As the importance of the captive as a risk management tool grows, Nigel Allen discusses with Jose Sanchez-Crespo, John Andre and Henry Witmer, the value of having a captive rating

How vital a role does the captive insurance company play in today's re/insurance market?

John Andre: "As a result of the market issues in early 2000, I think the captive has become an increasingly important cog in the day-to-day activities of a risk manager for a large corporation."

Henry Witmer: "We are seeing the captive being used in more sophisticated ways than they were in the past, where they were used mainly as a formalised self insurance programme for certain specific lines in which organisations were having problems obtaining insurance. I think they are now looking at the captive as more of an enterprise risk management tool."

What have been the drivers behind the increased interest in captive financial strength ratings?

John Andre: "We rate a lot of captives, RRGs and others who want to attract members such as hospitals, doctors etc. These entities need a rating to establish a level of credibility and to compete against the large commercial carriers, such as the CNAs and AIGs of this world."

Henry Witmer: "A number of captives need to have a fronting company for certain lines of business. (Having a rating) can provide better access to the reinsurance markets which prefer working with a rated company similar to their own rating."

Jose Sanchez-Crespo: "Also, in some cases there will be a legal requirement, for example in gas and oil exploration in Latin America. The rules of the game are that the captives or the companies insuring some of those risks there in joint ventures will have to have a rating."

How does the rating process for a captive differ from that of a re/insurance company?

Jose Sanchez-Crespo: "A captive is a reinsurance company. They are reinsuring the risks. The only difference is that rather than it underwriting into the open market or going through brokers, they have a pre-established source of risk, ie the parent company. So, in terms of the approach, it is the same."

John Andre: "We always look at the parental relationship no matter what our ratings are on the insurance company that we are following. In a lot of cases, the parents will have pretty unique business operations, so it is important for us to understand them. So that is one element of the captive rating process that perhaps we don't have for the standard insurance rating process."

How has AM Best's rating process changed over the years to keep pace with the changing captive environment?

Jose Sanchez-Crespo: "I think the rating process has remained relatively unchanged. We are looking at risk, we are looking at financial strength, etc and those are components that have not changed. Obviously the level of detail that we have now, the amount of information, the inside knowledge is always dynamic, so this is always being fine-tuned."

Henry Witmer: "I think that the methodology is really moving right along with the captive industry itself and is becoming more sophisticated and the tools that we are using are becoming more sophisticated."

What characterises a highly rated captive?

Jose Sanchez-Crespo: "We look for a sound balance sheet that will support the liabilities that are contained within that captive. We will look very closely at the relationship with the parent, whether those assets within the captive are ring-fenced there, that they are at arms-length from the parent so that they will be backing the liabilities that the captive is taking."

Henry Witmer: "We look at the balance sheet for capitalisation and the ability to produce profits. We then look at its market profile, what the profile of the parent company is and how it supports the captive in terms of the amount of business which is going to it on a steady basis."

Jose Sanchez-Crespo: "We are looking very carefully to ensure that the assets and the capital that are within the captive are there to support the liabilities."

What are the factors that will trigger a re-evaluation of a captive's rating?

Jose Sanchez-Crespo: "All of our ratings are constantly being monitored and we have formal annual reviews. It could be a significant change in the business profile, the merger of two companies, resulting in the merging of the captives into one single entity. It could be the implementation of a new capital structure. It could be taking more risk than was originally anticipated or that the capital is not sufficient for."

John Andre: "Our analysts have a minimum of one annual meeting with the company whether it be in our office or at their site, but during the course of the year, our analysts will touch base with their rating contact be it someone internally at the captive or the captive manager to discuss their performance or certain events which may have occurred."

How much does the choice of domicile affect the rating of a captive?

Jose Sanchez-Crespo: "The domicile is something which we will look hard at. We will consider factors such as exchange control, the regulatory environment for captives, how easy it is for the parent to access the capital. It is one more element to be considered in the overall analysis process."

John Andre: "There are some states (in the US) which have a lot of experience in attracting and managing captives and overseeing the financial strength of those captives and so we become more comfortable with them. In terms of the new states which are coming on board we would certainly look at them more carefully."

How do you see the rating process developing?

Jose Sanchez-Crespo: "This is a very dynamic market and we like to think that we can stay on top of any changes in the market, whether they stem from the regulatory authorities, the monetary authorities or the sector itself. We try to reflect that dynamism in the market in our methodology, making sure that we are up-to-date on any changes and how these changes might affect the market."

Jose Sanchez-Crespo is general manager, AM Best Europe, John Andre is vice president, property/casualty, and Henry Witmer is senior managing financial analyst.

Captives - Characteristics of highly rated single parent captives

Quantitative factors:

- Captive is meeting stakeholder expectations (Mission)

- Parent company flexibility

- Strong/permanent capital and surplus

(Held by captive or, if held by parent, captive has ready access)

- Optimal reinsurance program

- Conservative reserves and appropriate net retentions

- Appropriately structured investments

(Traditional or non-traditional, including investment in affiliated companies)

- Sound liquidity

- Consistent, positive operating performance

Qualitative factors:

- Committed financial support by parent company

- Prudent risk management program

- Demonstrated interest by parent in captive's activities and performance

- Multiple lines or specialized and stable product strategy

- Good geographical spread of risk

- Ongoing, open dialogue with AM Best analysts

Captives - Typical rating information requested

1. Annual reports

2. Latest financial statements for parent and subsidiary companies

3. Actuarial reports, both internal and external

4. Corporate structure and history

5. Management structure and key executive committees

6. Biographical information on principal officers

7. Operating and business plans, including financial projections

8. Capital management strategies

9. Complete Best's Supplemental Rating Questionnaire

10. Any other information the captive believes is relevant to the rating process

11. Any other reasonable information requested by AM Best, including but not limited to: a) estimated impact (net and gross) from catastrophe or other unusual events; b) details of changes in ownership, management, products, or operations; c) revised projection of year-end results; and d) plans to mitigate losses and/or to correct an identified problem