1 January 1970Analysis

Decisions, decisions - investments

It isn’t easy picking an investment manager. It’s a crowded field with a host of options and yet the importance of choosing the right partner has lost none of its significance. With captives looking to eke out the maximum returns in today’s turbulent investment environment, while at the same time maintaining a conservative and measured portfolio that matches their underwritten liabilities, how exactly does a captive decide with whom to trust its investment portfolio? Is every manager in the top quartile, as some would suggest? Bermuda Captive seeks to untangle some of the questions surrounding your choice of asset manager.

The first step captives need to take when considering an asset manager is to find one that understands the particular needs of a captive entity. As Richard Garland, managing director, Americas and Japan client group at Investec Asset Management outlined, “you need to focus on their experience in both asset management and in constructing portfolios that link in with the liabilities of a captive insurer”. Such an approach is all about understanding the “captive’s risk-neutral state”, said Dr. Eugene Durenard, consultant, head of research and product development at Capital G Investments, with the asset manager “aligning investment risk with the captive’s business risk”.

“The captive owner should home in on investment risk management, including how the manager addresses interest rate risk, default risk, liquidity and market risk within the portfolio, as well as the track record of the manager, and the level of communication and reporting they can expect,” said Andrew Marsh, head of institutional and fixed income management, Capital G Investments. “It is about understanding the captive business and constructing a portfolio and strategy for asset allocation that is appropriate to, and agreed upon by, the client.”

You should also ask about the “classes of investment they have access to as an asset manager, and how exactly they have access to them”, said Michael Mead, president of MR Mead and Company. After all, you don’t want to be paying twice for your services, he said. You should also run your loss history past them and get their opinion on what investment strategy best fits your circumstances, he added.

The captive should also put the investment manager under the microscope. As Hugh Rosenbaum, an independent consultant, outlined, you should examine how many clients they have, what is their experience in your particular area and how highly regarded they are at the firm and within the industry. Best in class is evidently what you are looking for and proof that you can outperform the parent’s treasury people, said Rosenbaum. Making the right choice involves interviewing a number of potential investment managers, said Mead, with an investment committee drawn from the parent helping to determine which manager will be the best fit for the captive. He added that it is helpful to include persons actively involved in “both investments and claims management” in order to clarify the particular investment approach you would like them to take.

Investment differentiation

The major differentiating factor between investment managers is “their approach to their clients”, said Dr. Durenard. Some large firms tend to “place their clients in rather general pockets”, he said, with such a stance unlikely to be beneficial to a captive’s specific needs. Garland concurred, adding that the notion that big is beautiful had led some captives to choose firms that apply a “cookie-cutter”, rather than a bespoke, approach to asset management. Small and medium-sized firms generally apply a more tailored approach he said, although the captive will always have to ask whether the strategy being employed is the optimum one for them—one that “diversifies the risks and at the same time achieves the best possible return”.

There are limitations, however. As Mead indicated, “you can’t get too esoteric with your investments. It is important to set out a conservative, liquid platform in the beginning and as you gain history with your investment advisor and your own claims management, you can find a level of investment where you can opt for more long-term, higher riskreward items”. Rosenbaum concurred, pointing out that, when a captive portfolio reaches sufficient size to justify risk-taking, then limitations on ratings, such as that only a small percentage of captive investments should be lower than AA can sometimes be counterproductive, as can overly strict asset-liability matching. It becomes part of the investment manager’s role to facilitate this, too, while resisting the temptations presented to owners to reach for further returns too early in the captive’s development.

"Captives are there to mitigate the risks of the parent. It is a risk reduction rather than a money-making vehicle-- and the investment manager needs to keep this fact in mind."

Marsh said that once a captive has grown and matured you can apply an excess return investment strategy that can be “constructed to have a low correlation to the business risk of the captive”, but in the early days it is necessary for a captive to tread carefully. The investment approach will very much depend upon where the captive is in the investment cycle and what market opportunities are out there, he said. Dr. Durenard explained that to understand the appropriate investment strategy for a particularcaptive, it is necessary to “understand the risk or draw-down that is allowed on the non-reserved asset side of the captive”. “Today it is very much about employing strategies that help the investor survive market stagnation,” Marsh concluded.

Despite the need for liquidity and a safe investment approach, there are opportunities for captives to eke out further returns in today’s troubled investment environment. Garland said that one area that captives can explore is emerging market debt, with returns on such instruments holding up well against those of developed markets. “Historically, captives and insurers have gone for developed fixed income and have viewed emerging market debt as a more risky asset class. But in some ways with the macroeconomic issues around the world, there is more risk in developed than emerging market fixed income at present,” he said. Marsh added that many of those instruments in developed markets that had been considered safe before the economic crisis—such as government bonds that still enjoy AAA ratings—are no longer the safe bets they once were. He argued that as an investment manager it is essential to understand the changed risk environment in order to be able to “deliver a cleaner total return stream”.

Garland also highlighted the potential of credit and high-yield instruments and even—over the longer term—emerging corporate debt. In the end however, “captives are there to mitigate the risks of the parent. It is a risk reduction rather than a money-making vehicle—and the investment manager needs to keep this fact in mind”, said Dr. Durenard. As such, conservatism will inevitably be the watchword of any captive investment portfolio. Or as Marsh succinctly put it: “choose an investment manager who acts as your investment risk manager”.

The Bermuda option

While London and New York continue to be the main centres for investment management, a number of other locations are vying for the role, with Bermuda being one such location. As Marsh indicated, Bermuda benefits from a high level of sophistication in all aspects of captive management, with investment management being just one. “For captives focused on specific lines or those that have international exposure, the concentration of expertise in Bermuda presents a huge advantage,” he said.

Dr. Durenard concluded that from a “portfolio trading and execution standpoint, access to market and liquidity is as good in Bermuda as it is in New York or London. We have access to the same pricing, market-makers and banks”, with the Island’s investment managers able to make a compelling case to captives considering locating all their management functions in one place.