The benefits of ratings

AM Best has seen an increasing interest in ratings in the past year, driven by a combination of regulatory factors and the challenging economic environment.

A heightened focus on corporate governance, regulatory developments—not least Solvency II—and a variety of fronting requirements have contributed to a greater desire for an independent and informed opinion on a captive’s ability to meet its obligations and pay claims.

There are two basic drivers for a captive to seek a rating: to improve its interface with the conventional market and to address the evergrowing pressure of corporate governance.

Many fronting companies and reinsurers prefer to deal with rated counter-parties. They may be prepared to work with captives but this often affects the cost of the deal, the capacity available or the collateral demanded. A rated captive may be able to achieve preferential terms when arranging fronting or reinsurance protection.

The rating can also tell the other party about the credit risk inherent in ceding business to the captive, or the quality of business for which reinsurance is sought. More generally, there may be a variety of stakeholders in the success of the captive who need reassurance that it is being run according to best practice. In some markets there may be a regulatory requirement that the captive is rated.

AM Best rates approximately 200 captives in 48 jurisdictions, taking into account quantitative and qualitative considerations, and has specific rating methodologies for captives and protected cell companies (PCCs). In December 2011, a criteria report Alternative Risk Transfer was published, underlining the key rating considerations specific to alternative risk transfer entities such as single-parent captives and group captives.

The main features examined by AM Best as part of the ratings process for captives and PCCs are explained below.

Key components of an AM Best rating

First, AM Best examines the balance sheet strength, measuring the capitalisation of a company compared to the risks it is able to accept. Among the main tools used is our risk-based capital model and the Best capital adequacy ratio (BCAR). This ratio is a very important element to our quantitative analysis but is by no means the only one. We also need to analyse other factors including the quality of the reinsurance programme, the robustness of the reserving systems and the investment policy.

The second component is the operating performance of a company. This captures the quality of the earnings, the main sources and how robust and resilient profitability trends are. There is a significant focus on the quality of the technical account (the strength of the technical profits), and while AM Best does not ignore the results from investments, a strong technical account tends to be preferable to a volatile investment result.

The third element refers to the business profile and is where the greatest difference between rating a captive and rating a traditional company can occur. Business profile relates to market position, the quality and diversity of the sources of income and the quality of the business that the entity is accepting. The challenges of a competitive environment and a company’s product and geographical concentration are also significant. In the particular case of captives, the significance of the business to the parent and the level of integration of the risk management function are highlighted.

No single element translates automatically into a particular rating.The three components are examined together to see how they interact, paying particular attention to likely future heading. Ratings are prospective, so companies are analysed based on three to five-year projections, depending on the nature of the business.

Enterprise risk management (ERM) is an overarching element of the rating analysis and is embedded throughout the three components of the rating. ERM covers the framework, ie, the mechanisms that the company may have to monitor the risks that it accepts and how they impact on the three main areas cited above.

Captives and their parents

AM Best analyses the relationship of a captive to its parent. The rating of the parent is not a ceiling to the rating of a captive but is examined to understand the importance of the captive to the parent. Issues analysed include, for example, how much added value is provided and how is the captive integrated within the company’s risk management function.

AM Best will compare the stand-alone assessment of the captive and the published rating, or shadow assessment (in the case of no published rating being available) for the parent.

If the parent is much weaker than the captive, reassurances may be needed that the captive maintains its independence and is able to generate capital and retain it going forward. At the same time, if there are any loans back to the parent, AM Best needs to ensure that they have been set up under market conditions that allow it to be considered an arm’s length transaction.

Conversely, if the parent is much stronger than the captive, any potential parental support in the case of explicit guarantees, letters of credit or a track record of capital injections that support the captive’s operations could be supplemented.

The impact of reinsurance

The rating of a captive’s reinsurers can also affect the analysis and the rating outcome. One aspect will depend on the quality of the reinsurance programme, as part of the capitalisation analysis. Furthermore, AM Best may need to consider how exposed the company could be to large retentions and how these may impact on the BCAR score on a stress basis.

However, if the captive’s entire reinsurance arrangements are with reinsurers with an A rating, this does not automatically mean the captive will achieve a similar rating level. The three areas mentioned above—capitalisation, operating performance and business profile, along with ERM—will be important for attaining a high rating.

"AM Best's country risk assessment includes an evaluation of the local regulatory environment, and other factors including the level of development of the insurance market."

If most of the business is being ceded or retroceded to a highly rated reinsurer, the BCAR scores are likely to be very high because there is virtually no insurance risk retained while the credit risk remains low. For ratings purposes, this would increase the need to focus on the quality of gross business written. Other key issues specific to captives, such as the nature of the insurance risks covered and the integration with the parent’s overall risk management programme, will also need to be considered.

How domiciles affect ratings

The domicile of the captive and/or its parent can be significant in AM Best’s country risk tier (CRT) analysis. Countries are placed into one of five tiers, ranging from CRT-1, denoting a stable environment with the least amount of risk, to CRT-5, the most risky jurisdictions.

AM Best’s country risk assessment includes an evaluation of the local regulatory environment, and other factors including the level of development of the insurance market and political and economic stability. AM Best does not favour one domicile over another, although it will closely examine the reporting standards in place.

For captives, the most likely locations in Europe fall into the CRT-1 or CRT-2 category. In these cases, it is unlikely that the CRT will act as a drag on the final published rating.

Rating PCCs

The main issue for PCCs is to ensure that any ring-fencing between cells is clear cut, particularly the potential exposure that a particular cell may have to the liabilities of other cells.

Depending on the complexity of the PCC structure, an understanding of the whole system may be required. A rating may apply to a core PCC company or to individual cells.

Factors that could affect ratings

Although the rating is subject to an annual cycle of reappraisal there may be circumstances in which the rating has to be reassessed within a shorter period. This will be when significant or unexpected events occur and AM Best needs to assess their impact, for example, a change to the captive manager.

A number of possible factors may affect the rating. For example, if the risk profile of the company were suddenly to change (due either to the nature of the risks the company writes or the volumes accepted) and this were to lead to high volatility in technical results as well as increased capital pressures, there would probably be a negative effect on the rating. Additionally, if the investment policy were to become much more aggressive, it may have a negative impact on the rating.

Another possibly negative factor would be if the terms of the loan to the parent were to change—either the loan amount becoming much larger, or the terms more preferential to the parent; this would need to be looked at very closely.

A key potentially positive driver of a rating would be the financial position of the parent. If it were to improve and the significance and value of the captive were to increase, a positive movement of the rating would be considered.

More information on captives and ratings can be found on www.ambest.com

Carlos Wong-Fupuy is senior director, analytics. He can be contacted at: carlos.wong-fupuy@ambest.com

Yvette Essen is director, industry research, Europe and emerging markets. She can be contacted at: yvette.essen@ambest.com