Captive Trends

How buoyant is the captive sector?
Taking start-ups as the measure, the captive market is probably growing as fast as ever - 462 new captives were registered in 2002, compared with 316 the year before, and 2003 has also started strongly.

This activity could be a reaction to the difficult market conditions that have adversely impacted most corporate insurance programmes.

What trends do you notice?
There are several notable features. Most captives are of US origin and, increasingly, most new ones are too. And because more US states now have captive-friendly regulations, more of these captives are been formed onshore.

A recent development is the increasing use of cell captives, first introduced in 1997. Many other domiciles have followed suit since. There are over 150 cell companies with 600 plus cells in operation. Their appeal relates to speed of set-up and lower unit costs. And while new captives are being formed at an accelerating rate, the closure of now defunct captives has also been running at record levels.

Has the AM Best's Captive Directory changed to reflect this dynamic scene?

The Directory began life in 1976 as a simple listing. At the time that AM Best acquired the publication from Tillinghast-Towers Perrin in 1999 it had 4,135 entries. Today it has 5,004. We have enhanced the directory's database and the sources of information. Last year we converted it to an online service within the AM Best Captive Center on our website (see
www.ambest.com/captive/ ). Users can now search for captives according to various criteria, accessing information that is being continually updated.

Why would a captive want a rating?
Five years ago the answer might have been framed in terms of US market practice. It is very rare for a US insurer not to carry an AM Best rating and, therefore, risk retention groups and self-insured pools often did likewise. Today, however, it is recognised that captives of all types can benefit from a rating. We've identified 25 sources of value that can be derived from a rating on a captive; in practice, several are likely to apply in any one case.

They fall into two main categories. First, a rated captive should find it easier to deal with the conventional market. Fronting and reinsurance capacity may be engaged more effectively and on better terms. For example, we've seen that an AM Best rating can help a captive reduce the collateral requirements of its fronting arrangements.

A second reason why a rating on a captive can count may be explained in terms of corporate governance. In this new age of greater disclosure numerous stakeholders need assurance that the risks in a captive operation are understood and under control. While a rating is not in any sense an audit or a view specific to corporate governance, the rating process does offer an independent view of the company from the perspective of its financial health.

Is a rating a practical proposition for any captive?
We anticipate that about a third of all captives would benefit significantly from an AM Best rating. Other captives would be too small or operate in a way where a rating might have

little useful impact. In terms of process, the issues AM Best addresses would typically be consistent with those things that the captive management would focus on in controlling the financial condition of the insurer.

Accordingly, little, if any, additional information would really be required. Experience suggests that rated captives find the process is not an undue burden. We discuss full details of the process with the captive before it commits to the rating process.

Is there a special rating scale for captives?

No. All AM Best's financial strength ratings are presented in the same scale and the analysis on which our opinion is based will be consistent whatever the type of insurer concerned. But we do recognise captives are different from conventional insurers, for instance in their objectives and methods of operation.

We need to understand the risk management strategy that a captive is intended to serve. With this in mind, last year we published AM Best's rating methodology for single parent captives. What is important is that, as a transparent and consistent market based comparison, a rating allows a captive to be seen in this wider context.

What are the main factors that determine the rating?

We focus on three main areas: balance sheet strength (including capital, reserves, reinsurance and investments); operating performance and business profile. We analyse the company's strategy and the experience of its management team. A key analytical tool is

AM Best's capital adequacy ratio, a proprietary model that identifies an insurer's risk-adjusted capital needs.

It is important we assess the real creditworthiness of the captive, which may not always be evident in its financial statements. For example, where there are equalisation reserves, where there is a very cautious claims reserving policy or where capital, although not paid up, is supported by letters of credit, the effective equity will be recognised. Conversely, if we were concerned about reserve adequacy we would reduce the reported equity levels accordingly.

What information is required to undertake this analysis?

All our captive ratings are fully interactive. The rating process entails the sharing of information about the captive's underwriting, capital structure, investments etc. Typically, sizeable amounts of non-public information are shared. This information is, of course, treated in the strictest confidence by AM Best. The details of this information would generally be consistent with what a well-run captive uses in its own management process.

A fundamental part of the rating process is the management meeting at which AM Best's analysts discuss this information from a strategic viewpoint with those who control or influence the captive's operations. This may include outside directors, brokers and other advisers, and treasury and risk management personnel from the parent.

How does the status of the parent affect that of the captive?

The rating is assigned to the captive, not its parent and is specific to the captive's ability to meet its ongoing policyholder obligations. A crucial factor is the regulatory controls associated with maintenance of capital in the captive. The parental relationship is an important consideration, but not a completely overriding one.

How long does the rating process take?

To a large extent this is in the hands of the captive. Supplying the requested information and convening the management meeting with all desired attendees can take time. Once that meeting has been held we would expect the rating to be assigned within six to eight weeks.

How do captive ratings compare with the market in general?

Overall this is a better picture than the market as a whole, though the percentage of captives in the superior range (where size is more material) is lower. Also, in the past 18 months, when most insurers have been suffering, proportionally fewer captives have been downgraded. This is as one might expect; many captives are conservatively capitalised for the risks they are retaining, and typically the rationale for captive usage means those risks are of a higher quality than those offered to conventional insurers. It is also worth noting that most captives have had a lower exposure to distressed equity markets.

Clive Thursby is manager, alternative markets and Jose Sanchez-Crespo is general manager, AM Best Europe