S&P Clarifies Its Position On Captives

National Underwriter.







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It is common for subsidiaries insured or reinsured by a captiveto provide evidence of insurance to authorities--for example, wherethe subsidiary is operating in a marine port or if involved intoxic waste cleanup. Authorities generally have minimumrequirements for accepting insurers, and an S&P rating cansignificantly contribute to the captive being acceptable.

An important use of insurance policies is as evidence of coverageto lenders, mortgagees, and others with a financial interest in theinsured venture.

Agreements governing these transactions normally specify thefinancial security required of the insurer. This may specify aparticular rating, or a group with a rated captive may insert thisas a requirement in the agreement.

A recent interesting development has been the ability of the lenderto use the captive to support the securitization of a mortgageportfolio, with the captive providing mortgage indemnityinsurance.

For many captives that reinsure the insurance companies issuingpolicies to the captives parent and other subsidiaries in thegroup, a rating can be an important contribution to being speedilyaccepted by the fronting insurer. Most insurers carefullyscrutinize the financial security of any reinsurer, and ratings areprobably the most widely used tool in this evaluationprocess.

With regard to costs, a rating can bring efficiencies from thereduced need for the use of third-party fronting insurers tosatisfy the financial security demands of subsidiaries within thecaptives group, group customers, joint venture partners,authorities, and lenders.

This means the elimination of premiums paid to third-partyinsurers, as well as higher retention rates of profitable businessand cash flows. There may also be other charges in a frontingarrangement, such as additional security requirements like lettersof credit. A rating will at least provide an argument innegotiating such issues, and at best remove the needaltogether.

Some captives and other insurers see a benefit in the ratingprocess as a management tool. The process provides objective,external and expert opinion on financial security and the criteriathat drive them, and use of models such as our risk-based capitaladequacy model. Captives have found the capital model helpful incapital and financial strategy discussions with the parent company,insurance regulators and tax authorities.

How does S&P rate captives?

Unlike our rating process for commercial property-casualtyinsurers, the evaluation of a captive is dominated by anunderstanding of the relationship with its parent or sponsor. Ifthe captive is deemed "core" to the parent according to ourmethodology, it automatically qualifies for the parents rating. Ifnot, the captive would be evaluated on its own merits according toour normal criteria.

We therefore begin with an assessment of the credit quality of theparent by referring to its S&P corporate credit rating--or, ifthe parent is unrated, through an evaluation made by one of ourcorporate rating analysts specializing in the industry sector inwhich the parent operates. For the captive to be designated as"core," it normally must meet these tests:

Third-party business (excluding where the parent is the operator ofa joint venture) must be small relative to risks assumed from theparent.

The captives strategy should be clearly defined and closely alignedwith the parents risk financing strategy.

Investments in the parent must be of acceptable quality andliquidity. The investment activity must be supportive of, and notgreater than, the insurance operation.

The score on S&Ps capital adequacy model must be at least inline with the parents rating. The captive should be able towithstand the impact of the largest net loss imaginable withoutcapital falling below a "BBB" level.

The captives reinsurance program must provide complete protectionfor all risks not retained. No gaps must exist between the limitsand conditions provided to the parent.

A captive that does not meet the guidelines for "core" status maybe evaluated on its own merits, but would not qualify for theparents rating.

In the vast majority of cases, the parents rating will be superiorto that which would be assigned to the captive if it was evaluatedon a stand-alone basis. The main reason is that the captivesbusiness position is significantly impaired (as compared to mostcommercial insurers) by the dependency on a single client.

At the same time, it is not possible for a captive to be ratedhigher than its parent.

Whether a captive is assigned the same rating as its parent, or israted on its own merits, its rating is affected by fundamentalbusiness conditions in the insurance and reinsurance markets, aswell as those in the parents industry.

This is where our views of competition, reserve adequacy,investment returns, regulatory climate, reinsurance pricing, andavailability of capital and liquidity come into play.

Ratings involve judgments, and we realize that not everyone isgoing to like them. We currently have a negative outlook on theproperty-casualty and reinsurance sectors, which means that despitethe hard market, we expect more ratings to fall than to rise overthe medium term.

While we recognize that interest in captives and self-insurance isskyrocketing in this environment, we also realize thatcaptives--like many p-c insurers--may also be susceptible tochronic reserve deficiencies, asbestos problems, runawaymalpractice and product liability awards, and the effects of anemicinvestment markets.

Nevertheless, the level of ratings on p-c insurers remainssubstantially higher than ratings in nearly every other sector ofthe economy. Well-run and well-resourced insuranceorganizations--including captives--can and do receive highratings.

That we have high standards is not something we need to apologizefor, but does mean that insurers with high ratings have passed asignificant test.

Ultimately, captives and other insurers will decide where they wantto be rated based on many variables. We believe S&P's longhistory of analytic excellence, objectivity and integrity will helpmaintain our leadership position in the provision of ratingopinions on companies in all sectors of the economy.

(For earlier stories about the financial strength and risksof captives, see NU, Aug. 12, page 29; Aug. 26, page 32;and Sept. 16, pages 10 and 27.)

Steve Dreyer is managing director and NorthAmerican practice leader for Standard & Poors Insurance Ratingsin New York. He can be reached [email protected]. Christian Dinesen, a directorin S&Ps European Insurance Practice, contributed to thisarticle.

Reproduced from National Underwriter Property &Casualty/Risk & Benefits Management Edition, October 14, 2002.Copyright 2002 by The National Underwriter Company in the serialpublication. All rights reserved.Copyright in this article as anindependent work may be held by the author.