Solvency II and the financial crisis are enabling insurers to take a closer look at the captives they front for.
Inquisitive questions and collateral are becoming "popular" again and captive owners are asking themselves how they can shape their captives and address their fronters' concerns about their financial security. The author cautions that the following opinion is the truly subjective view of someone on the security vetting
team at AGCS.
European insurance companies currently find themselves in a difficult situation. On the one hand, they are becoming aware of the implications of the future regulatory regime Solvency II which requires them to evaluate the credit risk inherent in cessions to captives. On the other hand, an overreliance on ratings has evaporated in the aftermath of the credit crisis following the near collapse of perceived financially strong entities such as AIG.
The rating is now only one part of the vetting process while useful market indicators such as CDS spreads, market implied ratings and qualitative company information are considered in order to achieve the best early warning signal. In the past, default transition matrices from rating agencies provided comfort in the formof historical default probabilities for given ratings. Today, credit managers have to realize that even well- rated companies can be vulnerable to exceptional
Well-meaning governments and policymakers have softened accounting rules to allow financial institutions to keep equity cushions. However, credit managers are asking themselves if financial reports can still be trusted. The financial crisis has shown that other criteria also determine whether a company in trouble is allowed to survive or not: its system-relevance and connectedness with government, society and key industries.
Banks certainly benefited from their indispensability to the system and in most cases so far have been saved from bankruptcy (with the exception of Lehman Brothers). But also for industrial companies it is thought that: the more connected a company is, the more insulated it is from financial crises, hostile takeovers or credit crunches.
The secretive company
The opposite of the connected company is the secretive company, where an often mazy shareholding structure is combined with an unwillingness to share financial information. These companies are frequently family-owned and run by the founders or their descendants.
This approach may have worked well in the past to build up their company and deserves a lot of respect, but is not a recipe to win solidarity in times of crisis. Such companies are isolated from their environment and when times get tightmay find few people willing to help them out of trouble. That is why ratings are well worth being considered. At least they show that the company is connected to the investment community.
What does this mean for European companies engaging captives in their insurance programmes? There is an increased focus on the security of captives and given the lack of information and unrated status of the majority of captives, this continues to make it difficult to enable analysts to permit fronting for these entities.
Apart from assuring the balance sheet strength of their captive companies they must view themselves as part of a larger network embedded in their countries and the European Union. An excellent rating helps but is also not sufficient on its own.
The winners will be those who play their cards openly and disclose to their insurer their connections to the outside world. Key questions are intercompany links with other corporate entities (treasury, shared investments and intercompany borrowings), type and volume of exposure to the risks of their parents, level of dominance of the company in their home country and in the European Union (market share), public and political interest in their well-being (shares and stakes of the state and level of integration in society) and their ability to convince other players to give them credit (in some cases in the form of a letter of credit to their fronter).
Transparency and willingness to share information and answer questions help to build trust, even if the value of disclosed information is inflated and becoming less and less meaningful on its own.
The collateral connection
Unfortunately, there is an unhealthy trend to de-collateralization in international insurance regulation. The European Reinsurance Directive has abolished compulsory collateralization of reserves where it still existed e.g. in France. Captives domiciled in the European Union don't have to post asset pledges or letters of credit any longer for their liabilities to their fronters.
The reasoning behind this move was the consideration that educated business people can decide for themselves what an appropriate level of security shall be. The financial crisis has though shown that greed sometimes wins over reasonable considerations, because there is a fundamental timing mismatch between the two conflicting targets. Business growth pays off in the short term, whereas sound credit management makes the company survive in the long run.
Compulsory collateralization provided an equal level playing field and fair competition in that respect. It prevented fronters fromcompeting by undercutting each other in collateral. Again, one hopes that rating agencies will have an eye on credit risk management and punish aggressive fronters on their ratings in a way, that they themselves become unattractive security for captive owners. The run for quality softens the pressure on security terms – as long as budgets are sufficient to afford the surcharge in premiums for quality fronting paper.