New ventures, new vehicles: a number of reinsurers have found innovative ways to team up with hedge funds and other investors to tap into fresh capacity while taking some risk off their books.

Although the idea's been around for a while, early successes and changes in the market have spurred a recent upsurge in the creation of new affiliated reinsurance companies, fueled by fresh capital, but still dependent on the sponsor for underwriting expertise.

These new companies are sometimes called "sidecars," although the term is so new that variations of it--including "sidebar" and "side pocket "have popped up, as well as different definitions of what it is. In the broadest sense, a sidecar is a new reinsurer sponsored by an established reinsurer, with most--if not all--of the capital coming from third-party investors.

The sidecar has no underwriting engine of its own, but it relies on the sponsoring reinsurer to act as its underwriting manager for a fee.

Sidecars give third-party investors, often hedge funds, a relatively easy way to enter the insurance business without having to master the nuts and bolts of operations. For a sponsoring reinsurer, a sidecar brings three major benefits: access to capacity necessary to fulfill clients' needs, a diversified revenue stream and a reduction in capital requirements (from removing risk from the balance sheet.)

Sometimes these new companies offer fully-collateralized retrocessional coverage. Other times, these new companies act more like traditional reinsurers, and seek to gain a rating from an rating agency. Often, the sponsoring reinsurer has both options available to clients, and is able to offer both rated paper through one entity and non-rated, but collateralized paper, through another entity at different prices.

Whether or not these new reinsurers, who act in consort with an established player, are publicly called sidecars, there's no doubt their presence has brought new capital to the industry and softened the hardness of the property catastrophe market following the busier than usual hurricane seasons of 2004 and 2005.

Blue Ocean

Montpelier Re Holdings launched a venture, Blue Ocean Re, in January 2006 with $300 million in capital, 57% of which came from outside investors. Blue Ocean took over Montpelier's former retrocessional book of business. While the reinsurance community has come to refer to this type of vehicle as a "sidecar," Blue Ocean Re sees itself as a more traditional style of company specializing in property retrocession.

The impetus for launching Blue Ocean stemmed in part from the additional scrutiny of rating agencies with regard to the level of capital required to support property retrocession business within a rated company.

"It's a matter of looking at the framework of a rated entity, and what it would take to maintain a strong rating following the rating agencies' increase in capital requirements,' said John Bassett, who was the retrocessional underwriter at Montpelier before becoming president of Blue Ocean. "We decided that retrocessional business no longer had a suitable home with potential for a suitable [return on equity] with a sustainable rating at Montpelier Re," Bassett said.

Blue Ocean's private investors include hedge funds and other private investors who have not been named, Bassett said.

The new company took over where Montpelier left off, offering renewals to Montpelier's property catastrophe retrocessional clients. Blue Ocean is a stand-alone company writing on Blue Ocean paper, although Montpelier provides the underwriting services. Blue Ocean is a new company with new capital, Bassett said.

Bill Pollett, treasurer of Montpelier Re, said Montpelier took a number of steps last year to protect its A.M. Best Co. rating, including exiting offshore marine and retrocessional business, buying more reinsurance, raising more equity, issuing a cat bond, reducing its probable maximum loss and its capital requirements, and investing $133 million in Blue Ocean.

Bassett of Blue Ocean said brokers and clients have been receptive to this new style of capacity. "In an area (retrocession) where capacity is scarce, clients and brokers are keen for alternative solutions,' Bassett said.

First Generation

Renaissance Re and White Mountains pioneered the sidecar concept, said Mike Millette, managing director of Goldman Sachs.

Top Layer, a joint venture between State Farm and Renaissance Re Ltd., was formed on Jan. 1, 1999, to provide high layer property-catastrophe coverage on an excess-of-loss basis for non-U.S. risks. Both State Farm and Ren Re generate income from Top Layer through both their ownership stake in the company and through various business arrangements with the company. Representatives from both companies comprise Top Layer's board of directors with State Farm controlling two-thirds of the voting rights. Additionally, State Farm earns premium income through the assumption of risks from Top Layer while Ren Re Ltd. underwrites and manages the company's business for a fee.

Then after Sept. 11, 2001, there were a handful of similar ventures between reinsurers and other investors. One of the most successful was DaVinci Re, a strategic joint venture between Ren Re and State Farm to provide new capacity to the property-catastrophe reinsurance market following the events of Sept. 11. All business is underwritten by Renaissance Underwriting Managers using the same underwriting discipline and systems as Renaissance Re, which is widely recognized for its risk management skills, according to A.M. Best company reports. DaVinci's business is underwritten side-by-side with Renaissance Re's existing property-catastrophe books of business.

Accordingly, DaVinci's risk exposure profile is comparable to that of Renaissance Re's property-catastrophe portfolio.

Another example is White Mountains launching Olympus Re as a Class 4 reinsurance company based in Bermuda after Sept. 11. The company was formed to provide additional capacity to the insurance and reinsurance markets. The company offers property catastrophe, property per risk excess, property excess-of-loss, aviation and marine excess-of-loss coverage. The company's strategy is to develop and maintain a top quality book of business, diversified geographically by cedent and exposure, laterally by class and vertically by attachment level through an excess-of-loss reinsurance program. Virtually all of the company's premiums were written through quota share agreements with Folksamerica Reinsurance Co., a wholly owned subsidiary of White Mountains Insurance Group. White Mountains, through its subsidiaries, holds a 10% interest in Montpelier and warrants to purchase stock that would increase its ownership to 19%.

"They set the precedent for the sidecars we see today, which are quite different," Millette said.

Second Generation

Industry observers saw how Ren Re and White Mountains were able to diversify their revenue stream by adding a fee-based stream, plus take some property risk off their books, while still being able to offer clients capacity.

"When we rolled into 2005, long before Katrina hit, the sidecar idea was percolating," Millette said. "It was a fertile environment"

A major factor in that fertile environment was the explosion of growth in hedge funds and their willingness to look for opportunities to invest in reinsurance. Hedge funds are typically interested in short-tail lines, such as property catastrophe coverage.

Before Katrina, Montpelier Re teamed up with West End Capital, a hedge fund, to launch Rockridge Re, which assumes higher-layer short-tail risks from Montpelier. Rockridge opened with about $91 million in capital.

After the losses from Katrina, capital in the reinsurance market became constrained, making the idea of sidecars even more interesting, Millette said.

According to Goldman Sachs, in addition to Montpelier launching Blue Ocean, other reinsurers have had a hand in creating new reinsurers funded by third-party investors. (See "New Vehicles.")

"They all write property reinsurance, but vary quite a bit among them," Millette said. Blue Ocean is entirely retrocessional coverage. The others are a mix of catastrophe excess-of-loss or property reinsurance quota shares and other lines.

Most of the sidecars, including Cyrus and Flatiron, act as a reinsurer for the sponsoring reinsurer. "They write no external business. They aren't always rated," Millette said.

In the case of Blue Ocean and Rockridge the sponsoring reinsurer, Montpelier, is also an investor in the new company, while the other sponsoring reinsurers may not have invested in their sidecars.

"The exact dynamics of the companies vary, but they are all pools of capital designed to take a share of business generated by an associated reinsurer," Millette said.

True Sidecar

According to A.M. Best Co., a sidecar works best when the reinsurer, who's acting as the sidecar's underwriting manager, has not invested in the company.

"By using a sidecar, they take the business off their books and none of their capital is at stake," said Bob DeRose, assistant vice president, Property/Casualty Division, A.M. Best Co. "If they have invested in the sidecar, it's on their balance sheet as an asset, but we do not count it as an asset."

By this definition, Blue Ocean, Rockridge and DaVinci Re are not true sidecars, DeRose said.

Examples of true sidecars include Cyrus Re, which opened its doors February 2006 to write property catastrophe coverage with XL Capital. Cyrus Reinsurance Ltd. is a Bermuda reinsurance company, and a wholly owned subsidiary of Cyrus Reinsurance Holdings SPC, a Cayman Island exempted segregated portfolio company. Cyrus Re was capitalized with $525 million through private equity and debt offerings, including investments by High-fields Management and other hedge funds, according to Chadbourne & Parks, a New York City-based law firm. Cyrus Re writes quota-share property catastrophe reinsurance and retrocessional coverage for two subsidiaries of XL Capital.

Another example of a true sidecar is Flatiron Re, which was set up specifically to offer reinsurance to Arch Reinsurance Ltd.

"A true sidecar means the reinsurer has no investment in the vehicle, but controls the underwriting," DeRose said.

Rob Bredahl, president of Benfield Inc., said he considers sidecars as facilities that directly write risk with the cedent, rather than behind an existing reinsurer.

When the capacity, provided by a hedge fund, sits behind a reinsurance company, with only the reinsurance company's issuing paper, that's collateralized retrocessional quota-share coverage, not a sidecar, Bredahl said. "Although both types of facilities are being called sidecars" Bredahl said.

He noted a number of companies have established collateralized retro quota-share vehicles that clients may not even be aware of.

"A pure sidecar is flexible capital. The reinsurer receives underwriting fees for managing it. If the market turns softer, that capacity can go away. There's no infrastructure behind it," Bredahl said.

The advantage to clients of this new capital is that it's helping keep premium rates lower. "If you relied only on existing reinsurers to provide capacity, rates would be higher," he said.

Here Today, Gone Tomorrow?

Bredahl said most reinsurers are interested in forming sidecars or have created one. "More will be formed, if the market stays hard. If the market softens, then interest in sidecars and collateralized quota shares will fade," Bredahl said.

Steve McElhiney, president of EWI Risk Services Inc., a Dallas-based risk management and insurance intermediary, said while some kind of consortium or pooling mechanism makes sense in light of the constrained capacity of the market, he's concerned that hedge funds and other investors aren't going to stick around for the long-term.

"Their level of long-term commitment is untested" McElhiney said. "It's not as good as dealing with a traditional reinsurer that is rated. The whole issue of hedge funds needs to be monitored and controlled. The fact that they are now gravitating toward property catastrophe insurance calls to mind their long-term level of commitment and their appetite to weather substantial losses."

Bassett of Blue Ocean said he's heard no complaints from brokers or clients. "They are quite grateful for the cover" he said.

Key Points

* Reinsurers are working with third-party investors to form new reinsurers.

* Hedge funds have been enthusiastic investors in these new vehicles, sometimes called sidecars.

* Some of these new companies are designed to last only a year or two.

Learn More

Arch Reinsurance Ltd.

A.M. Best Company # 75169

Distribution: Brokers

DaVinci Reinsurance Ltd.

A.M. Best Company # 84749

Distribution: Brokers

Montpelier Reinsurance Ltd.

A.M. Best Company # 84809

Distribution: Brokers

XL Re Ltd.

A.M. Best Company # 86106

Distribution: Reinsurance brokers

For ratings and other financial strength information about these companies, visit www.arnbest.com.

New Vehicles

Several established reinsurers have launched new ventures in the last year, including these:

* Montpelier Re Holdings launched Blue Ocean Re with $300 million in capital, 57% of which came through outside investors.

* Arch Reinsurance launched a quota share agreement with Flatiron Re, a new vehicle with $900 million in capital.

* XL Capital and Highfield Capital launched Cyrus Re with $525 million in capital.