Dear friend,
"Yes - I'm giving you my pen and yes, that means you can burn me, but remember, if you do, I'll never do business with you again."
A decade on and the simple analysis and thinly veiled threat of a long-serving Lloyd's broker binder underwriter continues to ring true. I'd just asked him what safeguards he had against our Spanish broking firm writing for income and stuffing a Spanish property reinsurance facility he was leading off for us full of absolute rubbish.
He said that quarterly borderaux were quite handy and that he could occasionally ask for chapter and verse on individual risks if he was worried, but ultimately he knew that he had no real safeguard other than the fact that he knew us well and trusted us not to act against our long-term mutual interests.
The only ultimate sanction of any power he had was the threat of withdrawal of his support when renewal time came along. As it turned out, we tried our best not to burn him - having a binder gave us kudos and leverage in the market and opened up doors to potential customers.
So, why the intro? It hints to the fact that what holds for broker binders also holds true for sidecar financiers. Sidecars are the latest manifestation of the efficient deployment of capital in the reinsurance market.
On the face of it, a sidecar deal works like a marriage made in heaven - a reinsurer is able to leverage the skills of its underwriting team and its position in the market but without having to give away ownership of the firm or unbalance its finances through piling on more debt. Sidecars also protect reinsurers from the damaging consequences of having to pull out of lines of business that they feel their balance sheet can no longer handle.
In turn, sidecar owners get to deploy capital quickly into the hardest sections of the market over a potentially short timeframe without having to invest in an underwriting team or office space. Since they only have one dedicated customer, sidecars don't have to bother with the trouble and expense of getting a rating - any security worries can be overcome by collateralising reserves if and when they appear on the scene. Reinsurers complete the work and take a ceding commission.
Additionally, sidecars work well tactically for owners as they give them the chance to test the water. If, after a couple of years, market conditions continue to appear strong, there is nothing to stop a sidecar backer adding to capital, hiring its own team, renting an office and accumulating all the trappings of a full-blown start-up, with or without the blessing of its host reinsurance company.
However the deal is structured, sidecar investors have to be aware that the key to success is going to be in the quality of the team with which they partner. Of course, quota shares contain more inherent safeguards than broker binder business - retrocedants take a decent retention and are often significant stakeholders in the sidecars - but there is no guarantee that these safeguards are going to work in practice.
Ultimately, the backers of sidecars hand over their underwriting authority to the ceding reinsurer - it's as simple as that - to do their bidding.
The troubles at Olympus Re, which in many ways is an early forerunner of the sidecar model due to its close interdependent relationship with White Mountains' Folksamerica Re, serves as a stark warning to potential sidecar passengers in the investment community.
Last month, White Mountains dropped a bombshell by announcing that Folksamerica Re had to increase its gross Katrina, Rita and Wilma loss estimates by $203m (net of reinstatement premiums). The bad news was that under the terms of Folksamerica's quota share reinsurance treaty from 2005 with Olympus Re, $143m of the loss is ceded to Olympus.
To set this in context, on 31 December 2004, AM Best reported Olympus' capital and surplus at $651m. Also, in the 2005 annual report of major Olympus investor Leucadia National, it valued its 20% share of Olympus Re's 2005 storm losses at $123.8m, putting the 100% figure at a whopping $619m. Hence the obvious need for recapitalisation - in which Leucadia did not participate - and the reason why AM Best downgraded Olympus from an A- rating to B- between October 2005 and when the ratings were eventually withdrawn in March of this year.
Fast-forward to today and almost a year after the first storms of 2005 hit, and this huge loss to Olympus is going to be increased by a further 23% at the stroke of a pen.
White Mountains confirmed that without other action, this cession would exhaust the bulk of Olympus' capital and proffered a deal to prop up Olympus to the tune of up to $137m of the ceded losses. As we go to press, it remains to be seen whether Leucadia and the other major Olympus shareholders will go for this deal.
However, the lesson is there for all - from Blue Ocean to Cyrus to Flatiron to Starbound and even Olympus' Helicon - sidecars are high-risk ventures and once into the deal, your only leverage is an implied threat never to trust the driver again if you crash.
Under such circumstances, it is imperative to make sure you trust the driver implicitly before you get in the cab.
