3 March 2014Analysis

European stoics

The European captive sector has proved itself remarkably resilient in spite of significant headwinds associated with the European economic crisis, which lingers on in a number of European countries. Despite European economic woes, captives and captive domiciles have seen no marked decline in numbers or activity.

An examination of some of the leading captive domiciles provides an indication of the stoicism of captives in the face of macroeconomic pressures. They nonetheless face challenging times, particularly when it comes to asset management.

“While the eurozone manufacturing purchasing managers’ index had shown its fifth consecutive month of growth, a fine line between growth and contraction remains.”

Addressing the current environment for captives, Dr Paul Wöhrmann, head of captive services at Zurich Global Corporate for Europe, APAC & LATAM, said that the insurer had seen no marked decline in captive numbers seeking out its services. He said that their value as risk management tools to parent companies remains undiminished despite market pressures. He admitted that Zurich has been obliged to pay closer attention to issues such as counterparty risk and may in some instances ask for additional collateral from its captive partners, but said that the crisis has not notably changed the captive environment.

Andreas Ruof, head of proposition development at Zurich Global Corporate, captive services, added that for captives the crisis might in some ways prove beneficial. “CFOs are certainly taking more interest in their captives as a result of the crisis. They are exploring ways to work smarter and deploy their capital in a more efficient manner.” This had for example encouraged some to consider adding life business into their existing non-life portfolio, as they look to maximise capital efficiencies.

Wöhrmann agreed that in many instances premiums have diminished in light of the soft commercial market and the fact that economic conditions have pressured potential growth, but said that the value of captive insurance remains. It is not dependent on the cycle, he said.

Wöhrmann agreed, however, that pressure on investment returns had been rather more significant, particularly for captives with long-tail lines. “For short tail lines, assets tend to be invested in short-term investments such as cash and as such the change of interest rates in Europe has had less of an impact on captives. However, for those with long tail lines, their asset positions have been more acutely affected,” he said.

Running of the bulls

The European investment environment may be troubled, but there are nevertheless pockets of opportunity and cause for future optimism, said Ken Hsia, portfolio manager, Europe equities within the Investec Global 4Factor Equity Team. As he explained: “Globally focused European companies have driven recent equity returns in the region, and European-centred businesses that have survived and which are able to exert pricing power in what are now less competitive market segments are likely to benefit in our view.” If captives and their parents can find these equities, they are likely to be able to benefit.

He explained that while macroeconomic issues cannot be simply ignored, signs indicate that the best businesses are succeeding in improving earnings and driving deleveraging. “Finding these businesses, alongside investing appropriately in the best in class global leaders listed in Europe, should offer plenty of opportunity to outperform,” he said. These are potentially attractive propositions for investment portfolios.

Not that it is all good news on the investment and economic front. As Hsia explained, Europe’s recovery remains fragile, with Germany the only major European economy back to, and now exceeding, pre-crisis levels of GDP. He explained that while the eurozone manufacturing purchasing managers’ index had shown its fifth consecutive month of growth, a fine line between growth and contraction remains. France dipped below this line during the fourth quarter of 2013.

European stock markets meanwhile remain below their pre-crisis levels, with the MSCI Pan Europe Index still 30 percent below peak levels. Successes have been achieved in Denmark and Switzerland, breaching previous peaks, said Hsia, but he credited the quality of local companies with helping their recovery.

Hsia said that investments in global winners whose “global revenue footprint” was less dependent upon European operations would likely fare best in the current environment. He said that global players had been the key drivers of upward momentum in the MSCI Europe Index.

“These global businesses, ranging from leading German carmakers to French and Italian luxury goods businesses, are numerous, not exclusively large cap, and are often not well known outside their area of expertise. They remain a compelling reason to invest in European equities.”

Hsia added that there is “great scope for margin improvement in Europe” and suggested that European corporate earnings will begin to catch US corporates, behind which they have tended to lag since the economic crisis.

“This is attributable, in part, to some industries taking action to tackle low capacity utilisation by implementing rationalisation plans, taking out costs and stripping out excess capacity, so that supply becomes balanced with demand. The end result is often fewer competitors, which is good for the survivors.”

Hsia said that in 2012 European equities were trading at a 15 percent discount to developed market equities. That gap has since narrowed substantially and Hsia predicts that “European valuations can lift from here, especially as Europe already ranks well on returns and risk”.

“Europe also ranks highly on more qualitative factors, such as corporate governance, due to the maturity of the corporates and the history of engagement with their shareholders. This should benefit companies that are cheap when earnings recover.”

Hsia cautioned, however, that risks remain, with the most glaring being continued instability in the eurozone. He explained that a central assumption around Investec’s investment case is that stability will be sustained, adding that with bond yields improving, public balance sheets becoming less stressed, and political stability evident in France and Germany, the “muddle-through” approach is likely to be continued.

Hsia concluded: “We believe a disciplined evidence-based investment approach should ensure one gets the balance between conviction and more hopeful optimism right. The biggest risk—and it is not exclusive to Europe—is the gradual withdrawal of stimulus by the US Federal Reserve and the influence that has on all markets.

“In this environment, our view is that a bottom-up stock-picking approach is beneficial, given its focus on company-specific risk over market risk.”