Life (Re)insurance Sidecars

Episode Summary

On the first episode of “The Practice Manual,” host Robert Chaplin is joined by colleagues Feargal Ryan, Theo Charalambous and Caroline Jaffer to examine life (re)insurance sidecars, including what they are, how they work and why they matter. With the U.K.’s Bulk Purchase Annuity (BPA) market expected to surpass £500 billion over the coming decade, life (re)insurers face a critical challenge: accessing the right capital to compete. During the episode, the panel examines how life (re)insurance sidecars — specialised vehicles that channel third-party investor capital into the (re)insurance sector — are emerging as a strategic solution, and explores the structural, regulatory and commercial considerations involved in establishing sidecars in the U.K.

Key Points

• Sidecar structures explained: A life (re)insurance sidecar is a specialized investment vehicle — typically structured as a special-purpose entity — that allows insurance or reinsurance companies to transfer a portion of their assumed risks to third-party investors, whose capital provides capacity for the sponsor’s ceded risks.
• Benefits of sidecars for insurers and investors: For the sponsor, sidecars offer an alternative, potentially more cost-effective source of capacity, fees from underwriting and administration services, and access to investors’ expertise in originating alternative assets. For the investor, sidecars provide direct exposure to the life and annuity business, the opportunity to access permanent capital and predictable premium flows and asset management fees.
• Regulatory landscape: The Prudential Regulation Authority (PRA) does not currently consider the U.K. ISPV regime appropriate for life reinsurance sidecars, and while several life reinsurance sidecars service the U.S. markets from Bermuda, the PRA has expressed a preference for on-balance sheet assets to remain in the U.K., making it very difficult to use Bermuda structures in this context.
• Asset management perspective: Sidecars give asset managers a route to deploy illiquid and alternative asset expertise in the (re)insurance sector, with asset management serving as a central pillar of sidecar transactions.

00:00- 1:00 Rob Chaplin (RC): Welcome to The Practice Manual. This is a new podcast series from the London Financial Institutions Group here at Skadden. The idea behind this new podcast series is to break down some of the mysteries of what we do in the legal sector and to focus on specific areas within our practice and to share, if you like, the secret sauce. We’ve been working on this for some time now, and we’re really, really excited about this, our first episode, which is about life insurance sidecars.

Today, I’m joined by my colleagues Caroline, Feargal and Theo, and we’re going to talk about life insurance sidecars. So, first of all, Theo, what on earth is this funny thing, a life insurance sidecar? Very strange name. And who are the parties that are part of that transaction, Theo?

1:01-2:15 Theo Charalambous (TC): A reinsurance sidecar is a specialized investment vehicle that allows insurance or reinsurance companies to transfer a portion of their assumed risks to third-party investors. Although they’ve been part of the market since the 2000s for property and casualty risks, sidecar transactions have more recently been implemented to support the reinsurance of life and annuity risks, driven by more new business and increased capital requirements on the supply side, and the convergence of insurance, private capital and asset management, as well as better cost of capital on the demand side.

There are three key parties. First, the sponsor. So that’s the life insurance or reinsurance company ceding risks. Second, the investor. That’s the third-party capital providers that may also manage the assets backing the liabilities. Third, the reinsurance sidecar itself. That’s the special-purpose vehicle through which the investor’s capital provides capacity for the sponsor’s ceded risks.

02:16-02:34 RC: And so, Theo, what’s in it for each of these parties? Why would a cedent insurance or reinsurance company want to do one of these things? And why would an investor and its associated asset manager, if there is one, want to come into one of these transactions?

02:34-03:27 TC: For the investors, a life reinsurance sidecar offers direct exposure to the life and annuity business, portfolio diversification from a non-correlated long-term asset class, and the opportunity to access permanent capital, predictable premium flows, as well as asset management fees. For the sponsor, a life reinsurance sidecar offers an alternative, potentially more cost-effective source of capacity, fees from underwriting and administration services, ceding and profit commissions, as well as access to investors’ expertise in originating alternative assets, particularly private credit instruments with higher risk-adjusted yields.

03:28- 03:38 RC: Caroline, you’ve been closely involved in the pension risk transfer space. Why are sidecars so important in that context?

03:39-04:22 Caroline Jaffer (CJ): So building on what Theo was just saying, similar advantages, but in a PRT context, there’s the ability to command for a sponsor to get on-demand capital, which is really important for large-scale PRT deals, including bulk purchase annuities. There’s also an investor advantage. So, investors gain a first-mover advantage over the assets and mandates, so that’s great for asset managers. And there’s a lot of market activity. BPA activity has recently exceeded £40 billion per annum, with industry observers noting that there could be more than £500 billion of transfers in the coming decade, which is a huge number.

04:23-05:03 RC: That’s an absolutely staggering number, Caroline, and certainly, if you look across the market, it’s fair to say that we have the potential for at least five glorious years, shall we say, for PRT deals, possibly longer. And there are some absolutely elephant schemes out there that have yet to transact in the U.K. market.

So, Feargal, clearly there’s some huge sums of money involved here. Huge opportunities for the cedent insurers and huge opportunities for the investors and their asset managers. How do you put one of these transactions together?

05:04-08:28 Feargal Ryan (FR): Yeah, that’s a very interesting question, Rob, and leaving aside for the moment the fact that in the U.K. it’s quite difficult to find a vehicle to actually use for one of these reinsurance/life insurance sidecars, fundamentally, this is about alignment. It’s about aligning the interests of the ceding life insurer with that of the investor.

And there’s three key challenges that arise in this respect. So the first one is in terms of duration and liquidity mismatch. These liabilities that are ceded into the life reinsurance sidecar, they’re long-tail liabilities, and that often doesn’t align with investors’ investment time horizons. So, for example, in a non-life insurance sidecar, typically you see an investor wants to get their capital out five to seven, maybe eight years after the inception of the vehicle, where that just isn’t feasible in a life insurance context. If you want to structure the reinsurance contracts between the ceding life insurer and the reinsurance sidecar, if you want to include a termination provision at the election of the investor, that can do serious damage to the prudential solvency treatment of that reinsurance agreement.

The second challenge is control and governance. Typically, the U.K. life insurer will retain control over the vehicle, not just because it’s ceding business to the sidecar, but also in terms of how it operates, because the investor will typically leverage on the U.K. life insurer’s expertise in actually operating one of these businesses. From a governance perspective, there are different approaches. If the life reinsurance sidecar is akin to a SPV vehicle you might see in a structured finance transaction, it might require that much governance, particularly if the underwriting guidelines are hardwired. Whereas if it’s seen that the sidecar is going to have a life of its own and make decisions at a sidecar level as to what business to accept or not, then you can see sometimes develop some very complicated governance arrangements. You might have an investor who has a right for a person to attend more meetings of the sidecar or potentially even have the right to appoint directors. And that can be complicated by whether the investor wants the investment consolidated into his balance sheet or not. Typically what we see is the investor gets these controls through contract and negative consent rights.

The third challenge we see is the dangers of a shift to an originate to distribute model from the U.K. life insurer. Effectively, this means that because U.K. life insurer is no longer putting up all the capital backing these BPA transactions that it might loosen its underwriting criteria. And, in the end, the economics of those types of transactions that shouldn’t have been underwritten, will pass through the investor. That’s a key consideration given how competitive the BPA market has become.

08:29-09:05 RC: Those are great points, Feargal. I think the question around control is particularly interesting as well because there are reasons to have a consolidated structure. There are also reasons to have a deconsolidated structure. So, the pattern of control rights will heavily influence that analysis. Now, as we all know, life insurance companies are very heavily regulated vehicles, and rightly so, because they are the custodian of people’s core savings in many cases. Caroline, how does the PRA view these structures?

09:06 CJ: Looking at the regulatory picture in the U.K., and think about the current market. Whilst there are several life reinsurance sidecars that service the U.S. markets from Bermuda, there are comparatively fewer serving the U.K. and European markets. One of the potential problems is the current use of the U.K.’s ISPV regime. The PRA does not currently consider the U.K. ISPV regime appropriate for life reinsurance sidecars and so it’s not currently feasible to quickly establish a new vehicle in the U.K. as a sidecar. So, that obviously puts a dampener on things. Thinking about the U.K. market as well, the PRA has expressed in their recent discussion paper on alternative life capital, a preference for on-balance sheet assets to remain in the U.K. This has some advantages from a regulatory perspective. I think the PRA are looking to reduce their supervisory burden. Obviously, if assets remain in the U.K. and things are focused in the U.K., that’s better for the PRA, but it also maybe eliminates the concern around regulatory arbitrage and parties looking to leverage a more favorable regulatory environment elsewhere.

10:16-10:52: We also should remember that the U.K. and the PRA has an objective to consider growth and competitiveness for the U.K., and so keeping assets within the U.K. and having U.K. productive assets are encouraging investment within the U.K., which is a good thing. And also touching upon something that covers funded, which is of course essential to the sidecar discussion, is recapture risk. So, keeping assets in the U.K. help mitigate that. So that’s an important regulatory consideration.

10:53-11:34 – RC: Caroline, that’s a great encapsulation, I think, of the regulatory conundrums which are at the heart of this. The U.K. market needs more capital. It needs a way of accessing that capital in ways other than an investment in the top-co in these life groups. So, there has to be some kind of solution to this puzzle to allow the market to continue to grow and to service the underlying demand in the market. I guess that leads us onto the next question, Feargal, which is once you’ve actually got one of these structures in hand, how do you decide what goes into the structure in practice?

11:35-14:53 – FR: It’s a fundamental issue with these sidecar transactions, and I think taking a step back, what investors really take comfort in is if the insurer has skin in the game. So, if they have an economic interest in the sidecar — and that could be 20%, 25%, 30% — then that allows for alignment in terms of economic outcomes and investors get comfort from that. Also, if the sidecar vehicle consolidates onto the balance sheet of the U.K. insurer, that’s another thing that investors would take comfort in.

FR: And then the key aspect, and it’s something that’s really heavily negotiated, are the underwriting criteria for the sidecar vehicle itself. There can be various iterations of that. You can have something that’s kind of hardwired. If a book of business hits certain criteria, it has to be ceded to the life insurance sidecar, and then the other side of it is that capital has to be drawn down from the investor. The investor has to make sure that capital is available to be drawn down to back those liabilities. So, it can be hardwired or it can be something that’s a bit more flexible. When it’s flexible, then that usually means that there needs to be a more complicated process in terms of underwriting guidelines and guidance, etc.

FR: And so, the key aspect of this is that there’s a tension between the U.K. insurer that is out there trying to price BPA deals and wants the comfort that the capital’s going to be available there, the reinsurance to the sidecar is going to be available, in order for them to win that business and to make sure that it’s very, very competitive in pricing. And on the other side, the investor’s concerned to make sure that the business actually coming in is profitable and is actually good business.

FR: On the other hand, because there’s no guarantees, a lot of the time, for future business that the U.K. life insurer is actually going to win these mandates, the investor’s going to be concerned that it might end up in a situation where it’s committed hundreds of millions or perhaps billions of capital to this venture, and it’s never drawn down, and effectively they’re left with a lot of dry powder. So, they’ll be very concerned that the U.K. insurer actually has the competitive strength to win these mandates. And I think what we’re seeing more and more is that investors coming to the table, not just with cash, but other connections and relationships within the pension risk transfer space with schemes, etc., and leveraging those relationships to make it more likely that the sidecar is going to be successful. And I definitely think as this space develops, that’s something that U.K. insurers should look at more closely.

FR: Boiling it down, if you keep it really simple and you’ve got hardwired criteria, and you can make that work, then that makes things a lot easier. If you’re having to rely on a situation where you have governance that’s kind of independent, that can make the sidecar vehicle actually quite cumbersome and it can increase execution uncertainty.

14:54-16:27 RC: Those are good points, Feargal. We at Skadden do sidecar work all around the world and do multiple sidecars each year. I guess if we looked across our population of sidecars that we’ve done over the years, what we would say, probably, is that the ones that have attracted the lowest cost of capital, the ones that have been easier to fill, are the ones where we’ve either got an effectively guaranteed stream of business which we’re able to place into the sidecar, or alternatively, we’re placing existing blocks of business which have already been transacted on a primary basis into the sidecar. And that may be done through a series of smaller sidecars, or it may be some kind of platform or facility transaction.

And those are probably the smartest ones, the sort of platform facility ones, if you need to keep drawing capital in the future. The ones that have struggled or have ended up being much more expensive for the underlying insurers or reinsurers have been the ones where we’ve had a situation where, just as Feargal said, there’s a large amount of capital which is being demanded from the market and a lack of certainty about deployment. Because implicitly, the investor in those structures is going to charge you effectively one way or another for the risk it’s taking that the sidecar won’t be filled.

16:28-16:32 – RC: So, lots of competing interests there, Theo. How do we balance those?

16:33-17:25 – TC: Thank you, Rob. It ultimately comes down to the economics. If the investor’s cost of capital is too high relative to sidecar returns, then the structure becomes unviable very quickly. And this is particularly relevant in the increasingly competitive BPA market.

Unlike property and casualty sidecars with shorter fund structures, life reinsurance sidecars require evergreen or long-term arrangements, because automatic commutation is not typically feasible given the long-term nature of the life liabilities. There must be a realistic and sustainable flow of business that deploys committed capital.

17:26-17:43- RC: That’s right, and that also engages some quite tricky regulatory issues as well. Now, one thing we mustn’t forget, and one that’s clearly close to many investors’ hearts, is asset management. So Feargal, asset management, how does this tie into this subject?

17:44-20:05 FR: Asset management is a central pillar of any life reinsurance sidecar transaction, and that contrasts quite dramatically with the non-life reinsurance sidecar transaction where it’s important, but it’s not as dominant a factor as it is in a life reinsurance sidecar.

FR: When we talk about illiquid assets, what we’re talking about are typically private credit, infrastructure loans, commercial real estate and private equity. They are particularly attractive because they offer enhanced yield potential compared to liquid securities. They work very well in the life insurance context because you can match them with long-dated liabilities and benefit from matching adjustment liquidity premium. They are very much becoming an ever more increasingly important part of a life insurer’s balance sheet because they allow life insurers to price their insurance more keenly, and that obviously has tangential benefits to larger society by closing insurance gaps, etc. Also, it’s a key priority for U.K. government to increase investment in the U.K. and the life insurers ‘ ability to originate U.K. assets is an important policy objective for the U.K. government.

FR:  What we’re seeing increasingly in these types of transactions is a shift from a model where an investor came in with their asset manager and had a mandate over an entire portfolio of assets to a model where the investor’s coming in and getting priority over certain asset classes within a portfolio, for example private credit, where the U.K. insurer maybe doesn’t have as developed a capability. And what we’re also seeing is the U.K. insurer have much more control over the asset management in these types of vehicles. It’s seen or perceived that if the U.K. life insurer retains control over the asset management, it’s more likely that U.K. illiquid assets are going to be originated than it would be if this is left exclusively to external asset managers.

20:06-20:13 RC: Clearly, in everything you say, Feargal, there is a lot there from a regulatory perspective as well, Caroline.

20:13-21:34 CJ: Yes, that’s right. And just picking up on some of the points that Feargal was mentioning earlier, there is, as we said, the PRA has expressed a preference for U.K. productive assets to be invested in, as mentioned in their discussion paper. But it’s also worth pointing out that there’s a tension there in that there’s an asset shortage. So, we hear regularly from industry that life insurers are looking for appropriate assets to invest in, that they are of high quality, long duration and meeting life insurers’ requirements, but also, crucially, as you’ve mentioned, matching adjustment compliance. So, the asset managers are going to have to balance the kind of tricky tightrope of having to get maximum returns for their clients, but also the regulatory hurdles that are out there in terms of investing in appropriate assets for their clients.

CJ: I do think it’s positive that PRA have opened this up to discussion in terms of the discussion paper that we’ve mentioned because we may see some more kind of innovative solutions coming to market, because although from a very high-level view it’s inconvenient maybe for asset managers to be restricted, having an asset shortage is also not good from a regulatory perspective either because it creates a kind of a bubble for those assets that could have systemic knock-on effects, so not good from either side.

21:34- RC: Let me try and bring this together, folks, with some closing thoughts. There is a clear market need for these structures. It would be hugely advantageous to the U.K. market if we can find a way to make these things work and become a routine transaction in the market, for sure.

21:59-22:42 RC: Now, what does that mean in practice? I think in practice, onshore structures are the way forward. I think it’s very difficult, given the current regulatory conversation, to see a world where we can use Bermuda structures in this context. If we could, I think that would be good for a number of reasons, but we have to be realistic about all of this. The PRA discussion paper, DP2/25, is curiously short in this context and doesn’t really give us a road map as to how all of this can work. And certainly, our feeling is there’s going to need to be further dialogue about all of this within the insurance community.

22:47-23:13 RC: So, at the moment, barring an evolution from the PRA, it would seem that the U.K. ISPV regime is closed to U.K. life sidecars, and what everyone is talking about at the moment is using empty life companies. Now, the problem with the U.K. market is there are very few empty life companies out there. That’s for a number of totally separate regulatory reasons. Effectively, it’s hard to keep shells going in the U.K. in the same way in which you can in the U.S.

23:13-24:05 RC: If you are a group that is lucky enough to have an empty life company, that gives you an enormous headstart. The question is, why can’t you just simply set up a new U.K. life company? Well, the reality of this is, and there have been several attempts over recent years to set up new U.K. life companies. Some have stopped in their tracks, others have actually led to an authorised company. But the problem is that to set up an authorised company, then to get the internal model going, to get the matching adjustment permissions in place, is a multiyear process, and then the regulator will require you to scale the business over a period of years. So, in terms of being able to get a company to market match-fit very quickly, that remains very difficult.

24:06-24:23 RC: Nonetheless, we do place a lot of hope in the PRA’s secondary competitiveness objective. And it will be extremely interesting to see how that manifests itself in the regulatory evolution, which we’re hoping to see over the rest of this year.

24:24- 25:05 RC: Before finishing this podcast, I’d like to say to all of our viewers, please don’t forget our book on Solvency II, which is available on our website. So, please look at that. It’s a really fantastic guide to the Solvency II regime in the U.K. and more broadly in Europe. There’s also the sister series, “The Encyclopedia of Prudential Solvency.” We haven’t quite finished that yet. It’s nearly there, and once it’s done, we’ll get that bound up into a book like the Solvency II one and get that out to people, and the compiled version will be on our website as well. So, that’s another exciting project, which is, in that case, coming to an end.

25:06-25:21 RC: So, I think all that remains today is to say thank you to Caroline, to Feargal, to Theo. It’s been a great session. Thank you for participating, and do please join us for the next episode. Bye for now.