Author: Alex White
What is insurance sidecar?
A sidecar is a capital-efficient reinsurance vehicle. It allows an investor to assume the risk and return of a book of liabilities from an insurer. Sidecars allow insurers to remove most of the risk of a book of business in a generally far cheaper way than through full re-insurance, while enabling investors to access substantial leverage and, thereby, target higher expected returns.
Similar arrangements have been used in life insurance for some time, notably by Berkshire Hathaway. They are now becoming a bigger part of the casualty insurance market too.
How does a sidecar work?
It's easiest to explain with an example, with purely indicative numbers:
- The insurer cedes $350m of premiums backing $400m of liabilities (due over 5-10 years)
- To top up the sidecar, the investor puts in $150m
- The investor (via a manager) runs all (or most) of the sidecar portfolio ($500m total), and pays out the liabilities
- In an extreme case, if the assets are inadequate, the liabilities revert to the insurer
Source: Gallagher
How have sidecars changed?
Sidecars have become far more sophisticated. Rolling back 10 years and more, they were primarily a way for investors to gain access to underwriting profits. Little consideration was given to investment strategy.
Now, investors expect to derive material return on equity from the investment strategy, too. This has meant sidecar portfolios now tend to contain higher-risk investments, such as private credit, structured credit and emerging market debt. In addition, they incorporate much more advanced ALM — with claim profile-driven asset selection, and dynamic liquidity management.
Why does it work for the insurer?
In a word, price. Reinsurers look to earn a premium, so might charge materially more than the value of the liabilities (though with some allowance for discounting).
Meanwhile, the investor will pay for leverage, meaning the cost to the insurer can be less than the liabilities. This can result in a very significant difference in price, which can make retaining the residual tail risk worthwhile. By ceding liabilities, they can also write more business.
Why does it work for the investor?
It allows them to access leverage. In this example, $150m of capital backs $500m of assets. This means they can earn a material return on equity.
Taking the example above and assuming a 7-year horizon, earning a return on assets of 6% p.a. translates to a 10% annual return on equity. The table below shows an example of how, even in a simplified case with no early withdrawals, return on equity can be amplified to a greater return on assets.
| Return on assets (p.a.) | Return on equity (p.a.) |
| 0% | -6% |
| 2% | 0% |
| 4% | 5% |
| 6% | 10% |
| 8% | 14% |
| 10% | 17% |
Source: Gallagher
Note: assumes starting asset PV of $500m, initial investor equity of $150m, total liability PV paid of $400m.
Unlike traditional leverage, the investor isn't borrowing the money directly. Therefore, they aren't at risk of being stopped out in the same way they would be if they borrowed directly.
What is the downside for the insurer?
The main downside is that, in a tail event, the liabilities revert to the insurer. On this point though, the investor adds an extra layer of capital as protection. Assets would need to lose the full value of the investor's capital (minus any capital paid out) before the insurer would be worse off for having done the deal than having done nothing.
The insurer also gives up potential upside if the assets earn more than they need to pay the liabilities.
What is the downside for the investor?
The investor needs to pay the liabilities and runs the risk that those are higher than expected. On any specific deal this could end up being a bigger factor than asset returns.
What about the investment strategy?
The assets used are likely to include relatively niche/specialised illiquid credit, including ABF, bridge lending, and a broad suite of bank disintermediation assets. These components will typically be sub-IG, though can be taken as a whole portfolio and securitized, leaving an IG senior tranche and sub-IG mezz tranche.
These assets require specialized skills, and Gallagher have experience and expertise in liquid and illiquid credit, both researching managers and doing detailed quantitative analysis, such as stress tests and ALM modelling. Stress tests can be particularly useful as a way to "peer under the hood" and challenge manager modelling.
Where can sidecars go wrong?
As with many deals, the parties' interests are not perfectly aligned. In particular, the investor is seeking profits while the insurer is seeking to minimise the chance that the tail of liabilities reverts to them. This means the investor is likely to want a higher risk, higher return portfolio.
Regulation can mitigate this risk, but these deals will likely make most sense with a more aggressive portfolio than a typical insurance investment, so it's critical to have a detailed understanding of the assets (especially private credit) that would back such a deal.
Broadly, there are two risks which can derail sidecars: underwriting and investment. A serious downside scenario is likely to involve both higher-than-expected liabilities and asset losses. Any correlation here would make tail events much more likely.
How can Gallagher support you?
Sidecars can be an extremely valuable tool for insurers, but the devil is very much in the detail. Gallagher has all the resource and expertise to help you decide whether to use a sidecar, structure it, and appraise potential investors and their investment proposals.
Just recently, Gallagher helped source a prospective investment manager for a sidecar. We also undertook a detailed review of the manager's proposed investment strategy, which included performing our own independent stress tests. Gallagher's dedicated support gave our client confidence to move forward.
