limited Risks: A reinsurance sidecar is a great way using which an insurance company can bifurcate risks. A sidecar contract clearly states what is being insured against which types of losses and what the maximum possible extent of monetary loss to both parties is.

  If a hedge fund investor invests directly in the reinsurance company, they have to assume all the risk of the company. However, when it comes to an insurance sidecar arrangement, the investors can literally pick and choose the type as well as the extent of risks which they are comfortable with.

• Less Regulation: The reinsurance sidecar structure works well for the reinsurance company as well. This is because raising capital can be a very complex issue for a reinsurance company.

  1. Firstly, there are several regulatory challenges which need to be dealt with.

  2. Secondly, the capital raised is either equity which is permanent or debt which adds to leverage.

  The reinsurance sidecar is a convenient short-term solution for the reinsurance company to raise capital temporarily with minimal hassles.

Cons of Reinsurance Sidecars

Now, it needs to be understood that almost every financial innovation has its flipside and the reinsurance sidecar is not really an exception.

• Dilution of Management: First and foremost, the reinsurance company loses a degree of control over its operations.

  A sidecar arrangement allows third party financial entities to inspect the books of the reinsurance company and even have a say in their decision making. This could be problematic for both parties if they do not agree on the risk return profile which needs to be adhered to during the existence of their partnership.

• Adverse Selection: A huge problem with the reinsurance sidecar structure is that there is a high chance of adverse selection taking place. This means that one party may unwittingly assume more risks than it intended to due to the lack of information. Now, reinsurance business is mostly based on understanding catastrophes.

  Catastrophe Modelling is a complex activity which reinsurance companies can do quite well. However, hedge funds may not have the core competency required to make the right decisions. It is for this reason that there is a high probability that the hedge fund may end up selecting the wrong reinsurance partner or taking up too much reinsurance risk. The only way for hedge funds to mitigate this risk is to learn more about the business of reinsurance and catastrophe modelling which isn’t really their core skill!

• Complicated Exit: Lastly, reinsurance sidecars are created for a fixed period of two to three years. Reinsurance contracts are also created for a limited period. However, getting both the periods to coincide can be a difficult job. This means that more often than not, there will be situations in which one contract outlives the other. Now, ascertaining the pro-rate break up of premium which is commensurate with risk can become challenging.

  For instance, in summer there is almost zero chance of a snowstorm occurring. Hence, prorating the premium is not only about the number of months. This can lead to tremendous complications particularly when contracts have to be terminated.

The fact of the matter is that reinsurance sidecars have their pros and cons. The cons are somewhat difficult to mitigate even after knowing that they exist. However, the benefits are so significant that most investors are willing to overlook the complications and continue with the arrangement.