Side Pockets

Side Pockets in (Re) Insurance investments

Ashish Chaturvedi
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What is Side Pocket?

Side pockets are part of the Insurance-Linked Securitization (ILS) strategy. These are created to segregate assets that become illiquid or hard to value because of some events that have caused direct insured loss but the actual impact of those losses is still developing. The main objective for sectioning the underlying assets into a specialized vehicle- ‘Side Pocket’- is to protect existing investors, so that they can come out of uncertainty of valuations and be unaffected from redemptions by other investors at uncertain valuation. 

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Why is it required ?

Insurers/Reinsurers or Insurance-Linked Securitization (ILS) funds who enter into fully collateralized reinsurance structures as sponsors to gain additional protection than traditional reinsurance will have the investors’ capital in a closed collateral construct essentially trapping the funds until the loss development is clear and contract payouts are finalized. This usually happens in case of catastrophic events (e.g. Hurricane Irma 2017, Tohoku Earthquake Japan 2011) when the tail is too long. This would mean the investors don’t have access to these funds until the loss estimates are known. To provide a solution to this problem- investors be able to access their trapped collateral- the market designed the process of side-pocketing.  

How does it work: 

The primary purpose of side-pocketing is to provide an exit route to investor capital, more like an open-ended mutual fund with an n-year lock-in period. This provides a confidence level to the investors that their ILS capital would not remain trapped for months or years together. The issuers can create  

  1. New class of shares (Simpler process) 
  2. New legal entity (Expensive and Complex procedures) 

Approaches:

Two kinds of approaches are common with Insurance-Linked Securitization (ILS) fund managers: 

  1. Side pocketing by Contract (Simpler process) 
  2. Side pocketing by Event (More complex to understand by investors) 

There are accounting impacts in both approaches that are considered carefully: 

  • Can the main fund borrow assets from side-pocket as collateral for new investments 
  • What accounting principle should be used and how is it disclosed to the investors and the governing body 
  • What fees will be charged on side-pocket assets vs. main fund assets 
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References