Louise Twiss West and Claudio Lede ask the all important question. Segregated accounts or pooled vehicles: which is better for medium-sized captives?
Whether an investor is a sophisticated corporation or a retail newcomer, the question of whether to invest through segregated accounts or pooled vehicles is a relevant one. With recent discussions in the industry over accounting methodologies, the question is especially significant for captive insurance companies, regardless of size or complexity. Although smaller or newly formed captives may be satisfied with liquidity funds, as assets build, captives will typically look to diversify from a pure liquidity portfolio into fixed income and other applicable asset classes. This makes the issue of suitable investment management approaches even more pertinent.
While there is no generally accepted threshold for the classification of a ‘medium-sized’ captive, it is typical for a captive to appoint an investment manager upon reaching assets of $10 to $30 million. There are two dominant investment approaches available to captives within this range: segregated accounts and pooled vehicles. In this article, we review some of the characteristics, strengths and weaknesses of each alternative.
Segregated investment accounts
Segregated accounts are otherwise known as ‘separately managed accounts’ because they can be tailored to specific investment guidelines. The most common type is in the form of a ‘discretionary mandate’, as the investment manager is hired as the sole decisionmaker in the investment process, although in practice, the process is more consultative. The portfolio guidelines are the result of a collaborative effort between the captive and the investment manager, based on the company’s investment policy, and before any major shift occurs in the portfolio, client consent is generally pursued.
The different methods for offering separate accounts will vary across asset managers. For instance, very large managers can offer a range of preset investment guidelines across risk profile and asset classes that a client can choose to adopt. Thus, several small accounts can be managed in bulk using the same investment strategy for each account. The ‘customised’ experience is then delivered by the investment and reporting platform.
The segregated model is understood and welcomed by most insurance companies, risk managers and captive managers because the investment management can be specifically tailored to the client’s investment policy and thus is perceived as being more sophisticated. Within the segregated account, it is conventional for a client to hold individual securities, allowing for a cost basis accounting approach. Essentially, this accounting practice values a fixed-income instrument (e.g. a bond) based on its purchase price plus the accrued income. This cost basis reporting method avoids reflecting market price fluctuations over the life of the bond (commonly referred to as ‘mark-to-market’) and any possible impact to capital reserves. It is worth mentioning that although unrealised losses do not impact capital requirements, some regulators have started reviewing amortised cost statements to prevent major solvency issues.
Further considerations regarding separate accounts, which should be reflected on before choosing an investment vehicle, include other qualitative and practical aspects. Captives should consider the time and resources that will be consumed to select the right investment manager, as well as gain a full understanding of the elements that will build the total expense ratio, such as additional custodial, brokerage, accounting and reporting fees.
• Reporting (typically using amortised cost method)
• Customised investment guidelines and security selection.
• Unclear total expense ratio (TER)
• Requirement for additional service providers (e.g. custodian, accounting, etc.), incurring additional costs.
The pooled vehicle or ‘fund’ concept is very simple. Assets from a diverse group of investors are pooled together under common rules governed by a prospectus, which includes detailed investment objectives and guidelines. The most common types of mutual funds are usually open-ended, meaning that each single investor can invest into and redeem from the pool whenever the fund trades. Generally speaking, the asset base of the fund will be relatively steady as not all investors will subscribe or redeem at the same time.
The combined assets of many investors will benefit all of them by providing a greater scale and improved liquidity than if an investor held any single position. These important benefits are often overlooked because of the perception that funds are less sophisticated than discretionary mandates. This notion can be challenged upon the basis that pooled vehicles are commonly used to constructdiscretionary mandates for smaller to medium-sized captives. Using this model brings efficiencies of cost, scale and reporting to captives, captive managers and fund managers. Although it may seem obvious, it is worth noting that another benefit of this scale is diversification for investors by reducing exposure to single securities and issuers.
The fund approach also involves a simpler due diligence process as public information such as fund ratings, fee schedules, rankings and performance make the selection process simpler and transparent. Because of the thousands of different mutual funds available, a level of customisation is typically achieved through the variety of managers, investment styles and asset allocations chosen. Pooled vehicles, particularly passive funds such as ETFs (exchanged traded funds), are gaining prominence as an easy and inexpensive way to gain exposure to more asset classes.
As a result of the funds’ accessibility to subscriptions and redemptions, the value of the portfolio is assessed on a mark-to-market basis on any dealing day. Therefore, fund reporting is typically provided as fair value rather than amortised cost value and will reflect price movements. As regulators move towards more stringent reviews of captives’ solvency and capital adequacy, this reporting approach is gaining accounting favour, despite the fact that investment losses may trigger additional capital requirements.
• Cost efficiencies
• Simpler accounting
• Diversification and scale.
• Standard (non-customised) investment approach
• Mark-to-market valuation (losses and capital requirements).
There is no single solution that best fits all captives’ needs. A captive must decide whether to choose the customisation that a segregated account brings or the efficiencies that a pooled vehicle can provide.
With the thousands of mutual funds available to investors, the same customised approach that an investment manager offers can now be achieved through a careful selection of cost-effective funds. Captive insurers must realise that regardless of whether segregated accounts or pooled vehicles are employed, the basic principles of sound investing remain the same: look for a consistent asset management process, a strong track record, disciplined risk management and superior customer service.
Louise Twiss West is the head of business development at HSBC Global Assett Management (Bermuda) Limited. She can be contacted at louise.twiss-west@ hsbc.bm. Claudio Lede is the head of product development and marketing at HSBC Global Asset Management (Bermuda) Limited. He can be contacted at: email@example.com
Issued by HSBC Bank Bermuda Limited. HSBC Global Asset Management (Bermuda) Limited (“AMBM”) of 6 Front Street, Hamilton, Bermuda, is a wholly owned subsidiary of HSBC Bank Bermuda Limited (the “Bank”). AMBM is licensed to conduct investment business by the Bermuda Monetary Authority. The Bank is licensed to conduct banking and investment business by the Bermuda Monetary Authority.