A.M. Best
CIT goes behind the scenes of A.M. Best with Steven Chirico to discover how the ratings process really works
What information do you need to rate a protected cell captive?
The information is not dissimilar to the information that we would need for any rating that A.M. Best carries out. We would require audited financial statements from all the cells and the general cell, and an actuary report for all of them. We’d also get the reinsurance and vendor contracts for all the cells. We basically treat them as discreet entities from a ratings perspective. We consider each individual cell as a separate company, so we get a look on a standalone basis of what each cell looks like.
Other information that we require is management biographies. We would have to understand the cell captive and its operations from a qualitative perspective and then the purpose of each cell. Sometimes cell captives are grouped together with disparate businesses and some of them are businesses that are related in some way, but either way we have to understand from a qualitative perspective why this cell exists, what its purpose is, how it is functioning and how it is used.
There are other bits of information that we would require if we had specific questions, such as liquidity or if there’s substitute capital in the form of letters of credit, we would have to understand those and get those documents, but those are particular to certain scenarios. Finally, we always require a meeting, almost always face-to-face on an initial rating, and that’s any rating, so it would also apply to cell captives.
There are a lot of different terms for protected cell companies and similar structures depending on the domicile—are they all rated in the same way?
It’s a little bit of a different process because of the caveat with cell captives. The legislation in all of the domiciles that we are aware of wants to make each cell discreet financially from any other cells, so that you can’t use the assets of one cell to satisfy the liabilities of another cell.
But the problem is that whether you are in the British system or the US system, the Cayman Islands or Guernsey, and you have cell captive legislation, there hasn’t been one good court case to look at when a cell or a number of cells have gone bankrupt, that the assets of another cell could or could not be used to satisfy those obligations. So the permeability of those cell walls is still open to the subjectivity of a court.
Because of this, we take a little bit of a different approach. We do an analysis on each individual cell from a capital strength (risk adjusted capitalisation) perspective and then we rank them in order from weakest to strongest cell. This gives us an idea of how weak the weak cells are and how strong the strong ones are, and the probability of the weaker cells becoming compromised becomes part of the ratings determination. We have to be confident that the weak cells aren’t going to be able to drag down the strong cells. In my view, it is the most unique kind of rating that we do.
How does rating captives differ to rating traditional insurance companies, and what are the key issues to consider?
From a raw financial perspective, there is very little difference. We use the same capital model that we would a commercial insurer.
We evaluate operating performance in a similar way, but we take a little bit of a different look at operating performance, for example, net income, as we understand that captives have a different mission. A captive’s number one mission is not to make money, but to provide as low a cost and stable coverage for its parent company, or if it’s a group captive, its policy holder owner/s, as possible.
So we’ll look at dividends to policyholders, or a dividend from a single parent captive to its parent company, and view operating performance in certain cases before those events happen. We’ll also look at pre-dividend operating performance and particularly if the captive has the ability to not pay a dividend to its parent company or to its policy-holder and they have the willingness and the ability not to do that. We base that on financial flexibility and we give them a different take of operating performance as making money is third or fourth on the list for a captive as opposed to its main goal.
Do you physically visit every captive before rating it?
That is an interesting question for captives because sometimes the captive manager is where almost all the work is done. Some captives are virtual meaning they have no employees and no physical presence—they’ll just have a mailbox in Bermuda or Vermont! If this is the case, we visit the captive manager because that’s where all the work is done. In a single parent captive, we like to go to the parent company’s home office, so generally on an initial rating there is a face-to-face meeting. They also have the option to come to the A.M. Best offices for their rating meeting.
In subsequent years, we either visit or we conduct conference calls depending on the size of the company, the complexity and what’s going on in a particular year. Sometimes nothing changes for a captive and we just do a conference call with management. But sometimes captives have a lot of stuff going on such as putting in new lines of business, having a tax challenge from the US Internal Revenue Service, or planning to re-domicile, and in those types of scenarios an interactive meeting would be required.
Why would a company decide to leave the ratings process?
Captives generally leave the rating process because they don’t need the rating anymore. For example, say a captive was writing a line of business and the decision was made to write that business in the commercial market, and a captive wrote other lines of business that really don’t need a rating, it may look at the frictional cost of a ratings fee and decide to halt the process.
Another reason is that if a company merges with or acquires a business, it could end up with two captives while only needing one, so it will put one of the captives into run-off and continue on with its main captive. Sometimes, depending on where a company is in the world, it might decide to refocus where its risk management activity is done, so a global company would have its risk process decentralised in each of the large countries in which it does business, and then make the decision that it is going to consolidate risk management activities. And if it consolidates it in, for example, an Asian market, then the rating is not really required. Frankly, we are a little bit of a pain as we require a lot of information and communication and we ask a lot of questions, so it takes quite a bit of time for any rated company to maintain its rating.
Company ratings are currently voluntary. Do you think there will come a time when the rating process becomes mandatory?
I think that there’s going to be a higher level of global insured solvency work being done, but I’m not sure if it is going to be done through ratings agencies, governments or associations. In Europe, there’s Solvency II and there’s an implementation process and it is quite complex, and while some would argue that there are quite strong benefits to it, others would say that there are actual anti-competitive components of it that aren’t any good. I think that there is definitely an eye toward better global insurer and solvency regulation and I think that ratings could absolutely be a part of that.
I think that we’re moving towards a more robust analysis being done. Where that’s done is frankly less important, but the answer is that insurance companies should be well capitalised for the risks that are being rated and how you get there remains to be seen. Until Solvency II is implemented in the EU, I think we’ll only be able to guess, and after it is implemented, we’ll see what solutions are proposed.
