Ratings Agencies Look More Closely At Captives

By Michael Ha

At a time when the hardening market has prompted many insureds to turn to captives as a risk management solution, rating agencies that evaluate captives are finding their services more and more in demand.

In this expanding alternative risk transfer market, A.M. Best Company in Oldwick, N.J., remains the market leader in rating captives, but other rating agencies are also stepping up their efforts, according to representatives of those organizations.

Carol Pierce, assistant vice president at A.M. Best, said her organization globalized its initiative for the captive market in 1999 and has assigned ratings on 200 captives as of year-end 2002.

“We get requests for ratings from parent companies through their risk managers and captive companies through their managers, as well as from auditors and accountants,” she said.

Risk managers reported that banks requested a rating in order to lend money, and “some companies also see a rating as something nice to have in their back pocket for corporate governance reasons,” said Ms. Pierce, co-author of a report on captive rating methodologies last year.

“The majority of our ratings are published, but some companies just want to benchmark themselves against other companies for operational management purposes,” she said.

Some ratings are sought by parent companies' board directors, she added.

“These companies have publicly stated they won't place insurance with carriers with less than 'A-minus' ratings, but if their own captive turns out to be 'B-plus,' they would have a problem,” she said. “Getting an Excellent Best's Rating for their captives is a way for board directors to say 'we hold ourselves to the same standard.'”

There are other incentives to seek a rating from an independent rating agency, Ms. Pierce said.

For instance, it's crucial for a captive to have credibility when dealing with its parent company's operational management, as well as with banks, fronting insurers and regulators.

Other benefits include the captive's ability to improve terms with reinsurers and excess carriers. High ratings can also make it easier for single-parent captives to underwrite affiliated third-party risks to diversify their portfolios and achieve better pricing.

“Captives are a large portion of the insurance market,” Ms. Pierce said. “There are nearly 5,000 captives globally, and 54 percent of all captives as of year-end 2001 were owned by companies in the United States.”

When A.M. Best assigns ratings, it also performs an analysis on the parent company.

“If the parent company has a significant control over the assets of its captive, added weight will be given to the parent company's financial position and flexibility in the assignment of an appropriate rating to the captive,” Ms. Pierce explained.

A.M. Best's ratings focus first and foremost on the strategic mission of the captive and its relationship to the parent company. It also looks at the parent company's long-term commitment to the captive, and its willingness to provide capital when needed.

Ms. Pierce added that it is paramount that a single-parent captive demonstrate a sound level of capitalization to support the level of risk assumed.

In evaluating a captive's balance sheet strength, A.M. Best also looks at invested asset leveragewhich measures the exposure of a captive's surplus to investment, interest rate and credit riskas well as quality of the reinsurance program, adequacy of reserves, diversification of assets and liquidity.

In addition, it also examines a number of other factors, such as whether captives have consistent, positive operating performances and profitability.

Other major rating agenciesStandard & Poor's, Moody's Investors Service and Fitch Ratings, based in New Yorkare also increasing their efforts in the alternative risk transfer market.

Grace Osborne, director at S&P, noted there has clearly been a growing interest in captives as an alternative to the commercial market, and requests for ratings have been coming from companies seeking assessments for their captives. When S&P assigns a rating, it examines a number of factors, including the captive's risks and management as well as its capital adequacy. S&P currently has ratings on some 20 captives.

“When the captive enters into a reinsurance program, we also look to make sure that there aren't any gaps in limits and conditions for its parent,” Ms. Osborne said. If a captive doesn't enter into reinsurance, “we would want to make sure that captive's exposures are covered by its assets. Our view is that the pure captive's rating should be equivalent to its parent's rating.”

Fitch Ratings hasn't assigned any captive ratings, but is in discussions with brokerage firms that manage captives, including Chicago-based Aon Corporation and Willis Group Holdings in London, about assigning ratings, said David Wharrier, director at Fitch and the author of its captive report completed last October.

“This report is a blueprint for how we would approach rating captivessome of the issues we would consider important,” Mr. Wharrier said.

He said Fitchs initiative in the captive market is driven mainly by corporate clients interested in setting up captives. “We expect to assign some ratings in 2003. We now have methodologies in place and are in a position to rate captives and compete with other agencies,” he said.

Mr. Wharrier explained the rating process would involve assessing the captive's role in the overall risk strategy of the parent company. “A captive's rating will typically benefit from any parent ratings if the agency believes the captive is an integral part of the group's risk management program,” he said.

“Obviously, he said, “a single parent captive is heavily reliant on its parent company as the major source of income, so parental support is key through both hard and soft market cycles.”

Mr. Wharrier observed that captive management is now common among international brokerage firms such as Aon, Willis and Marsh Inc. in New York, which assist in financial reporting, statistical analysis and monitoring, as well as general administration. But if a captive is managed internally, Fitch would assess the expertise of the captive manager and how its risks are calculated and monitored.

Additionally, the agency would examine the captive's capital adequacy, evaluating the level of capital in relation to a captive's risk exposures, including investments, underwriting and reinsurance.

Moody's Investors Service, another major rating agency, has assigned ratings on a handful of captives in the past year, according to Paul Bauer, an analyst at Moody's.

“They are ratings that companies specifically asked for. It's done more for the sake of companies themselvescompanies might want to know what risks they are retaining,” Mr. Bauer said.

Also, some companies set up bank lines in order to deal with short-term liquidity requirements, he added. So banks are very likely to be interested in the credit quality of the institutions they are lending money to.

In its rating process, Moody's looks at what kinds of risks are retained and how they are priced, as well as what financial assets are set aside to cover future losses.

“We want to get some feel for the loss history for the risks they are taking on, and we look at the concentration of risks and the exposure to catastrophic risks and systematic risks,” Mr. Bauer said. “One [piece of] advice I would give to captives is not to take on more risks than they have the means or the ability to handle.”

He noted that a danger in captives is a high concentration of risks. “There is a lack of diversification, and captives can have less information from an actuarial standpoint,” he said. “Individual companies would have more familiarity with their businesses, but may not have access to information, like loss frequency and loss severity, that large insurers typically would have access to.”

Reproduced from National Underwriter Edition, March 10, 2003. Copyright 2003 by The National Underwriter Company in the serial publication. All rights reserved. Copyright in this article as an independent work may be held by the author.

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Ratings Agencies Look More Closely At Captives

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