A.M. Best analyses the performance of the captive market in 2008 and asks: Captive versus commercial—who makes the grade?
It is clear that alternative risk insurers’ (captives’) financial performance during the ongoing economic crisis, which started on September 15, 2008, has illustrated the strength of this industry. Using rated captives, supplemented by anecdotal data from the overall captive sector as a guidepost, it can be discerned that captives fared much better than the broader commercial insurance market during this challenging time.
More specifically, captives have experienced a minute decay in performance as measured by the combined ratio after policyholder dividends (93.4 percent for 2007 versus 93.6 percent for 2008). Conversely, the commercial insurance market experienced a significant 12.1 point deterioration in performance as measured by the combined ratio after policyholder dividends (94.0 percent for 2007 versus 106.1 percent for 2008). Captives clearly have maintained a higher level of pricing discipline due primarily to the lack of pressure to maintain market share and chase rates down into loss territory. Surplus declines were much less severe for captives (minus 5.1 percent in 2008) than for the commercial market (minus 10 percent). These surplus decreases were primarily the result of invested asset market value declines not reflected in the income statement, supplemented by net losses running through the income statement.
Some group captives have seen a decrease in member retention, but a significant amount of the turnover in some insured classes is due to a shrinking eligible customer base following primarily on insolvency or merger and acquisition activity. The commercial market has introduced more competition, as well as competing alternative risk solutions. All in all, however, competition based on price has not been characterised by the brutality being experienced in the commercial market.
Why the disproportion?
One of the major reasons for the disparity between captive and commercial market performance is that most companies in the commercial market are incentivised to use cash flow underwriting, whereas in the alternative market, the incentive is to underwrite to break-even or underwriting profitability. Publicly traded insurance companies, and even mutual insurance companies to some extent, seek to maximise market share as a measure of potential future profitability based on growth. Companies operating in the commercial market use cash flow underwriting to attract new business with low prices, then invest the added premium in highyielding assets in the hope that the return on the investment will more than make up for the underwriting losses generated. During the next hard market, prices can be normalised (i.e. increased).
Initially, this strategy can earn a satisfactory overall operating profit in an inflationary environment and/or a rising stock market. However, 2008 experienced a perfect storm for this strategy. Many commercial market companies relied too heavily on this approach. They found themselves with far lower underwriting income as they chased premium rate declines coupled with far lower investment returns as asset write-downs and realised losses more than offset any investment income. Additionally, the investment income itself declined abruptly as dividends were cut and interest rates decreased on fixed income securities. Alternative market companies had more disciplined underwriting and less risky investment portfolios, which insulated them from many of the performance issues experienced by the commercial market. While equity investment returns have experienced a precipitous improvement in the second and third quarters of 2009, many commercial market companiessold underwater equities (mandatorily ordered written down by the NAI C Security Valuation Office or the other-than-temporary impairment rules of US Generally Accepted Accounting Principles) and replaced them with the anaemic returns of short-duration fixed income investment instruments. Underwriting results for the commercial market did improve, however, to 99.6 percent for the six months ended June 30, 2009.
Turmoil looms on the horizon
The hot topic on the legislative front is the international convergence of insurer solvency standards. While Basel II was implemented as a global framework for the banking industry, significant differences between insurance insolvency standards around the world pose difficulties in establishing consistent solvency regulations and eliminate the likelihood of successfully introducing a global insurance insolvency standard. In terms of convergence, US risk-based capital requirements (RBC) together with the European Union (EU ) Solvency II initiative would cover the two largest insurance markets in the world, which cumulatively account for almost twothirds of total life and non-life premium. What about the other third? In terms of the solvency standards of other non-EU member countries (so-called ‘third countries’), the Swiss Solvency Test is useful as many insurers and reinsurers have subsidiaries domiciled in Switzerland and it is already being used.
Additionally, as if solvency regulation convergence were not a big enough issue, particularly for captives with global scope, there is also the accounting basis convergence issue that exacerbates the complexity of the solvency analysis. RBC uses the Other Comprehensive Basis of Accounting (OCBOA) known as NationalAssociation of Insurance Commissioners’ Statutory Accounting Principles (SAP); Europe predominantly uses local statutory accounting and/or International Financial Reporting Standards (IF RS); and US public insurance holding companies report on the US GAA P basis. The divergence between US GAA P and IF RS is substantial when it comes to insurers, including alternative risk companies, particularly as it relates to the mark-to-market of assets and liabilities. It will, of course, remain to be seen how all of this legislative uncertainty will influence the insurance industry and the global alternative risk sector in particular. Until all these initiatives are definitively implemented in their final form, major impediments will remain in deriving and implementing consistent solvency regulation or even financial statement comparability.
Ratings level the playing field
The current economic and regulatory maelstrom is the primary reason why alternative risk companies have been approaching A.M. Best to secure a rating. A rating from Best can act as a levelling tool that can enhance comparability and benchmarking activities. To understand how, we need to digress a little. The rating assigned to an alternative risk company—whether large or small, onshore or offshore, one line of business or many—indicates the exact default rate as the equivalent letter rating assigned to a large global publicly traded insurer.
"Captives fared much better than the broader commercial insurance market during the ongoing economic crisis that started on September 15, 2008."
What does a rating from A.M. Best signify? A Best rating indicates our opinion as to the potential impairment probability for a given timeframe of up to 15 years. The higher the rating, the lower the impairment rate. For example, our opinion of the cumulative impairment probability of an ‘A-‘ (Excellent) rated company over a 10-year period is 5.05 percent, using current default tables. That means we believe a current ‘A-‘ (Excellent) rated company has a 5.05 percent chance of having its first official regulatory action taken by a domiciliary. Such actions include involuntary liquidations due to insolvency, as well as other regulatory processes such as supervision, rehabilitation, receivership, conservatorship, a ceaseand- desist order, suspension, licence revocation, administrative order, or any other action that restricts the insurance company’s freedom to conduct its business as normal. The impairment statistics that back up the A.M. Best rating are based on Best’s default statistics, which were gathered over a 30-year period. The rating is somewhat different from a general credit rating assigned to an issuer of public debt. The default definition for a general credit rating is generally determined as one or more missed interest payments or a bankruptcy filing.
A large part of the determination of a rating level for an alternative risk company, or any insurer for that matter, is the result of A.M. Best’s own proprietary capital model, Best’s Capital Adequacy Ratio (BCAR), which is subject to stress testing. A.M. Best believes that the rigour involved in attaining a secure rating (‘B+’ or above) goes a long way towards also fulfilling the requirements of RBC and the proposed Solvency II stress testing from a capital perspective. The Best rating is distinct because it addresses the uniqueness of the accounting and regulatory environments to which insurers are subject, thereby enhancing comparability and consistency and benchmarking activities.
For more information, visit A.M. Best’s website: www.ambest.com