Ratings: a confidence booster

A financial strength rating from a ratings agency such as A.M. Best or Standard & Poor’s (S&P) provides an independent third party evaluation to help determine the ability of an insurer to fulfil its financial obligations. For a captive, the benefits range from boosting member confidence to attracting new business.

“Our rating process subjects all insurers to the same rigorous criteria, providing a valuable benchmark for comparing insurers,” says Tina Bukow, assistant vice president, A.M. Best.

“While a rating isn’t required, companies tell us there are some key reasons for them to seek our ratings. A rating acts as a score card of the business process, can provide validation of business operations and risk management focus and is important both internally and to the market.

“To eliminate the volatility in their business costs, a rating might allow them to better control their insurance costs. Corporate governance has also become a major driver for ratings over recent years as there is more accountability at the board level.”

There is growing interest among states, countries and government bodies in entities getting rated, she adds—as international markets mature, ratings take on a more meaningful role.

Reinsurers evaluate credit risk of a captive as part of their due diligence and a secure rating might aid in negotiating terms, conditions, pricing and fronting costs. Third party business can be written in captives to diversify risk and a secure rating could reduce the concern about paying claims, says Bukow.

“A secure rating plays a role in group captives and risk retention groups by keeping current members happy and attracting new members,” she says. “A secure rating can also allow a captive to write new lines of business either not available in the commercial market, or too expensive or of limited capacity.”

A.M. Best has been rating captives for more than two decades, having embraced it as a natural and necessary part of its ratings activity.

“Focusing solely on insurance for the past 100 years or so gives us tremendous perspective and expertise,” says Bukow.

“Rating captives was more of a natural fit rather than a choice. A.M. Best saw the need in the market more than 20 years ago and never looked back. We became dedicated to the market and understanding the nuances of captives—it is one of the things that sets up apart.

“We have dedicated methodologies that specifically address the various types of companies within the alternative risk market: captives, risk retention groups, and one for rating protected cells.”

Hot topics in captive ratings

An area that illustrates the value of rating captives, and the factors involved, is the rating of oil companies’ captives. It is well documented that oil giants are currently under pressure, and as a result so are their captives, says Tufan Basarir, analyst, insurance ratings, for S&P.

S&P lowered the ratings on BP, Total, and Statoil on February 22 by one notch and removed them from CreditWatch negative. The outlook on BP and Statoil is stable and the outlook on Total is negative. The ratings of their captives also followed lockstep with the parents.

“Still on the subject of commodities, another trend we have been seeing is that fl oating platform projects are getting bigger and more expensive, so captives are being pressurised to cover bigger per-event maximum loss limits,” says Basarir.

He and his colleagues have also observed that increased attention to safety and risk management processes at large oil companies after the Deepwater Horizon incident has had a positive impact on the captives’ claims experience over the longer term. A benign catastrophe environment has also helped to boost margins.

Captives are typically subsidiaries of companies—for example, oil companies such as BP or corporate entities such as Diageo have captive insurance subsidiaries. Captives do not have a competitive position on their own and solely depend on their parent. They act primarily as a risk barometer for their respective groups.

“If we have a rating on the parent, rating a captive is relatively straightforward, as long as they comply with the aforementioned bullet points,” says Basarir.

“By contrast, traditional re/insurers are rated mostly on a standalone basis with consideration of any support from the parent if part of a group.”

Rating the parent

A.M. Best’s methodology for rating captives allows it to view the captive on a standalone basis and not cap the rating at that of the parent.

“Similarly, for non-US captives, we employ our Country Risk Methodology which allows us not to impose a cap on the rating based on the sovereign rating. If all criteria are met, we can then rate a company higher than the rating of the country,” says Bukow.

To assign a rating to a captive, it is not essential for S&P to have a public rating on the parent.

“The parent will still have to be rated, as this rating is the basis for the rating on the captive, but the rating on the parent need not be made public,” says Basarir.

“Regardless, it will always be necessary to establish a firm view of the parent’s financial strength—made possible with the involvement of the appropriate non-insurance S&P analyst—before the rating decision on the captive can be made.”

The main issue to be addressed in rating a captive is whether it is considered core to its parent, says Basarir. Once a captive is considered core, it is highly likely the captive would be assigned the same rating as its parent.

“It should be noted that the issues related to the core status of a captive differ slightly from those that determine whether an insurance subsidiary is core, which are outlined in S&P Financial Services Group Methodology.”

In the vast majority of cases, the S&P rating on the parent will be higher than would be assigned to the captive if it were considered as a standalone insurance company with no parental support.

“The main reason is that the captive’s business position is significantly impaired by the dependency on one client. At the same time, it is important to outline why, in nearly all cases, it is not possible for a captive to be rated higher than its parent,” says Basarir.

The key reasons are that the industry risk of the parent provides a ceiling for the captive’s industry risk; the captive’s business position is limited to the parent and fellow subsidiaries; and the captive’s management and corporate strategy are determined by the parent.

Equally important reasons are that operating performance is generally a reflection of the parent’s risk-financing strategy and the role played by the captive; investments can ultimately be determined by the parent, although some captives determine their own strategy; capital is provided by the parent, which is normally also in a position to determine the level of dividend; and the captive is completely dependent on the parent for financial flexibility.

A key point is that A.M. Best and S&P both take a detailed and flexible view of the captive’s position in relation to its parent, and rate the captive accordingly. Equipped with a strong rating, the captive can inspire confidence in key stakeholders, improving its potential as a risk management vehicle.