10 March 2014Accounting & tax analysis

Company loans may inhibit captives’ ability to pay

Captives making intercompany loans to their parents need to take into account potential liquidity concerns and the impact this may have upon their ability to pay claims.

That is the view of Fitch Ratings in its recent report entitled Captive Insurers and Intercompany Loans: Considering the Risks, in which its authors state that large intercompany loans may cause a captive “to fail to make timely claims payment even though the sponsor has not defaulted on the loan agreement”.

The issue is particularly acute among those captives writing property risks, which tend to be characterised by sudden and sometimes sizable claims, the report found.

While intercompany loans are being used to “optimise the sponsor’s consolidated cash profile, centralise cash management or enhance returns on invested cash”, their scale often exceeds 95 percent of the captive’s invested assets, threatening to capsize the closely-held entity.

Fitch said that while risks associated with an intercompany loan might be considered to be reflected in the parent and captive’s ratings, which tend to conform, it believes that the “existence of material intercompany loans could result in additional risk—primarily liquidity risk—that is considered and could cause Fitch to rate the captive lower than the sponsor”.

The rating agency said that the captive can mitigate some of this risk through other sources of liquidity, such as a letter of credit, but warned that captives unable to “fund any claim payment on a timely basis would be viewed as a default by Fitch”, even if the money was eventually reimbursed.

Fitch said that captives need to consider the ranking of the intercompany note, the flexibility of the note to accelerate needed funds in the event of a sudden influx of claims, and an ability to offset claims payment against the loan, in such circumstances.