Cash as an asset class?
As history shows, cash does not always produce tremendous returns. This is what you would expect from an asset class which offers other virtues, such as capital preservation and security. Although 2008 was a year in which cash (and short dated bonds) produced returns in excess of 5 percent, historically the picture has not been as good. For example, as highlighted in Barclays’ Equity Gilt Study 2013, £100 invested in cash in 1899, accounting for reinvestment of interest and inflation, returned only £267 by the end of 2012.
Like most people, I think of cash as something to be spent or invested as opposed to a standalone asset class. But actually cash in troubled financial markets can outperform bonds and equities and you only have to look at its performance in 2008 for confirmation of this. In addition, cash has a characteristic that is often overlooked: its optionality. Having cash on hand in a volatile market gives you the flexibility to purchase assets in the future at discounted prices.
It is a mistake to feel compelled to be fully invested in an environment in which there are few attractive opportunities. Just ask veteran investor Warren Buffett, whose company, Berkshire Hathaway, made a significant investment in Goldman Sachs in 2008 at the height of the global financial crisis. The deal attracted much media attention, specifically the generous 10 percent the bank agreed to pay Buffett’s Berkshire. However, this was only possible as it reflected the stress in the market following the collapseof Lehman Brothers, Goldman’s need for the funds, and the lack of other potential investors either willing or able to put the money forward.
It’s obvious therefore that during periods of such significant dislocation, when other investors are forced to liquidate positions, cash’s embedded option becomes particularly valuable. The reality for captive insurance companies is somewhat different, however, and I can’t see many rushing out to invest in the next Goldman Sachs when we experience another market upset in the future.
The old stock market adage that in a recession ‘cash is king’ certainly rang true for many investors in the aftermath of the 2008 financial crisis. As equity markets plummeted, investors rushed towards the safety and capital preservation qualities of government bonds and cash. Initially bond yields in the corporate, high yield and emerging market debt space soared, while yields of their more conservative sovereign brethren fell. Consequently 2008 was a good year to have a large percentage of cash or short-term debt instruments as the asset class outperformed all others in that year.
But what about now, four and a half years after what many regard as one of the worst bear markets since 1929? Does the post-2008 investment mantra ‘return of capital’ as opposed to ‘return on capital’ still hold true, and if it does, at what cost to captive insurance companies and a wider investor base?
"Captives, like any depositors, need to be more selective and informed when placing deposits. The risk that Cyprus becomes a template for bank resolution regimes elsewhere is real."
First, the makeup of a captive insurance company is quite unlike other corporations. The primary purpose of a captive is to act as an insurance vehicle to meet the claims responsibilities for its parent. They gather cash premiums and they know at some point in time they will have to settle a claim and pay out cash. From the perspective of a captive risk manager the captive is assuming risk on the liability side of the balance sheet. Risk is being underwritten. Against this, risk premiums build up as assets and need to be kept relatively liquid in order to pay these future claims. It’s the uncertainty of these future claims that creates a dilemma for a captive treasurer. Cash is essential, but what level of cash is the optimal level to hold in order to pay claims and generate an acceptable return on assets?
Prior to 2008, captives could achieve 5 percent-plus on a 12 month fixed deposit, so there wasn’t a dilemma for captives, and certainly no need to assume any risk on the asset side of the balance sheet by looking at alternatives to cash. The yield on cash deposits alone was often sufficient to cover the operating costs of a captive, and therefore they were self-funding. The interest rate environment is, however, very different today. Just when everyone thinks deposit rates can’t get worse, they do. Flat or negative yields ensure erosion of capital with little upside. Consequently captives—acutely aware of future claims—are balancing the conundrum of actively searching for yield while trying to minimise risk. They are beginning to embrace the need to segment their reserves into the different classifications of operating, core and strategic. Operating and core funds need to be liquid and available immediately to cover claims, whereas strategic funds can be used to invest in longer dated securities to maximise yield pick-up, while minimising volatility.
Poor yields on cash aside, there are other disadvantages in being overweight in this asset class, such as inflation. With inflation levels close to 3 percent and interest rates in the US at 0.25 percent, this toxic combination of low rates and high inflation equals negative real returns. For example, if a captive has $10 million invested in a money market fund generating an annual income of 0.125 percent, at the end of the year the real value of this $10 million is $9,712,500, a real return of negative $287,500. Not exactly a risk-free trade, rather an annual loss of 2.875 percent.
Of course cash’s most advantageous attribute is capital preservation. It is simple and transparent, and you can access it instantly. This is a real boon to cash as a legitimate asset class. But try telling that to depositors in Cyprus where this traditional concept of safety was challenged. In a deal with the European Union, International Monetary Fund and European Central Bank Cyprus received a $13 billion bailout by winding down Laiki Bank and shifting deposits below €100,000 to the Bank of Cyprus to create a ‘good bank’. Deposits above €100,000, which under EU law arenot guaranteed, were frozen and used to resolve debts. And then there are the newly introduced capital controls which prevent individuals from withdrawing more than €300 per day from any one bank, and money transfers are prohibited unless they are for commercial transactions.
Uninsured depositors should consider themselves senior unsecured creditors and assess whether they are being compensated for the increased counterparty risk. Captives, like any depositors, need to be more selective and informed when placing deposits. The risk that Cyprus becomes a template for bank resolution regimes elsewhere is real.
The question then becomes: where do captives move some of their overweight cash positions in order to mitigate cash’s negative attributes of poor yield, inflation and current insecurity? A short-term fixed income investment comes to mind. It probably won’t produce a yield in excess of 2.5 percent, which is currently required to exceed inflation. However, the strategy will offer a yield enhancement to cash, and at the very least such a strategy should always form part of a captive’s core investment strategy, given the strong need to protect and preserve capital, while offering broad issuer diversification.
Although cash is essential for captive insurers it does not exclude the sector from exploring opportunities in non-cash alternatives. Consequently captives who wish to actively search for yield while trying to minimise risk should embrace the need to segment their cash reserves into the different classifications of operating, core and strategic.
Colleen McHugh is a corporate investment adviser within the captives team at Barclays. She can be contacted at: colleen.mchugh@barclays.com
