Loans between a captive and its parent are “a potential liquidity risk that could arise if claims volume rose unexpectedly”, according to Fitch Ratings.
Its Captive Insurers and Intercompany Loans report, released 7 March, said that the liquidity risk may further limit the captive’s credit profile and cause it to be rated lower than the sponsor.
Donald Thorpe, senior director at Fitch, explained: “The presence of material intercompany loans highlights the linkage between the solvency of the captive and the solvency of the parent company sponsor.”
“This linkage makes it difficult, or even impossible, to develop a credible opinion about the captive's credit profile without a thorough understanding of the sponsor's credit profile. Intercompany loans present a potential liquidity risk that could arise if claims volume rose unexpectedly.”
Parent companies and their captives often use intercompany loans to optimise the sponsor’s consolidated cash profile, centralise cash management or enhance returns on invested cash.
Intercompany loans have become commonplace and can be material to the captive, often exceeding 95 percent of its invested assets, according to Fitch.
“[I]nsurers writing property risks tend to require more immediate liquidity than those writing casualty risks, and the presence of intercompany loans may pressure the liquidity profile of a property-oriented captive,” commented Fitch.
“That said, the pure captive presents a unique twist to the normal perception of liquidity risk in that a pure captive insures its sponsor. The implication is that in some cases the sponsor itself may be the claimant.”
“This situation may allow the captive greater flexibility in settling claims if the loan agreement, the insurance policy, regulatory policy, the type of coverage and the captive's claims-handling practices allow the captive to simply reduce the amount of the intercompany note as a means of settling claims for which the sponsor is the claimant. The ability to net claims against outstanding loans, if any, is likely to vary from case to case, and each situation needs to be judged given its unique circumstances.”
Fitch added in its report that the terms of the intercompany note are critical, a fronting arrangement adds another layer of complexity to understanding liquidity risk, and a captive may have access to sources of liquidity other than its sponsor.
“When an intercompany note from the sponsor represents a material portion of the captive’s invested asset base, liquidity risk is introduced. This risk may further limit the captive’s credit profile and cause the captive to be rated lower than the sponsor. However, there are a number of ways that liquidity risk can be mitigated,” concluded Fitch.
“Ultimately, the presence of a material intercompany loan requires the captive insurer to have credible plans in place for how it will pay claims. To be credible, these plans should consider both a base case where claims develop as expected and a stress scenario where a major catastrophe, or other sudden event, accelerates the captive’s need to pay claims.”
