Captives may be conservative investors but even they can learn some important lessons from the financial crisis, explains William Dalziel.
Storms have a strange way of focusing the mind. Anyone who has experienced first hand the immense power of hurricanes and has had to deal with the consequences of them on their property will appreciate this. Clean-up operations after a hurricane follow a distinct pattern. Everyone knows what is expected of them and how they need to work together to resolve the problems left in the wake of the storm. A collective approach is required.
While the analogy does not bear pushing too far, for many captives, right now it feels like the morning after the storm. The difference is that many captive owners are less clear about what needs to be done to get things back on track now that the dust has settled from the global financial crisis.
The credit crisis exposed weaknesses in many critically important institutions, including banks, rating agencies, regulators, some insurers and other participants in the global financial system. As far as insurers go, the one or two large names that needed government funding were the ones to attract most of the attention. However, most insurers were affected to a lesser extent, mostly through their investment portfolios.
Surviving the storm
There is insufficient data available to fully quantify the degree to which captives—as a subset of the insurance sector—were impacted. It is likely that most came through the test in reasonable shape. In general, captives are well capitalised, have been able to maintain steady premium income and have very conservatively invested assets.
Like all insurers, the capital held within captives can only be called upon in the event of specific, contractually defined contingencies. So there can be no ‘run’ on a captive. These characteristics mean that most were able to avoid a fire sale of assets once the crisis hit in earnest in September 2008, following the collapse of Lehman Brothers.
Captives have traditionally favoured US sovereign fixed income investments. These assets benefited from the flight to safety and so bucked the trend in 2008. Along with cash, government securities were one of the few investments to produce a positive return.
The limited data suggests that few captives had investments in the mortgage or asset-backed fixed income instruments most directly implicated in the crisis, thus sidestepping some potentially large losses.
Before the crisis, following a number of years of disappointing investment returns from fixed income, an increasing number of captives started to show interest in widening their investment net. They began to take on modest exposures to equities, hedge funds and commercial real estate. The logic was sound—correctly diversified portfolios help suppress volatility and can improve investment returns.
Through the crisis, however, logic was the first victim and all risky assets were shunned by the market, leading to substantial nominal losses for the 2008 calendar year in equity holdings and smaller losses from hedge funds. In addition, many hedge fund and real estate investments suddenly became illiquid—a problem that persists today. Those captives that expanded their investment horizons will have experienced some problems, but in most cases, these were small positions within their overall portfolio and much of that paper loss has been recovered in the second and third quarters of 2009.
By and large, the damage to captive portfolios has been contained, and in most cases, the losses have not represented a risk to the viability of captives. Nonetheless, the crisis has thrown into relief a number of issues that need attention by captive boards and their asset managers.
Assessing the damage
One of the first questions captive boards need to address headon is how was it that a crisis of this magnitude could have unfolded without either them or their asset managers seeing it coming?
"Those captives that expanded their investment horizons will have experienced some problems."
While the unprecedented nature of many of the issues that featured in this crisis means that the full depth and savagery of the crisis was not foreseeable even by experienced investors, there was enough time to take reasonable protective measures. The investment committee or board members must have a shared view of the macroeconomic environment in which they are operating, and that view should help them determine their appetite for risk.
Captives need to identify how the different parts of their portfolios performed both in absolute terms and against benchmarks and their peers. The key is to try to understand why the different assets behaved as they did and what role each played in the portfolio’s overall return.
If the captive came through the crisis well, was this the result of good luck or good judgement? Many years of being overcautious in the investment approach may have served the captive well in 2008, but the opportunity cost in lost returns over previous years may have been greater than the amount at risk during the crisis.
Clearing up the mess
Some things will have been damaged during the crisis. These might include the captive’s solvency margin, the portfolio liquidity or the captive’s relationship with its asset manager.
A low solvency margin may call for an injection of fresh capital, while illiquid assets may not be a problem in the context of the portfolio as a whole. The confidence in the asset manager will either have been strengthened or irreparably weakened by the way he managed his way through the crisis.
The asset manager relationship is based on the expectation that he will discharge the role delegated to him by the board. This is likely to enter tricky waters if the captive owner does not have confidence that the manager understands the external investment environment, if the manager fails to communicate important changes to the captive or changes his investment philosophy or approach midway through a challenging period—that is, he loses his conviction. Such failures almost inevitably lead to the captive having to find a new manager it can work with.
Understanding the nature and degree of damage will enable you to determine whether it is fixable or not. Either way, a clear plan of action to repair the damage will help the board move forward and will give the regulator the comfort it needs that the captive can not only survive, but come through this stronger.
Preparing the portfolio
One thing is certain. After all the post-mortems are done, and the institutions and systems have been strengthened, the next crisis will be different to the last one. So preparing the captive and its portfolio has more to do with having the right people, processes and information in place than with trying to fight last year’s battle.
The four areas that merit particular attention are:
• Corporate governance: How is responsibility delegated by the board and how does the board maintain oversight? This includes not only board processes and documentation, such as the captive’s investment policy, but also having the right mix of skills and experience among the board’s members. Successful captives will often have to control substantial pools of capital and reserves, so the board should be able to bring a command of investment matters to bear on the day-to-day management of the portfolio
• Risk management: The identification and management of risks in the investment portfolio—the asset side of the balance sheet—is no less vital than the management of risks on the liability side. The board should understand and be comfortable with the processes, procedures and resources committed to risk management by its asset manager
• Investment process: What criteria determines whether a particular asset is suitable for the captive’s portfolio, what are the buy and sell disciplines employed by its asset managers, how consistently are those disciplines maintained? How often does the asset manager review his views and assumptions? The captive’s asset manager will be able to document his investment process. Once the board understands this, it can hold him accountable for maintaining a consistent process, lessening the temptation for the manager to ‘make it up as he goes along’ during periods of market disruption
• Communication: Captive boards appreciate the need to maintain a consistent stream of communication with their captive’s stakeholders. This helps set realistic expectations, builds confidence in the board’s control of the captive, and demonstrates to policyholders, regulators, captive owners/ shareholders that the board understands and can respond effectively to the captive’s evolving operational and competitive context. The same reasons demand that an effective communications process is in place between the asset manager and the board. The communication should include not only investment returns, but market data to contextualise the performance, information on how the performance has been achieved, and the outlook for the portfolio.
It does not take long for things to get back to normal after a storm. All the more reason for the clean-up work to take place in an orderly fashion and at a deliberate pace.
In the same way, the routines that govern the captive’s calendar will soon reimpose themselves and the board’s focus will soon be demanded by other issues. So now is the time to appropriate the lessons—clear up the mess, remove the debris and strengthen the captive’s investment portfolio.
William Dalziel is executive director, captive investments at London & Capital. He can be contacted at: firstname.lastname@example.org