To loan inter-company, or not to loan inter-company? That is the question...
To loan inter-company, or not to loan inter-company? That is the question. While there are undeniably benefits to this practice, they can often also act to the detriment of a captive’s overall financial strength rating.
In recent months, regulators in particular have expressed a significant interest in intercompany loans, because it is them that must give their approval. This has led them to seek the guidance of agencies such as Fitch Ratings, to better understand the context surrounding intercompany loans and obtain an outside perspective on their risks.
In short, intercompany loans can be thought of simply as internal loans made to a sponsor from the captive. It is also salient to point out that these loans generally apply to pure captives—or an entity with one parent as sponsor, one customer as sponsor, and one significant asset that, in this case, is the intercompany loan itself.
Donald Thorpe, head of Fitch’s captive analytical efforts in North America, explains: “Although there is a chance that these loans will have no effect on a company, there is always the potential that they could significantly reduce liquidity.”
“Generally speaking, the captive would be rated the same as the sponsor because everything is linked to the sponsor—it’s the only customer and the only owner. However, the issue is that the intercompany loan limits the liquidity of a captive and hinders its ability to pay claims. This then causes Fitch to work more to understand its nature and possibly lower its rating.”
The crux of the argument resides in the everyday practicalities of operating a captive, namely—the fact that captives must retain a certain amount of available cash in order to pay any claims that arise. In other words, the company needs to figure out how to convert the loan back into cash at a moment’s notice.
Although this might not be as much of a problem with relatively predictable claims such as liability—the fact remains that more unusual ‘stress’ scenarios, such as property and catastrophe, are so sudden that they need more liquidity to cope with a sudden spike in claims.
Thorpe continues: “Some intercompany loans are very large, around 90 to 95 percent of a company’s investment portfolio, and thus have all their cash concentrated in a single asset. The important thing is that the captive should have a sense of what to do if claims spike.”
“This contingency plan can be as simple as going back to parent and asking them to pay the note—but this introduces parent’s liquidity factor. Alternatively, in a situation where the parent company is also the insurer, the claims could be offset against the note.”
As well as the parent acting as a source of cash, there are other ways to rescue a captive that has fallen foul of intercompany loans—financially, as well as in the eyes of organisations like Fitch.
In many instances, captives possess letters of credit due to the terms of their business—at the behest of a fronting carrier, for example. This letter can act as a potential source of liquidity, to the extent that the captive has reinsurance.
According to Thorpe, many insurance policies also have what is known as a cash call, with which the reinsurer can provide cash to the primary insurer to pay claims.
Although these are indeed potential sources of cash and, therefore, should be considered in Fitch’s analyses, letters of credit and reinsurers are considered more as tertiary sources of assistance, while the captive and its sponsor are thought of as being primary sources.
Despite the fact that these methods can save the perpetrator of an intercompany loan, Thorpe hastens to add that these examples are idiosyncratic at best and, as a result, may not be an option in every situation.
The fact remains that the presence of intercompany loans adds a potential liquidity risk, and this risk must be mitigated for it not to be reflected in the ratings.
While there is currently no specific initiative to educate captive managers about the issues surrounding intercompany loans, some research papers, such as the one recently published by Fitch, have been found to help.
Thorpe adds that no reform in the regulations is imminent, even though regulators are intensifying their interest in them. At this point at least, it appears that regulators will continue to trust captives to make their own mistakes.
