8 September 2014

Captives should rely less on cash

An over-reliance on cash can be self-defeating for captives as an investment strategy; instead, they should begin to look at other asset classes that have outperformed cash in recent years.

This is a key finding of wealth manager London & Capital’s Captive Indices first edition. It explained that while ‘cash is king’ for many captives, an over-reliance on the asset class is likely to represent a “sub-optimised investment strategy, particularly in the current low interest rate environment”.

High grade corporate bonds, high yield bonds and US equities have all significantly outperformed cash over the past decade, said the wealth manager.

In a low interest environment, captives can find their money being eroded by inflation as their discounted liabilities grow.

London & Capital added that returns on cash are unlikely to cover a captive’s operational costs, let alone contribute to the cost of claims or help reduced future insurance premiums, which results in policyholder premiums have to be higher to compensate for the erosion of capital.

The wealth manager said: “In a low interest rate (and possibly inflationary) environment, the case for relying solely on cash will likely be damaging to returns. Nor is a large investment grade bond allocation likely to truly maximise returns.

“These may have been more stable during crisis periods - such as the Eurozone debt crisis of May/June 2010 - yet in the longer term their returns were lacklustre compared to assets with higher intrinsic volatility.”

Over the coming year, the wealth manager foresees that high grade corporate debt will continue to be supported by companies improving profitability and large cash reserves. However, volatility in government bond markets may result in some sporadic periods of volatility in investment grade corporate bonds.

It also expects high yield bonds to be boosted by reduced credit risk, falling defaults and attractive yields as equities enjoy the tailwind of improving company earnings and greater pricing power.