Captives and investments portfolios: separating myth from reality

Jack Meskunas (pictured left) of Oppenheimer & Co and Mikhail Raybshteyn (pictured right) of EY explore some of the market’s thoughts and views when it comes to captive insurance investments and considerations.

With decades of service to the captive insurance industry, we frequently feel as though we have “seen it all” with regard to captive insurance investment strategies and portfolio management approaches. There are, however, several industry approaches to asset management for captive insurance structures, and in order for captives to maximise the returns on their investments for a given level of risk, these approaches need to be discussed and analysed.

Approach #1: Parent company loan-backs is a sufficient investment strategy—myth or reality?

This is a big one and why we put it first. A number of captives seek a more streamlined approach to investments and turn to strategies such as lending excess cash available for investment back to the parent company and letting the parent invest it, while earning a moderate (average arm’s length guided) return in the form of interest income and potentially forgoing a higher yield returns. On the captive’s books, this is held as investment.

While this approach is common and often discussed at the onset of captive’s formation or at certain points during captive’s life span, it may not be the most effective for majority of the captives and may hinder the ability of a captive insurance company to build additional surplus that could be used to expand the captive insurance programme, take on additional risk, provide potential policyholder dividends in the future, etc.

As observed by the Oppenheimer team, some parent companies and their internal investment divisions feel the assets that would be in the captive are “too small” to be invested on their own and such separate investment portfolio would be inefficient from a fee perspective and would be better handled by the corporate in-house CIO. While this is not uncommon, the focus of non-insurance corporate CIO and investment strategies may be very different from those needed to be employed by an insurance enterprise.

While some regulators are accepting of loan-backs, from the longevity and viability standpoint, it may be worth revisiting the investment decisions and consider a separate strategy for a captive, executed by a captive insurance-focused asset manager to provide higher returns that are better matched to portfolio longevity and expected claims activity.

Food for thought: while this approach is not a myth, by far, it is something that should be weighed against other opportunities and options.

Approach #2: New captives need to keep cash on hand—myth or reality?

People who attend captive conferences with some regularity most likely have heard conversations and claims, at times, that new captives need to keep cash because … who knows. While it is true that sometimes “cash is king”, in the captive insurance space this is not necessarily true all the time. Unless there is a concern that a captive may, depending on policies it wrote, need a large amount of cash to pay claims, or lacks the necessary reinsurance to protect the captive as a “going concern” if such large claim comes in, cash should be invested. 

NB: in the cases described above there may be other issues to resolve, aside from investment decisions. While it is easy just to leave the money in cash, the opportunity cost of doing so is large, particularly when rates are as high as they are now.

It is not uncommon to see feasibility studies that either ignore investment returns, or plug in a (usually low) round number of 2 percent, 3 percent, or 4 percent as expected investment returns. While this is done for executive convenience and speed to market, this area should not be overlooked. Given that over time the investment returns are frequently one of the most profitable activities of a captive (or should be), it may be misleading to pull an anticipated investment return number out of thin air. 

The timing is the key here and why it is always a good approach to leave four to six months for a captive formation. A better strategy is to have a customised portfolio analysis for the captive, and use the expected returns from that in the captive feasibility study. More realistic return numbers may highlight other opportunities for the captive right from inception.

Food for thought: cash may be king when the power is out in your neighborhood, but in the captive insurance space keeping cash sitting around is far from optimal and you will be better served with a prudent investment strategy.

Approach #3: Money market funds are “investments”—myth or reality?

In the investment business we love our “sayings” and those with gallows humour are frequent. For example, there is a saying that “interest rates go up the escalator and down through the window!” The meaning here is that rates generally rise slowly through a series of increases by the Federal Reserve, but when the Fed decides to change course and lower rates, they typically do it very quickly and sharply as shown in Figure 1. 

Figure 1: Federal Reserve funds rates since 1980

The issue here is that while there are times when money market rates seem sufficient or even attractive, those times have generally been short-lived, as history analytics show. While users of the money market funds with the “attractive rate” were temporarily satisfied with their returns, opportunities most likely have been missed—while rates were high—to extend duration by investing the money in a bond portfolio that would allow them to earn that higher rate over a longer period of time and maybe even better match claims longevity.

Before the Fed possibly starts cutting interest rates later this year, it may be a good time to rethink the short duration investment approach such as money market funds and extend duration through other investment options. Those extending duration are likely not only to lock in higher rates now, but also likely to see significant capital appreciation in their portfolios as the prices of the bonds they are holding rise as interest rates fall.

Food for thought: just like in golf, good players needs to perfect their short game and their long game. The key in the captive insurance market is to seek advice from a professional investment manager “caddy” as to which game will move you closer to that trophy.

Approach #4: Bonds are bonds are bonds—myth or reality?

Bonds are NOT all created equal. There is quite a variety, with government bonds, corporate investment-grade bonds, corporate “high yield” bonds, and municipal bonds. In addition to these, add convertible bonds (bonds that can convert into underlying equities), baby bonds (typically $25 value and trade like stocks), zero-coupon bonds, and asset-backed securities offered as an entire “alphabet” of synthetic securities such as CDOs, CLOs, CBOs, CMOs, and CSOs, to name a few.

Each of these types of bonds react to interest rates differently, with some reacting quite linearly—like government bonds which (if held to maturity) are considered “riskless”—to high yield bonds or collateralised mortgage obligations (CMOs) that may be more or less sensitive to interest rates and changes in interest rates.

Synthetic securities tend to change not only in price, but also in expected maturity (quoted as “average life”) when interest rates move. As a recent and powerful example, as the Fed funds rate went from 0 percent to over 5.25 percent in 18 months, CMOs that were issued with 3 or 4 percent coupon mortgages went from an “average life expectancy” of 10 years out to 25 years! Imagine what that does to the value and liquidity of your portfolio.

It is logical if you think about it—who would refinance a 3 percent mortgage with a new 7 percent one? Conversely, CMOs issued now with 7 percent coupons that are expected to last 15 or 20 years may pay off in two or three years if rates go down substantially.

Food for thought: the reality is that you can use a variety of investments in your captive, and invest wisely to help your captive maximise its return on investment and value. The myth is that you can do it in a vacuum, therefore consult professionals and take expected changes in market conditions and interest rates seriously into consideration.

Approach #5: One-size-fits-all portfolios are appropriate for all—or are they?

Just as one-size-fits-all clothes don’t really fit anyone well, one-solution-fits-all captive insurance investment portfolios may tick the box of asset management, but they lack the customisation captives deserve. It is important to pay homage to the business of the captive. What kinds of risks is captive insuring? What do the frequency and severity of risks look like? How well is the captive capitalised, and how financially capable is the parent company to assume uninsured risks?

As a financial advisor, Meskunas spends a lot of time speaking with captive managers or the captives directly to get a better understanding not only of the risks insured, but also the risk tolerance of the captive owners. Let’s take two examples of medium-sized captives he advises.

The risks insured are similar but the risk tolerances of the owners are polar opposites. One utilises private equity, hedge-funds, equities and bonds while the other is interested—and invested—only in six-month maximum duration investment-grade corporate bonds. The one-size-fits-all asset managers may suggest putting both clients into their one blended portfolio. This aligns well with the saying “If your only tool is a hammer, everything starts looking like a nail!”.

Food for thought: one-size-fits-all is in fact a myth. The reality is that a captive owner and a captive manager should consider all moving parts of the captive insurance business before settling on the investment strategy.

Approach #6: Passive investing is better than active investing—true or false?

This is an age-old debate. Arguments have been made favouring passive over active, and active over passive ad nauseam. While an argument can be made that if your time horizon is “forever” the argument for passive is stronger, anyone with a memory that goes back to 2022, 2020, 2018, 2015, 2011, 2008, 2002, 2001, and 2000 will know that passive investing left equity investors (and others) somewhat flat-footed, with unhedged and directional losses that could not be avoided with a passive-only strategy.

As recently as 2022 and 2020, passive investors saw markdowns in their portfolio ranging from 20 to 40 percent at any given point. Captives generally can’t afford to be in a position where they may be forced to liquidate to pay claims at “inopportune” times in a passive portfolio. In all the years mentioned—nine out of 23 years, or 40 percent of the time—active investments generally protected investors from the volatility and market lows. In summary, one of the best ways to make money in the equity markets is to not lose money—or at least to have less volatility so that even when investments decline, they resume growth from a higher base than the passive investors.

Taken to the next level, captives that can use hedged or alternative strategies often profit in times of market volatility. Larger captives that can participate in these “lower liquidity” strategies can smooth the returns in their portfolios over time.

Food for thought: no matter the strategy, don’t forget to invite your captive domicile regulator to the table. Attractive returns may not always come from approved investments, so getting the regulator on board is key.

Approach #7: Bond funds are the same as investing in bonds, mutual funds are the same as investing in stocks—maybe?

Funds of stocks and funds of bonds are not quite like owning individual stocks and bonds. This is a particularly important distinction for captives, regardless of their domicile.

Bonds have stated coupons and most pay interest semi-annually. Interest income from bonds may or may not be subject to tax withholding for offshore captives. Bond funds generally “convert” interest to dividends and while that recharacterisation may not mean too much to an onshore captive, it may subject certain offshore captives to a 30 percent withholding on the payments.

With 30 percent withholding, a 5 percent yield bond yield becomes a 3.5 percent bond fund yield. Another important feature is that bond funds don’t have a stated coupon or maturity. While the underlying portfolio may have an “average maturity” it is constantly reinvesting and buying and selling bonds based on the whims of primarily retail investors.

Open end equity funds (they have five-letter ticker symbols) generally have “embedded” capital gains, and just to make matters worse, when the stock market is in decline, and the retail investors are selling, the funds often are forced to sell stocks that have large capital gains. This creates a double whammy effect of both losing money, and getting a tax bill on your 1099 for your “realised capital gains”.

Food for thought: know what you own, and why you own it—and what the tax consequences of your holdings could be in both “up” and “down” markets. Or simply put: measure twice, cut once (so to speak) when it comes to settling on investment strategy and allocation.

Jack Meskunas is an executive director of investments and a captive insurance asset management advisor at Oppenheimer & Co. He can be contacted at: jack.meskunas@opco.com

Mikhail Raybshteyn is a tax partner in the Ernst & Young Financial Services Organisation Insurance Sector and is the Americas Captive Insurance Services Co-leader. He can be contacted at: mikhail.raybshteyn@ey.com

The views reflected in this article are those of the authors and do not necessarily reflect the views of any organisation or such organisation’s global members.

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