AM BEST
What are the challenges and opportunities presented by writing additional lines of business through your captive? Chirico: There are two main risks. The first one is pricing: when you get into a new line of business you simply don’t have specific experience of pricing on that line. Number two would be reserving. Assuming you get the price right on the line of business, if you don’t adequately reserve initially and you have perpetual reserve development, as time goes on you may find yourself in trouble.
Do you expect to see further innovation in terms of the form and deployment of captives? Chirico: One of the things we have been seeing very recently is captives being used as profit centres, whereas historically captives have been viewed as cost centres. Take a single-parent captive, where you are looking simply to recoup the frictional costs of running the captive, get your losses paid and your risk management programme implemented through the captive. If it makes money—great, but it is all done on a cost centre basis. This situation is morphing. Today, parents are looking to see whether they can make money with their captive—the concept of using the captive for ‘friends and family’. If you are a very large industrial company that has a captive, then you can make your captive available to some of your vendors or customers. The concept is that if the parent feels comfortable doing business with a particular vendor or customer, then there could be appetite from a value-added perspective to let them use the parent’s captive to solidify the business relationship further.
AM Best rates around 200 captives. What are the key areas that AM Best considers when rating a captive? Chirico: From a broad-brush perspective, capitalisation is job number one. We also look closely at the effectiveness of management and the captive’s ERM. If you take a very small group captive, they may not feel they have a very robust ERM programme because they don’t have a binder that’s thick and gorgeously presented, but when we meet them and start asking about how their claims are doing and about what they are seeing from a pricing perspective and the principles of running a captive, and they can cite that off the tops of their heads, I say, well that’s your ERM right there. There’s a little bit of an awakening. It’s not what’s in the binder—it’s the effectiveness of all the functional risk areas of an insurance company working together, understanding where everyone is and breaking down divisions within the captive.
We also look closely at losses. If a company is writing high severity, loss frequency business, they are going to have to maintain more capital for a given rating level than a company that is writing lower volatility business. Last, but not least, is the strength of the parent company in the case of single-parent captives. During the crisis there were several captives of global
52 CICA | Forty years of captive leadership
industrial companies that were affected by troubles at the parent, and these problems resulted in rating movements at the captive. That said, positive developments have also gone the other way. As the economy has recovered, some of the large banks that have captives have done particularly well, and this has then been reflected in improved ratings on the captives.
How can captives work to improve their rating position? Chirico: They need to work on each of those functional areas. More, higher quality capitalisation, strengthening of ERM and displaying low volatility in cash flow and operating performance, will eventually lead to a rating elevation because it will be indicative of a stronger company from a solvency perspective.
What are the benefits of being a rated captive? Tina Bukow Truman: What we are seeing from the firms that apply for a rating is that there are a number of major benefits. The first of these is corporate governance. Following the onset of Dodd-Frank, board members find themselves in an increasingly onerous position as regards corporate responsibility. There was a time when board members had a relationship with the firm, but were not accountable for its business. Now, with the regulatory climate being what it is, there is a huge responsibility, with board members of all industries more and more concerned about things being done correctly.
Another key reason is with the cost of credit sky-rocketing, and the costs of fronting and reinsurance also presenting challenges, many firms are seeking out ratings to cement their position in the market. At the same time, regulatory requirements such as Solvency II are encouraging firms to enquire about and come through the process in anticipation of the regime. Many feel that if they have gone through the rating process, when it finally becomes law, then they may have solved some of the necessary requirements and it will be an easier process when they move to comply with the regime.
A further motivation is oversight. In this economic climate companies really want to be sure that they are on track, with a rating and its oversight providing words of encouragement to the board and management. Finally, there are also instances where firms are moving into new lines of business or states—where there are new regulatory requirements—with ratings representing a useful tool to assess and shape the firm’s approach to new business. l
Steven Chirico is assistant vice president at AM Best. He can be contacted at:
steven.chirico@
ambest.com
Tina Bukow Truman is senior manager, business development at AM Best. She can be contacted at:
tina.bukow-truman@ambest.com
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