28 November 2013Analysis

Toughing it out again

As we penned a year ago in this magazine, it has certainly become commonplace that captive owners continue to be frustrated by low returns on their captive’s assets and continue to be worried about investment risk and volatility. And for certain, the common theme that returns are sacrificed either because of a collateral requirement, or from a fear of entering the market and diversifying away from the perceived relative safety of cash, also continues.

After some discussion, we decided that a ‘part 2’ to last year’s article was appropriate. Substantiating this is that a surprising number of captives remain with holdings in money market funds that are paying zero (literally 0.00 in the case of certain money funds that invest in only US government securities). We believe that unfortunately, behavioural finance applies in these instances. All too often there is a ‘trickle down’ effect from a captive’s parent company, particular if the parent is a publicly traded institution.

The mindset of how the parent invests its balance sheet assets overlies how the captive invests. This methodology sometimes gets lost on the difference in the parent company’s mandate (preservation of capital—more on this later) versus the captive’s mandate as an insurance company (to protect principal and meet regulatory requirements, but to also outpace inflation, costs, and preserve the relative ability to meet future claims liability with current dollars). And in the case of captives that have parents that are private companies, to preserve the future ‘wealth’ of the captive as a wealth transfer vehicle.

"With fixed income securities interest rates at near all-time lows-- and even negative in real terms-- we believe investors should cast a wider net in search of income."

For the past several years, one way a captive has been able to mitigate costs, but also stay completely risk averse, is to look for cheaper credit options, for example, by switching their letters of credit (LOCs) to very low cost insurance trusts. In our opinion, a move such as this may bean appropriate manoeuvre for some, but there are drawbacks. First, a captive may pay in the realm of 0.03 percent to 0.07 percent in fees to the trust provider versus say 0.30 percent to 0.60 percent in LOC fees. This looks viable on the surface, but the trade-off is more limited investment choices and collateral options.

If the cost of the trust is say 0.07 percent and the underlying investment option is yielding, say 0.03 percent, then the captive could actually have a net cost instead of a net profit (again, not including other costs of operating the captive). On the other hand, LOCs generally have a larger range of accepted collateral, giving the captive a broader choice of investment possibilities across asset classes including, but not limited to, cash, bonds, stocks, commodities and real estate. The potential asset returns—even in today’s very low interest rate environment—could be far more significant with a diversified investment portfolio, tailored to the captive’s proverbial risk tolerance, or level of acceptable volatility.

So, the important question remains: what are our full options and what is the right deal to strike with a bank or investment manager? Ongoing financial turmoil and prolonged economic weakness across the developed world make it harder for captive insurance companies and their respective parent companies to balance their core objectives of stability of value, while growing at an internal rate of return that exceeds the rate of inflation and internal liability costs.

These things have continued to be a bit contradictory, with interest rates at very low levels and the costs of operating a captive or any other insurance programme at, or above, those of previous years. The core question that continues to be asked, and one we think will continue to be asked based on our forward macroeconomic outlook, is: ‘how do I grow my capital base when growth is so hard to come by? Also, even if I am highly risk averse, does it make sense to allocate to other asset classes such as equities, given the recent outperformance of that asset class versus bonds and cash?

Let’s review some basics relative to a captive operation and mandate. First, the more it costs a captive or other insurance programme to operate, the less cash it retains to invest and thus use to fund current and future operating costs. These costs typically include, but are not limited to, management fees to captive managers, costs related to insurance trusts or LOCs, and internal operating and compensation costs, to name just a few. If investment returns on cash and fixed income in particular remain relatively low (or potentially negative) for a prolonged period, captives should reconsider the proportion of their total assets that are allocated to ‘no’ or ‘very low’ risk investments, in addition to their overall investment approach.

We believe that a regular and thorough review of the captive’s specific investment policy statement and its true need for liquidity is mandatory. Cash and other low volatility, short-term fixed income investments will always be part of a core investment strategy within the captive world, given the strong need to protect and preserve capital in a way not dissimilar to many other types of insurance companies or vehicles. The traditional view of fixed income investing has focused most often on yield, with little consideration for capital appreciation. But now, more than ever, we believe investors should think in terms of total return, a focus historically intrinsic to institutional investors that are charged with managing endowments, pensions, or large life or property and casualty portfolios. Total return investing is straightforward. It is easily expressed as:

Total return = income return (from interest/dividends) + capital appreciation (or depreciation if investment value falls)

With fixed income securities interest rates at near all-time lows—and even negative in real terms—we believe investors should cast a wider net in search of income. If interest rates are truly set to increase, then some investors may be well suited to maintain some levels of cash, low levels of longer duration bonds, and increased exposures to publicly traded stocks, real estate and bonds with coupons that increase along with interest rates.

As mentioned above, a review of your overall investment approach is also key. More and more captive entities and their parents are looking for assistance with a more formal asset allocation approach. This translates into how best to integrate other risk assets into portfolios. Developing a more tactical and formal investing approach provides opportunities to generate incremental yield and total return, while keeping the desired volatility of the portfolio low.

The value of cash

Let’s re-examine cash as an asset class. With market volatility near all-time lows, economic and political concerns swirling globally, and increasing expectations of higher interest rates, investors may be tempted to keep a larger than usual amount of cash on the sidelines as protection against these risks.

This position may cause problems in future years. Cash provides a negative real return (return/yield minus inflation) and should be used sparingly while waiting for opportunistic entry points into other asset classes. For example, US inflation is approximately 1.7 percent, so the only thing guaranteed by holding a lot of cash is the continued loss of purchasing power. Holding $100 cash in, say, a US Treasury-only money market fund yielding 0.0 percent at current inflation levels will produce in five years the same statement balance of $100 (assuming that current yield remains the same).

If we now adjust for inflation (again, assuming inflation remains at current levels), that same $100 is now worth $90.57. So although your investment account statement in 2018 will initially indicate that you lost no money over the preceding five years, you’ll quickly realise that you have actually lost more than 9 percent in purchasing power. The market will have picked your entity’s proverbial pocket.

Be a tactical fixed income investor

Fixed income investing will certainly always be core to a captive’s investment strategy. Bonds generally provide stable cash flows, decent yields, and offer some stability in volatile market climates and are typically viewed as conservative portfolios. But we could be moving into an era where losing money on fixed income is the norm. Investors, in particular those who are averse to mark-to-market losses in their safe assets and who do not plan necessarily to hold their bonds to maturity, should be aware of the way bond maths works and take steps to help protect the principal values of their fixed income portfolios.

Currently, yields on government and corporate bonds are at or near all-time lows, and one important aspect to be mindful of in fixed income investing is the concept of duration, a measurement of a security’s sensitivity to interest rate moves. It is the approximate percentage change in the price of a bond for a 1.00 percent change in interest rates.

The higher a bond or portfolio’s duration, the more sensitive it is to interest rate moves, and the more a captive stands to lose if rates begin to rise. In the case of the five-year US Treasury, which has a current modified duration of approximately five years, if yields were to fall 1.00 percent, investors would make about a 10 percent return. If yields were to rise 1.00 percent, investors would stand to lose approximately 7 percent, according to figures from Bloomberg.

Again, if held to maturity, interim market value fluctuations are only for valuation purposes, but should one have to sell that bond prior to maturity, ‘market risk’ certainly comes into play. There are various ways to potentially mitigate interest rate volatility in a fixed income portfolio. These include, but are not limited to:

•  Considering professional active portfolio management;

•  Evaluation of portfolio duration and shortening if appropriate;

•  Considering bonds with coupons that adjust or ‘float’ with changes in interest rates;

•  Considering shifting from government bonds to high quality corporate debt and lower rated debt if appropriate; or

•  Buying stocks with ‘bond-like’ characteristics such as preferred stocks or high dividend paying stocks of high quality companies.

All of the above may offer the chance to offset a move higher in interest rates. Holding the low yielding, long maturity bonds can be a recipe for significant market losses should interest rates rise substantially. Given continued record low yields, we believe extra attention should be given to a fixed income investing strategy.

Colin Freeman is the manager of the Barclays captive insurance team based in the Isle of Man. He can be contacted at:

Richard L. Zulick is a director in the Americas for the wealth and investment management division of Barclays. He can be contacted at:

The views expressed herein are those of the authors, do not necessarily reflect the views of Barclays or its affiliates, and are provided for informational purposes only. These views are subject to change and do not constitute a solicitation for the purchase or sale of any security.Diversification does not guarantee a profit or protect against a loss. Dividends represent past performance and there is no guarantee that they will continue to be paid. Investing in securities involves a certain amount of risk. You are urged to review all prospectuses and other offering information prior to investing. Past performance is no guarantee of future results. An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although the fund seeks to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in the fund. Interest rate increases can cause the price of money market securities to decrease. Bonds are subject to market, interest rate and credit risk; and are subject to availability and market conditions. Cash Equivalents: portfolios that invest in very short-term securities provide taxable or tax-advantaged current income, pose little risk to principal and offer the ability to convert the investment into cash quickly. These investments may result in a lower yield than would be available from investments with a lower quality or longer term. Real Estate Investing is subject to various risks including fluctuation in underlying property values, expenses, income and environmental liabilities. Commodities are assets that have tangible properties, such as oil, metals, and agricultural products. Investing in commodities may not be suitable for all investors; they should only form a small part of a diversified portfolio. Commodity asset classes tend to have higher volatility and downside risk compared to traditional asset classes like bonds and equities. The views contained herein do not constitute tax advice. Consult with your tax/legal advisors regarding your particular circumstances. “Barclays” refers to any company in the Barclays PLC group of companies. Barclays offers wealth management products and services to its clients through Barclays Bank PLC (“BBPLC”) and functions in the United States through Barclays Capital Inc. (“BCI”), an affiliate of BBPLC. BCI is a registered broker dealer and investment adviser, regulated by the U.S. Securities and Exchange Commission, with offices at 200 Park Avenue, New York, New York 10166. Member FINRA and SIPC. Barclays Bank PLC is registered in England and authorized by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. Registered No. 1026167. Registered Office: 1 Churchill Place, London E14 5HP.