S&P Clarifies Its Position On Captives

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

An important use of insurance policies is as evidence of coverage to lenders, mortgagees, and others with a financial interest in the insured venture.

Agreements governing these transactions normally specify the financial security required of the insurer. This may specify a particular rating, or a group with a rated captive may insert this as a requirement in the agreement.

A recent interesting development has been the ability of the lender to use the captive to support the securitization of a mortgage portfolio, with the captive providing mortgage indemnity insurance.

For many captives that reinsure the insurance companies issuing policies to the captives parent and other subsidiaries in the group, a rating can be an important contribution to being speedily accepted by the fronting insurer. Most insurers carefully scrutinize the financial security of any reinsurer, and ratings are probably the most widely used tool in this evaluation process.

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

This means the elimination of premiums paid to third-party insurers, as well as higher retention rates of profitable business and cash flows. There may also be other charges in a fronting arrangement, such as additional security requirements like letters of credit. A rating will at least provide an argument in negotiating such issues, and at best remove the need altogether.

Some captives and other insurers see a benefit in the rating process as a management tool. The process provides objective, external and expert opinion on financial security and the criteria that drive them, and use of models such as our risk-based capital adequacy model. Captives have found the capital model helpful in capital 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-casualty insurers, the evaluation of a captive is dominated by an understanding of the relationship with its parent or sponsor. If the captive is deemed "core" to the parent according to our methodology, it automatically qualifies for the parents rating. If not, the captive would be evaluated on its own merits according to our normal criteria.

We therefore begin with an assessment of the credit quality of the parent by referring to its S&P corporate credit rating--or, if the parent is unrated, through an evaluation made by one of our corporate rating analysts specializing in the industry sector in which 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 of a joint venture) must be small relative to risks assumed from the parent.

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

Investments in the parent must be of acceptable quality and liquidity. The investment activity must be supportive of, and not greater than, the insurance operation.

The score on S&Ps capital adequacy model must be at least in line with the parents rating. The captive should be able to withstand the impact of the largest net loss imaginable without capital falling below a "BBB" level.

The captives reinsurance program must provide complete protection for all risks not retained. No gaps must exist between the limits and conditions provided to the parent.

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

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

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

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

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

Ratings involve judgments, and we realize that not everyone is going to like them. We currently have a negative outlook on the property-casualty and reinsurance sectors, which means that despite the hard market, we expect more ratings to fall than to rise over the medium term.

While we recognize that interest in captives and self-insurance is skyrocketing in this environment, we also realize that captives--like many p-c insurers--may also be susceptible to chronic reserve deficiencies, asbestos problems, runaway malpractice and product liability awards, and the effects of anemic investment markets.

Nevertheless, the level of ratings on p-c insurers remains substantially higher than ratings in nearly every other sector of the economy. Well-run and well-resourced insurance organizations--including captives--can and do receive high ratings.

That we have high standards is not something we need to apologize for, but does mean that insurers with high ratings have passed a significant test.

Ultimately, captives and other insurers will decide where they want to be rated based on many variables. We believe S&P's long history of analytic excellence, objectivity and integrity will help maintain our leadership position in the provision of rating opinions on companies in all sectors of the economy.

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

Steve Dreyer is managing director and North American practice leader for Standard & Poors Insurance Ratings in New York. He can be reached at Steven_Dreyer@standardandpoors.com. Christian Dinesen, a director in S&Ps European Insurance Practice, contributed to this article.

Reproduced from National Underwriter Property & Casualty/Risk & Benefits Management Edition, October 14, 2002. Copyright 2002 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.