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In the fourth quarter of 2005, a number of Bermuda reinsurance companies that survived Katrina, Rita and Wilma were restructured. Traditionally, that would have meant the replacement or enhancement of their capital base and a review of their books of business.

Four major companies, so far, have embellished that strategy with the establishment of a relatively new business model, first tried in the Bermuda market about four years ago. Most of the business these side companies write uses collateralized coverage, which in its simplest form is prepayment.

The sidecar companies have differing characteristics, but broadly, they act as stop-losses, and partition reinsurers' risks to improve the quality of their capital and therefore their ratings by reducing the volatility of their earnings.

The parents of some of the new companies participate in a percentage of the earnings of side vehicles in which they have an ownership; others cede business to unowned companies, stripping all balance sheet responsibility from the ceding company, other than the recoverability risk.

While sidecar companies may well improve the balance sheets of Bermuda reinsurers, they also make it easier for investors to flee the market, according to Mark Puccia, chief quality officer for insurance ratings criteria at Standard & Poor's.

"That capital is there for one year, two years, and that's it," he says, speaking at a property/casualty conference in January. "Those investors will then come back to that company and say in two years' time, 'OK, if the market is still hard the money is there. If it's not, it's gone.' Ease of exit. Done."

What has prompted XL Capital and the others to start these side vehicles are a number of unpleasant lessons the reinsurance industry has learned in the past two years, during which seven of the 10 costliest storms in history have taken place.

In 2004, an almost rhythmic series of hurricanes raised second- and subsequent-event coverage issues. Like punch-drunk boxers, some reinsurers were rattled by the economic effect of repeated blows, and some of their insureds found themselves without cover for periods, because very few policies addressed four separate, successive events.

In 2005, Hurricane Katrina, and then Rita and Wilma, raised other issues, mostly again in the category of the need for loss mitigation, but presenting different stresses under different circumstances.

Katrina, in one regard, was the storm for property lines; few emerged unscathed. The extent to which a storm of Katrina's magnitude would cross all the property lines had not been anticipated by some of the multiline carriers.

The new companies ease those various stresses by siphoning off some of their business at the higher levels into a "neutral" venue. The operations of all the new vehicles are subsidiary, in truth if not necessarily in accounting terms, and their purpose is essentially retrocessional, a market which spreads individual reinsurers' risks among the wider reinsurance community. By parceling out some of the worst of the volatility, the companies mitigate possible repetitions of the consequences of the major patterns of the past two years.

Sidecar vehicles are also attractive to reinsurers because they provide additional capacity without diluting shareholders' equity. Reinsurers earn "fee income" from these new ventures, which it is hoped will produce higher stock price multiples.

Not coincidentally, the ratings agencies are in the process of changing their standards, adding pressure to upgrade the quality of capital. Reinsuring the most volatile pages of a company's overall book to affiliated companies, owned or not, raises both the quality and the profile of reinsurers' retained risk portfolios and makes holding onto one's ratings more feasible in a market in which, suddenly, everyone seems to be one notch further down the scale than they used to be.

Among the first reinsurers to form sidecar companies were:

Montpelier Re. Last summer, Montpelier Re capitalized sidecar Rockridge Re, a Cayman reinsurer, at $91 million in partnership with West End Capital, the Bermuda-based hedge fund manager. West End is the main sponsor of Flagstone Re, a $530 million post-Katrina Bermuda startup.

After Katrina, Montpelier joined with other investors in capitalizing a new sidecar Bermuda reinsurer Blue Ocean Reinsurance, to offer retrocessional protection in the property catastrophe market. Blue Ocean has commitments for $300 million of common and preferred equity, including $133 million from Montpelier. Blue Ocean provides fully collateralized retrocession to parties other than Montpelier and has no current plans to obtain a rating from any of the agencies. Initially, Blue Ocean anticipates underwriting gross aggregate policy limits in excess of $350 million.

Montpelier also entered into two transactions providing a further $90 million in collateralized catastrophe protection through sidecar Champlain Ltd., another Cayman company. The coverage is based on modeled market loss triggers.

Upon the occurrence of an earthquake or hurricane in the covered territories, the parameters of the catastrophe event are determined and modeled against the notional portfolios.

If the modeled loss to the notional portfolio exceeds the attachment point for the event, or second event for the second transaction, then Montpelier will receive immediate payment from Champlain under the counterparty agreement.

PXRE. At year's end, PXRE completed two separate catastrophe-bond transactions, using sidecar Cayman Islands reinsurance vehicles called Atlantic & Western Re I and II. PXRE will use $550 million in borrowed money as collateral to mitigate certain losses in the years ahead. Stripped down to its bare bones, PXRE has reinsured some of its most volatile business at the cost of bank debt.

The company had been an early adopter of the idea, forming P-1 Re in December 2002 to provide quota share reinsurance through a special purpose Bermuda reinsurer capitalized by a group of institutional investors. P-1 Re was to provide PXRE with $194 million in collateralized reinsurance protection against property catastrophe, marine, aviation, satellite and per-risk losses for two years, but P-1 Re folded three months later.

XL Capital. XL Capital reinsures up to $500 million through quota share counterparty Cyrus Re, a newly formed Bermuda sidecar in which XL has no ownership, although it has an equity position in Highfields Capital Management, the company that owns Cyrus Re. XL cedes property catastrophe and some of its acquired retrocessional business, having initially funded a collateral trust with $500 million to support such reinsurance activities.

Highfields' agreement with XL continues the hedge fund's program of insurance investments. Highfields bought Irish Reinsurance Partners in 2001 to reinsure the nonlife contracts of French reinsurer Scor. The Paris-based company bought out Highfields' stake in Irish in 2005.

Arch Capital Group. XL Capital took a large loss on the 2005 hurricane season, notably Katrina, as did Montpelier Re and PXRE. By contrast, Arch Capital Group was not especially badly damaged in 2005, but nevertheless formed sidecar Flatiron Re at year's end as a reinsurance company with a limited life domiciled in Bermuda. Flatiron writes collateralized reinsurance, with a $256 million term loan facility and up to $264 million in additional private capital, for a total of $520 million.

Overall, $2 billion or $3 billion is not a market-changing sum. But should the sequestration of risk in this manner prove effective, the next time the chips are down for the reinsurers, more collateralized special purpose vehicle activity is sure to follow.

ROGER CROMBIE is a Bermuda-based writer and a columnist for Risk & Insurance^®.

March 1, 2006

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