Do Captives Make the Grade?

Closer relationships between reinsurers and captives are partly behind calls for ratings agencies to grade captives’ credit-worthiness, according to speakers at the Canadian Captive Forum 2006 in Toronto.

Currently, a very small percentage of captives come under the scrutiny of ratings agencies. But now hurricanes losses and corporate governance regulations have ratings agencies, captives and reinsurers all looking for ways to determine a captive’s financial strength.

The fact that some captives even negotiate treaties with reinsurers shows a tremendous shift in the culture, Andrew Barile, a 40-year veteran of the insurance and reinsurance industry, notes. Barile is the founder and principal of Andrew Barile Consulting Corporation Inc. in California.

“I won the Anglo-American Fellowship of the College of Insurance in 1967,” Barile told the conference. “I did a study at Lloyd’s of London, and do you know what my subject was? Captive insurance companies.”

CULTURE SHIFT

Barile noted he was doing work for Swiss Reinsurance when one of the first captive insurance companies opened for business. “The executives at Swiss Re said: ‘We’ll let Barile go to Switzerland and go on the fellowship, but we’re not going to reinsure a captive insurance company,'” he recalled.

“That was the thinking 40 years ago…The initial concept was that this is going to take business away from the traditional insurance company clients of the reinsurance people, and therefore don’t reinsure the captives…

“Today, thank God, we all love captives.”

Despite the change in attitudes, however, the nature of the captives’ business means that captives rarely line up to purchase reinsurance. Jon Himmens of TransAlta in Calgary noted the captive he counsels insures engineering companies. He said the risks the captive insures – such as the explosion of a transformer – have a very low likelihood of occurring. But the impact of the insured risks are potentially very damaging.

As a result, “when we have to go to the reinsurance market, it costs us an incredible amount of money and advance premium to take in,” Himmens said. “What dos this mean to us, when the rubber hits the road?

“It means we take on all liability for all of our risks that we insure. It also means we have to have the capital to pass all of the insolvency tests to run the captive properly…because we know we carry the risks internally ourselves.”

In other words, it means not purchasing reinsurance. And since captives often seek reinsurance only in rare circumstances, reinsurers typically haven’t been requiring captives to receive the blessing of ratings agencies.

But huge reinsurance losses after the 2005 hurricane season – in combination with Sarbanes-Oxley’s demands for improved corporate governance standards – may have changed all that, forum speakers noted. Stephen Scammell, a senior consultant at Tillinghast Towers Perrin, cited research that shows reinsurers are on the hook for 44-52% (or US$21-24 billion) of the commercial insurance losses as a result of Hurricanes Katrina, Rita and Wilma. “That’s a very sizeable impact on the reinsurance market,” Scammell said. “It’s a little different than what happened the year earlier, when four hurricanes hit the U.S. and Florida in particular. Because they were four separate events, the reinsurance market didn’t get hit nearly as bad as the one with Katrina.”

As a result, Scammell said, “there’s a lot of movement afoot to get captive insurers to get stronger financial ratings. The regulators are putting increasing pressure on the commercial market to improve the financial strength of the markets they deal with – and captive insurers are one of those markets. And hence the reinsurance and the commercial market are looking increasingly for stronger and stronger financial partners with captive insurance companies.”

Scammell predicted that as reinsurance capacity shrinks (the result of the hurricane losses), prices for reinsurance should rise. And as reinsurers look to resign treaties, they may in fact start looking at the capital markets over captives because of the perceived credit-worthiness of the commercial markets and the bigger size of most insurance companies as compared to the size of captives.

LOSS RESERVES

Scammell noted A.M. Best statistics that show 51% of the 218 insolvencies between 1993 and 2002 were due to insufficient loss reserves. Although hurricane losses weren’t an issue for most captives, if insurers try to run property lines through their captives, they would potentially expose their captives to catastrophe risk.

“If you write property risk into your casualty captive, do you really want to subject your capital to that kind of potential risk exposure?” Richard Inserra, the president of Insurance Strategies Ltd., asked rhetorically.

“Here’s the big issue: I know a lot of captive owners who are saying: ‘The commercial market doesn’t write it, I’ll just put it in my captive…’ “My [former clients] at the Empire State Building were in this boat, because their broker turned around and recommended putting all their stuff into a captive.

“I said: ‘Well, let me tell you a problem – if you’ve got a $100-billion loss, you’ve got to write a $100-billion cheque. Do you have $100 billion sitting around? And by the way, the building that you’re depending on as the collateral to get that [money] is no longer there…’

“You can’t write every risk on the planet. All captives are formalized self-insurance. It’s not another insurance company.”

As a result, A.M. Best doesn’t rate captives in exactly the same way they rate insurance companies, according to Henry Witmer, the managing senior financial analyst of alternative risk markets at A.M. Best. Witmer noted that the rating agency has already begun the process of rating captives. He said the ratings agency ranks captive insurers on the basis of:

* Financial strength, including risk assumed, premiums, loss reserves.

* Profitability, including underwriting and investments.

* Market profile, including pressure or support from a parent company and a domicile’s laws and regulations).

Witmer said A.M. Best annually rates between 150 and 200 captives, adding that between half and three-quarters of them are single-parent captives. Inserra observed this is a small percentage of the approximately 5,000 existing captives.

“Not all captives need to be rated,” Witmer replied. “In the past, we looked at ratings after five years.

“[Now] we look at what the loss and the exposures have been in the past programs. We look at business plans to see how strong they are, and whether they are backed up by actual analysis. So to find you a rule that may have existed some years ago [about how much history would be required to rate a captive], that’s not a hard and fast rule at this point.”

RATING CAPTIVES

Witmer noted ratings agencies do not assume that captives must always reinsure. “It depends what the exposures are. If, for example, the policy that was issued by the captive exceeded its capabilities, that would be an issue. But if the policy issued by the captive was capped at what is a reasonable retention level, and its reinsurance was placed outside the captive, it would not be an issue.”

Witmer said some captives want to be rated for benchmarking purposes. If A.M. Best gives the captive a grade and the captive agrees with the rating, then the rating goes public. If the captive disagrees with the rating, then the rating will not be published.

Inserra said the desire to assure compliance with corporate governance regulations has played a part in a captive wishing to be rated. He noted the example of one of his clients, Westerly Insurance Ltd.

“One of the driving factors for having it rated was that senior financial management was comfortable with the direction, but was not sure on the question of whether there was pr oper oversight,” Inserra said. “They were not insurance professionals. They did not have a really good comfort level. They were comfortable with the risk manager, with the governance, etc., but they wanted to have the oversight of a professional rating agency to help them feel much more comfortable…

“With Sarbanes-Oxley, I believe more captives will be looking at this as a way of providing expert oversight from the rating agencies or companies.”