Bermuda: Investors still wary of sidecars despite upbeat outlook for 2023 returns

The expectation is that this could help to support some growth of existing vehicles through reinvested profits and a moderate amount of new issuance.

But sources say that for a fuller recovery, the segment will need to generate between one to three years of positive returns, as well as implementing changes to structures, ceding commissions and shifting other terms and conditions more in favour of investors.

Strong returns

While sources cited 20%-30% as a range for average returns on sidecars this year, the overall range of projected returns was wider, from 15% up to 50% for higher-risk strategies.

This is a significant improvement on last year, when sidecar returns were broadly flat, and to 2021, when they were flat-to-down, sources noted.

Ryan Clarke, managing director at GC Securities, attributed the improved sidecar performance to factors that are supporting ILS more broadly.

“Similar to other ILS products, sidecars are benefitting from underlying cedant programs sustaining increased premiums, elevated attachment points and more restrictive terms and conditions,” Clarke said.

“These factors are all contributing to an increased premium buffer layer in the system, which can withstand more loss events before there is impairment of investor capital.”

However, despite the favourable factors Clarke mentioned, the consensus among sources that this publication spoke to was that 1 January sidecar renewals are unlikely to see a huge influx of new capital.

The reasons for this included continuing trapped capital and investors wanting to see multiple years of positive performance.

Another source said that while there had been a “lot of pitching of sidecars”, it was currently too early to tell whether the deals would get done.

“An increased premium buffer layer in the system … can withstand more loss events before there is impairment of investor capital” Ryan Clarke, managing director, GC Securities

A further source considered that several of the deals that had been out in the market were now looking like they might struggle to complete in a hard fundraising market.

However, they said the hard reset that reinsurance buyers had to go through in 2023 was “not a blip”, and that while reinsurers might hold rates flat this year, which would effectively mean decreases given inflation, they would not let up on terms and conditions.

“Taking that into account, sidecars could be attractive for some people,” they said.

Brad Adderley, managing partner and head of corporate at Appleby in Bermuda, was generally upbeat in his outlook for the segment, adding that there would be “one or two larger sidecars than we have previously seen,” somewhere in the range of $200mn to $300mn.  

Adderley notes the market could likely see “opportunistic investors who have come in and like the terms and like doing it for one renewal season”. 

Last year, Ark for example set up sidecar Outrigger Re, which exceeded its target capital raise by $50mn, raising $300mn and backed by White Mountains and a handful of private equity firms.

Aon said in its annual ILS report for 2023 that it has been observing rising sidecar interest, expansion of existing sidecars and the return of past ILS investors, resulting in the sidecar space growing to $7.1bn from $6.4bn the prior year.

“We expect the sidecar market to grow as cyclical reinsurance investors recognize the improvements in underlying portfolios” Paul Schultz, CEO, Aon Securities

“Interest in the sidecar sector is escalating as investors recognise the mutually reinforcing impacts of higher pricing, more remote attachments and restricted coverage,” the report said.

Paul Schultz, CEO of Aon Securities, added: “We expect the sidecar market to grow as cyclical reinsurance investors recognize the improvements in underlying portfolios.”

However, the current $7bn is below the peak outstanding volume of $8.4bn achieved in 2015.

Constrained capacity

With the sidecar segment’s shift away from the syndicated deals of years past and movement toward bilateral deals, new issuance in the space is said to be driven largely by investor appetite, with less emphasis on a sponsor’s desire to place a deal.

This differs to the cat bond space, where availability of capital flowing in from investors has helped at least to some degree to galvanise cedants into bringing new deals to market.

The main reason for the constraint in sidecars is that “it is probably a little bit premature to get back into sidecars after one year of good performance,” a source said.

Clarke believes that sidecars “will have to demonstrate internal rates of return (IRRs) at or better than modelled expectations, efficient investor entry and exit pathways, and a competitive return profile compared to other investment alternatives”.

One source suggested that a return to offering syndicated sidecars could be more efficient in drawing more investors beyond the small pool of those considering bilateral deals.

Some reinsurers, such as Scor, Swiss Re and RenRe, have had tactical success in raising third-party sidecar capital in the past year from large pension funds.

But the drop-off in syndicated sidecar vehicles in recent years suggests that some reinsurers are rethinking the cost of maintaining such vehicles when investor demand has slowed. As Trading Risk reported, Brit has recently opted to scale back Sussex Capital, after its Versutus sidecar shut down at 1 January this year.

Some vehicles had simply never gained scale, while M&A impacted Argo’s former Harambee, for example.

Structural issues

Investors are also seeking changes to the structure of sidecars before returning to the market, particularly on ceding commissions and trapped capital.

One source said that investors are looking for a reduced ceding commission, although these have already been cut from a range of 7% to 10%, broadly speaking, to 4% to 7.5%, suggesting that there “isn’t much room for movement”.

One investor said there was an argument for ceding commissions to go to “almost zero and have a higher performance fee.”

They said: “You need to put pressure on your sidecar sponsor such that there is no profit coming from the management fees. They should be fully incentivised to perform, so you want full alignment with the underlying portfolio.”

In recent years, trapped capital has been addressed through the use of more generous rolling capital structures that allow investors to shift forward capital on a reserved loss basis, without factoring up losses to hold buffered capital.

However, structural issues around capital trapping remain a concern, with this issue yet to be resolved, and even considered “inherent within sidecar vehicles”, one source suggested.

First Published In Trading Risk, October 2023