Hard markets, increasing utilisation, and strong performance

Gregory H. Cobb of Sage Advisory Services provides insights on how hard markets are influencing the use of captives and the importance of investment strategies.

The last several years of volatility in the commercial markets have contributed to what many insurance veterans refer to as the continuation of a “unique time in the industry, scored by an atypically hard market”. And it is! The industry is now in its sixth year of firming pricing.

“A successful investment programme will require a much more disciplined and collaborative approach.” Gregory H. Cobb

What is behind this atypical market? First, persistent economic and social inflation. Second, greater and more frequent insured losses from weather-related events. Third, the scarcity and rising expense of reinsurance protection. Fourth, a 10-year-plus run of low interest rates and income generation (until very recently) which has put unusual pressure on the underwriting side of the business.

With that, the use of captives has increased significantly. Existing owners continue to utilise captives in expanding current coverages, while many organisations are establishing new captives and/or exploring additional lines which can be embedded within a captive. Captives are clearly increasing in number, size, complexity, diversity, and becoming a core component of corporate risk management strategies. 

As noted by AM Best, captives are now the equivalent of 25 percent of all commercial written premiums globally, achieving an underwriting performance that continues to outperform commercial peers. Over the last five years, captives have generated an estimated $6.3 billion (dividends and surplus growth) that would have otherwise gone to the commercial market. What’s not to love?

Fixed-income investing: normalisation

From the investment side of the house, captives are breathing a sigh of relief after more than a decade of the ongoing and elusive search for yield, often having reduced quality guidelines and liquidity metrics to capture incremental yield and income. The recent path to higher yields has not been without its challenges.

Surging inflation and a persistent and aggressive tightening of monetary policy by the Federal Reserve brought an end to the decade-long era of low yields, but with that came a sharp decline in the market value of bond portfolios. On the bright side, market dislocations have given rise to attractive reinvestment yields.

When investors can couple higher official and risk-free rates with even moderate risk premiums, yields on high quality, liquid securities become very compelling. In the current environment, investors no longer need to extend themselves so far out on the risk spectrum in order to earn a reasonable stream of income.

However, it is instructive to see the current environment in the context of two distinct periods in the modern history of bonds. The years 1980 to 2011 were a period of relatively high yields and income generation, with the general trend of ever-lower yields generating a healthy dose of additional capital appreciation—the so-called “golden era” of bonds. During the 2011/21 period, inflation and bond yields had little room to fall lower, especially as official rates fell to the lower bound of zero.

This “lost decade”, characterised by a dearth of yield and income, led to the feverish search for yield via higher risk, more complex, and less liquid securities. Today, one should not expect a return to either period. Instead, over the coming years, the environment should be more akin to textbook “normal”, where fixed-income portfolios produce a reasonable and more durable stream of income while providing strong diversification versus higher volatility asset classes.

But normal should not be considered quiet! There is no room for complacency. Most institutional investors agree that we have entered a period of elevated macroeconomic and geopolitical uncertainty. In response, they are exploring a variety of avenues to build more resilient, flexible, and sustainable portfolios while capitalising on new and evolving opportunities.

This requires a considerably more active approach to asset allocation, a more rigorous approach to diversification, and the application of more dynamic risk management strategies. For captives, this suggests that a successful investment programme will require a much more disciplined and collaborative approach across parent, captive, and investment management teams. With the investment management team at the centre of this triumvirate, proper manager selection cannot be overestimated.

Selecting an investment manager: start early

Given the aforementioned need for a considerably more active approach to asset allocation, a more rigorous approach to diversification, and the application of more dynamic risk management strategies, investment manager selection becomes paramount. 

However, in many cases within the ecosystem of a captive, investment management seems almost an afterthought. Do not be that captive. Whatever the stage of the captive’s life cycle, make a deliberate and informed decision.

When selecting an investment manager, there are a number of key considerations:

• Is there demonstrated knowledge of the captive insurance space?
• How adept are they in managing the ecosystem of the captive?
• Will they be able to effectively integrate with senior management?
• Are they fully engaged with the industry so as to provide unique insights and perspectives?
• Do they deliver investment solutions across the full life cycle of the captive?
• Is delivery focused on product or instead, on unique and highly customised enterprise-wide solutions?
• Have they delivered consistent outperformance across extended market cycles?
• What are the resources for asset liability management, asset allocation, risk-management, and sustainable strategies?
• Are relationship management resources dedicated to the insurance industry?
• Can they deliver all the above in a highly cost-effective manner?

The selection of an investment manager should be a disciplined process. Start early. Take your time. Make the right decision. And by all means, have some fun.

Sage: disciplined and collaborative approaches

With more than 25 years of experience in managing investment portfolios for the captive industry, we understand the ecosystem of the captive insurance space and are uniquely positioned to assist captive managers, risk consultants, and boards of directors in successfully managing through the unique life cycle of each captive.

Over time, and through the life cycle of the captive, the balance of risk evolves—whether through offered lines of coverage, underwriting standards, reserve development, tolerable levels of surplus volatility, or regulatory regimes. As such, we take a disciplined and collaborative approach in the pursuit of portfolio solutions that are continuously and properly aligned with evolving risk agendas and the overall enterprise-wide objectives of parent companies.

There is no universal captive playbook for investments. In practice, each individual captive or risk-bearing entity requires its own unique investment solution. These solutions demand a disciplined and collaborative approach to fully understand the role of investment risk as it relates to overall enterprise-wide objectives. We bring to bear our investment expertise, risk management capabilities, insurance-dedicated service team, and deep engagement with associations, regulators, and rating agencies—all for the benefit of all our captive partners.\

No matter where a captive may be within its own unique life cycle (de novo, reserve, mature) or where the balance of risk may lie (insurance vs. investment vs. regulatory), Sage serves as an informed and engaged partner in the pursuit of all enterprise-wide objectives.

Gregory H. Cobb is part of the Insurance Solutions Group at Sage Advisory Services. He can be contacted at: gcobb@sageadvisory.com