Raghu Ramachandran, head of insurance asset channel, S&P Dow Jones Indices
Making returns in a low interest rate environment is particularly challenging for captives. Exchange-traded funds provide an option that circumvents many of the restrictions inhibiting their investment decisions, says Raghu Ramachandran at S&P Dow Jones Indices.
Through the third quarter of 2019, the decline in interest rates has challenged insurance companies in general. For captive insurance companies, the challenge of lower interest rates is particularly acute, as they must contend with smaller portfolios and have a limited ability to adapt their allocations.
“With an ETF, the fees are not dependent on the size of the investment.”
For the property and casualty (P&C) insurance industry, investment income represents the bulk of the total income. According to S&P Global Market Intelligence data, in 2018, the ratio of net investment income to net income for P&C companies was 94 percent. Thus, any reduction or variability in investment income would represent a challenge to the overall profitability of the company. For captives the issue is even more challenging, as they have less ability to withstand changes in income.
The problems associated with low interest rates aren’t new to the industry. It has been a decade since the US Federal Reserve began a period of low interest rates, but 2019 poses additional challenges: a possible turn in the credit cycle; an increased chance of recessions; and further reductions in yields could all force companies to rethink their investment strategy.
In the year to the end of September 2019 yields on US government bonds have consistently declined (Figure 1). The yield on 10-year US Treasury Bonds has declined almost 100 bps to 1.68 percent. At the front end of the curve, two-year US Treasury Bonds have declined 87 bps and three-month US Treasury Bonds have declined 54 bps year to date (Figure 2).
Investment-grade bonds have shown a similar decline in yields (Figure 3). The yield on the S&P US Aggregate Bond Index has declined almost 100 bps to 3.28 percent, and the yield on an intermediate duration index has declined 107 bps to 2.02 percent.
Another consequence of the recent changes has been a flattening of the yield curve. At the beginning of the year, the difference between a 10-year US Treasury Bond and a two-year US Treasury Bond was 16 bps; this declined to 5 bps by the end of Q3, and was briefly negative for a period in August. The difference between three-month US Treasury bills and 10-year US Treasury Bonds has been mostly negative since May. Many investors consider an inverted yield curve an early indicator of a recession.
For an insurance company, these changes are doubly troubling. The standard investment protocol when yield curves flatten is to lower duration, but that would reduce portfolio yields even further. Lower yields also mean the present value of long-term liabilities, such as medical malpractice claims payouts, is higher. In the UK, the prescribed discount rate for some personal liability claims was set below zero, meaning insurance companies had to set reserves higher than expected losses.
For captives, the options available for tackling these investment problems are limited because of their size. Over the last decade, larger insurers have traded liquidity for yield by moving a portion of their portfolio to non-public debt. Larger companies have also moved down the credit curve to increase their risk.
Captives are boxed out of these options. In order to invest in private debt, the minimum investment size might be $5 million or even $20 million, which is likely to represent too large an allocation for most captive portfolios. Investing in high-yield debt would also require a significant allocation.
The growth in exchange-traded fund (ETF) markets allows captives to invest in sectors or asset classes to which they might not have previously had access. Over the last decade, the amount invested in ETFs has increased to over $4 billion. ETFs are like mutual funds, with one vital difference: they are exchange-traded.
This feature of ETFs provides captives with three advantages they did not have before. First, ETFs have daily liquidity, whereas some bonds are very thinly traded. This allows companies to move in and out of ETFs quickly.
Second, because of their traded nature, ETFs have better liquidity than traditional bonds. Several studies have shown that fixed-income ETFs have tighter trading spreads than their underlying securities. Even in times of market stress ETFs continue to trade, while the secondary market for bonds becomes shallow or disappears.
Finally, ETFs allow investment in smaller sizes and with lower fees. If a captive wanted to invest $5 million in high-yield bonds, it might not find a manager who would accept such a small portfolio, or the manager would charge a high fee. With an ETF, the fees are not dependent on the size of the investment. A captive can establish fully diversified exposure with an investment of as little as $1,000.
While there is no data publicly available showing how captives invest, the use of ETFs by small P&C companies filing US statutory financials has increased at a compounded rate of 14 percent per year over the past 10 years (Figure 4). They initially gravitated to equities ETFs but have begun to use fixed-income ETFs more and more. In 2018, the use of fixed-income ETFs grew by 20 percent (Figure 5).
The use of ETFs might allow captives to increase their investment yield, maintain liquidity in their portfolio, invest in small size, and achieve diversity in their holdings all at the same time.
Raghu Ramachandran is head of insurance asset channel at S&P Dow Jones Indices. He can be contacted at: firstname.lastname@example.org
S&P Dow Jones Indices, Captives, Interest Rates, Insurance, Property & Casualty, Raghu Ramachandran, North America