The Intelligent Quarterly from the publishers of The Insurance Insider

Spring 2012

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Reinsurers are fuelling up with an increasingly sophisticated and flexible array of capital solutions while the market stands at a crossroads.

From Front Street to Lime Street, CEOs have been adding new banking, hedge fund and investor contacts to their speed-dials. Air miles have been racked up at a frantic pace, as carriers look to put plans in place to quickly fuel-inject their underwriting operations if the market ignites.

With a record first half for catastrophe losses and the subsequent impact on underwriters as cat model changes are implemented, there is a consensus that the market - at least for property reinsurance - is at a tipping point.

While there is disagreement over how much excess capital remains in the sector, there is agreement that a significant catastrophe would send the moderate rate rises seen on US cat at the mid-year renewals rocketing, with broad hardening across international business.

But where previous market dislocations in 1985, 1992, 2001 and 2005 brought waves of reinsurance start-ups to provide "just-in-time" capital to the industry, nobody's talking about a class of 2011.

Why? Because the disposable reinsurance model that emerged strongly after Hurricane Katrina is back, and it has matured fast.

Today's investors and carriers can access short-term capital structures on a need-now or contingent basis for a feeding frenzy when the market heats up, without the indigestion and bloated feeling when it cools down again.

Crucially, all parties can access the upside of the opportunity, without falling into the "tenure trap" (see box-out opposite).

So what options are reinsurers exploring for fast capital access post-event?

Capital options
There are four main access routes: debt - or equity that looks like debt; capital rented today, such as the "traditional" sidecar; contingent capital; and the contingent sidecar.

The cheapest method, at least in current market conditions, appears to be to access the capital markets by issuing debt or preference shares.

Bermudians Montpelier Re, Endurance and PartnerRe all went down this path in the second quarter after record Q1 industry catastrophes, raising $705mn from preferred stock issues between them (see table right). Meanwhile several Lloyd's insurers, including Chaucer and Novae, have been able to increase debt facilities in the past year.

Click to enlarge There has been significant activity in the second category, with Alterra's $200mn+ New Point IV sidecar and Validus' $180mn Alphacat Re 2011 vehicle launched post-Japan to take advantage of rising rates in cat reinsurance and retro business.

As well as public transactions, there are thought to have been several private deals, with a number of Bermudians utilising collateralised sidecar-style structures to provide capital support so that they can flex their underwriting.

The use of reinsurance capital in the form of quota share arrangements also falls into this class where, for example, a Lloyd's underwriter systematically uses other entities' balance sheets as part of a syndicate's capital structure.

Buyers of "rent capital now" solutions fall into three groups.

There are those forced buyers that are capital-constrained after the heavy catastrophe losses and must come into line with their regulator.

Then there is the buyer that spots a short-term opportunity and determines that it is sufficient to warrant activating a sidecar structure today - for example Alterra and Validus with their post-Japan vehicles.

According to a senior investment banking source, a third kind is a carrier that systematically recognises the value of renting capital versus buying it.

"Anyone who arbitrages the reinsurance market continually and uses third party capital and strategically levers that capital would fall into that category," he says.

Debt or preferred equity and traditional sidecar and quota share transactions may have been the first port of call for some reinsurers looking for capital to put to work right away this year, but these are tried and tested solutions.

What looks different in 2011 is reinsurers' fast growing interest in contingent capital and sidecar structures.

Rise of contingent capital
Scor provided a public demonstration of the contingent capital model when the first EUR75mn tranche of its EUR150mn contingent facility with UBS was triggered by Q1 cat losses in July.

The French reinsurer lined up the contingent capital facility with UBS - to which it ultimately issued shares at a pre-agreed strike price - late last year as an alternative source of retro protection.

And IQ understands that contingent capital-style transactions have been pursued by a wide array of reinsurers with their bankers, with at least half a dozen deals at various stages of completion.

According to sources, the facilities - which typically see carriers pay up front to secure a mezzanine layer of capital below senior debt to be drawn down under pre-agreed triggers - are being peddled by investment banks with insurance-focused teams, such as Goldman Sachs, Deutsche Bank, Credit Suisse and UBS, along with the big three reinsurance brokers.

Contingent capital is usually provided as subordinated debt or is equity-like, rather than senior debt. The structures are currently offered on a bespoke basis, depending on the level of contractual guarantees in the agreement or speed of access.

For example, a deal that would give a reinsurer access to $100mn available at four weeks' notice in a proscribed form post-event might require an upfront reserve fee payment of 200 basis points (bps) - but would be a contractually watertight guarantee of that money subject to the trigger being met. Click to enlarge

The mezzanine layer itself might then cost 600-900 bps, significantly more than the 300 bps a reinsurer would typically pay for senior debt.

A reinsurer that just wants to spend, say, 20 bps up front is "only really attracting the attention of potential investors" an investment banking source suggests.

First dollar exposure
The key distinguishing feature of contingent sidecars from contingent capital transactions is the first-dollar exposure that investors get under the collateralised quota share structure that they typically employ.

Indeed, contingent sidecars - aside from the contingent funding of the vehicle - are usually very similar to traditional sidecars in terms of structure.

The only truly contingent public sidecar transaction in 2011 to date was Lancashire Re's Accordion vehicle.

The $250mn shelf-style sidecar is structured to be flexed up to address fresh underwriting opportunities under conditions pre-agreed by the sponsor and investors.

According to Paul Schultz, president of Aon Benfield Securities, contingent sidecars are generally put together after carrier sponsors go out and talk to investors about market opportunities and where risk is currently priced compared to where it might be after certain loss events.

"The sponsor is saying to investors that they're not seeing the market at levels that they would currently recommend investing, but that given these type of scenarios they'd be able to put investors' capital to work to produce these pro forma types of returns," he explains.

Aspen CEO Chris O'Kane heralded the advent of contingent sidecars such as Accordion at the Standard & Poor's conference in New York this summer.

"The latest sidecars are more sophisticated, making capital available on a surgical basis just where it's needed for just as long as it's needed," he suggested.

For Schultz, the flexibility to respond to changing market conditions that such structures provide supports significant growth in their use.

"If capital market investors can continue to be flexible and provide capital on that basis I think you'll see more and more activity like this.

"Why wouldn't you want to be prepared for larger-than-expected or unexpected losses and try and give your company a leg-up post event to access capital," he says.

So aside from the contingent nature of structures now available to carriers, how else does the 2011 breed of disposable reinsurer differ from its predecessors?
One key difference is the absence of debt in sidecar structures.

In its most recent update on the insurance-linked securities (ILS) market, Aon Benfield observed: "In contrast to some of the 2005 sidecars, it is believed that little to no debt is being used to capitalise this new class of sidecar. Rather, equity is presumed to be the primary source of capital."

Taking debt away from the structure puts greater demands on a sidecar's underwriting return and the ability to leverage the vehicle is diminished.

Whereas post-Katrina sidecars that included debt needed only to generate underwriting returns of around 15 percent to lever the overall return to the low-to-mid twenties, a higher underwriting return would now be required to match that level for investors.

Further pressure is likely to come from the RMS US wind cat model changes. There is the possibility that higher collateral will need to be posted against risks now modelled as having a higher expected loss.

There has also been a significant growth in the number of private transactions being entered into by reinsurers. This has occurred both for traditional and contingent quota share and excess of loss structures, written on both a rated and collateralised basis - and for contingent capital deals.

Indeed, the handful of public transactions announced so far in 2011 are likely to represent only a fraction of the overall volume of deals getting done (see box-out on page 14).

Investor evolution
And there's been a rapid maturation of the investor community as it becomes more sophisticated and broadens its base, with pension funds, high net worth and family office money drawn to the space.

That has contributed to a much wider availability of collateralised reinsurance to cedants over the past few years, with the emergence of a growing number of ILS funds looking to put capacity to use at the same time as cedants have grown more accepting of the product as a risk transfer tool.

According to Andre Perez of Horseshoe Group, which assists in structuring and manages sidecars, the maturation of the market now offers investors many more ways of accessing reinsurance risk.

"Investors are a lot more sophisticated than they were post-Katrina and understand the space much better - they even participate directly in transactions in some cases," he tells IQ.

"For some transactions you get one to four investors together and just do a collateralised quota share, with no lengthy documentation and sometimes without the bankers being involved.

"Some of the big investors have gone a step further and just come down to Bermuda and discussed it directly with cedants, asking them what they can invest in. That's definitely a change from investors waiting passively for a reinsurance opportunity to land on their desk," Perez continues.

With greater sophistication on both sides of the demand and supply equation, it seems that the disposable reinsurer - paradoxically - is here to stay.