1 January 1970

Brave new world of investment portfolios

In a wide-ranging conversation, Scott Elphinstone, managing director and chief investment officer of Five Continents Financial Limited, a member of the Scotiabank group of companies, discusses the post-meltdown market and how traditional asset allocation strategies failed to take into account a number of factors that need to be considered in developing investment policies for captive investment portfolios.

Cayman Captive: What important factors are often not properly considered by captive insurance company shareholders and managers when determining and establishing investment policy?

Scott Elphinstone: Many captives did not appropriately consider the creditworthiness of their own bank. Without extensive government support, funds on deposit with many US banks would have been lost. While the banking crisis appears to be nearing its end, bank failures are at highs not seen since the Great Depression. The other factors that we often see include:

• A failure to appreciate that captive insurance portfolios are there to meet specific insurance reserve needs and are not mutual funds. This has allowed portfolios to contain more risk assets than they should have

• The lack of awareness that investment opportunities are not limited only to the US, and

• The important recognition that simply because a captive investment portfolio is structured offshore does not mean the portfolio is not highly regulated and tax-free.

CC: How do you view the US banking industry?

SE: It wasn’t only the US banking industry that got into trouble late last year. Many of the European banks followed the US model of using high leverage and banking a fantastic amount of loans to high-risk borrowers—either directly or indirectly through mortgage-backed securities. We could spend the rest of the week discussing the reasons why this happened, but let’s focus on today. In our view, if interest rates stay near zero for very much longer, there would bea risk that despite regulatory action, we may have another round of problems. If you can borrow from the government at basically no cost, there is a temptation to borrow a lot and let it run in the markets to rebuild profits. I think that is one of the reasons why the equity market has moved up so strongly. This is a time I would be conservative and stick to banks rated in the ‘AA ’ or better range. This was one of the factors we looked at when we were searching for a strategic partner and chose Scotiabank. Scotiabank is rated ‘Aa1’ by Moody’s, its second-highest possible rating, and has been ranked by Bloomberg as the ninth-largest bank in the world. In fact, all of the Canadian banks have done very well in this crisis, which reflects their strong domestic franchise and conservative nature.

CC: How do you distinguish between a captive investment portfolio that looks and performs like a mutual fund and an insurance-sensitive portfolio?

SE: Many captive shareholders and portfolio managers would rather look at the captive investment portfolio as a mutual fund. Unfortunately, or perhaps rather dangerously, this view overlooks the fact that the captive, unlike a mutual fund, makes money primarily by underwriting insurance and managing insurance risk. The reality of it being that an insurance company has a number of implications for investment policy and portfolio returns, among them:

a) T he portfolio needs to have liquidity to cover unexpected levels of claims. This results in a reduction in possible returns from the captive portfolio and an emphasis on holding cash and fixed income investments. Captive interests must learn to live with this reality and understand that the nature of insurance operations means that the core of the portfolio will be invested in cash and fixed interest investments.

b) Providing collateral for any required letter of credit or other credit enhancement structures will affect investment policy. The portfolio manager must make certain that the bonds dovetail the credit curve in respect of term-to-maturity restrictions that may be imposed by the bank.

c) The captive is a regulated entity. The regulator, for the protection of the captive itself and of the broader insurance industry, has a say in the asset mix of the captive portfolio. From a regulatory point of view, most jurisdictions, including the Cayman Islands Monetary Authority (CIMA), are of the opinion that “the more conservative, the better”. The CIMA, depending on each captive’s circumstances, has been very flexible in dealing with this issue.

Being an insurance entity affects the captive’s investment policy. Captive shareholders, captive managers and captive portfolio managers must all focus on the return on equity of the whole of the business, rather than merely the returns of its investment portfolio.

CC: Why would captive shareholders and portfolio managers not use the opportunities for profit available to an offshore captive structure from a global portfolio?

SE: While the benefits of investing globally in equities are more broadly understood due to the efforts of John Templeton and others, the fixed income market also offers tremendous values for thinking globally. Even if you chose, for risk reasons, to limit your fixed income investments to say US dollar-denominated bonds, the Eurobond market offers a greater variety of high-quality corporate and foreign government bonds that trade at a discount to US Treasury notes and bonds.

CC: Why should the captive portfolio not hold, for example, highrated US dollar-denominated Kingdom of Denmark bonds at a spread over similarly rated US Treasury notes and benefit from the enhanced return?

SE: At Five Continents, we call this ‘picking up nickels’, which is a simple exercise in adding value to our captive investment portfolios. In addition, we include in our portfolios large international corporations outside the US, which tend to be more highly rated as many entities operate with government support and a reduced focus on leverage to boost short-term returns to shareholders.

CC: What tax and regulatory pitfalls await a captive investment portfolio managed offshore?

SE: This is a complex area and I insert the mandatory tax warning for specific accounting and legal advice. That said, even offshore is not a tax-free world. Income tax and increasing regulation have major effects on portfolio construction for a captive insurance company. At Five Continents, we ask whether the captive is liable to pay income tax on its portfolio income. There are many examples we could cite where captive investment portfolios suffered as a direct result of portfolio managers making costly errors in security selection and portfolio construction. It is the portfolio manager’s responsibility and ongoing obligation to understand clients’ specific and particular circumstances.

If a captive has not elected or cannot elect to pay US federal income tax, withholding tax can be an issue. We know of onshore portfolio managers that converted a non-taxable stream of interest income into a taxable one. For a captive to find itself in this unfortunate situation, all the onshore manager has to do is buy a US-domiciled bond fund.The reality is that most withholding tax can be avoided by careful planning. For example, hold the bonds directly and avoid the fund.

We continue to learn of investment portfolios that are suffering the punitive tax implications of investing in funds that are classified as Passive Foreign Investment Corporations (PFI Cs) only because the portfolio manager did not avoid offshore funds. A better choice would be US-listed exchange traded funds (ETF s). Unfortunately, if errors are committed, they are not easy to correct or compensate. Taxation and increasing regulatory issues are not only difficult to understand, but they vary by jurisdiction and can yield unintended results if proper planning is not carried out. Obtain professional advice, right at the inception.

CC: Final thoughts?

SE: When creating an investment policy and looking for offshore portfolio management expertise for a captive insurance company, make sure you consider the realities of the global market, the requirements of being an insurance company, income tax and regulation.

What worked yesterday does not necessarily continue working today.

Scott Elphinstone is chief investment officer of Scotia Five Continents in Cayman. He can be contacted at: scott.elphinstone@scotiafcfl.com