How captives can stay strong
Commercial insurers, with their significant human and capital resources, have certain advantages when it comes to coping with the challenging business environment facing the insurance sector. Their scale makes it easier for them to bring in the necessary expertise, create operating efficiencies and diversify their sources of risk to protect against these headwinds.
“The key objective is to understand how the asset and liability risks behave relative to one another.”
Captives, on the other hand, have felt the changes particularly acutely. They are constrained by fewer resources, have a less diversified line of business and are often less flexible when it comes to managing their investment portfolios.
However, captives can still add value in many ways, even in the evolving insurance environment. Despite resource constraints, there are ways to address these challenges through their investment portfolios.
The challenges facing captives
Captives typically outsource certain functions to third parties, which large insurers tend to keep in-house, such as oversight of investment management and actuarial work. In some cases, this may result in a lack of communication between the investment side of the business and the underwriting side, which can lead to ineffective asset-liability management. It may also lead to suboptimal allocation of risk between assets and liabilities and inefficient use of regulatory capital.
Captives also tend to face a higher degree of balance sheet volatility, due to having comparatively less diversification in their assets and liabilities. This increases the balance sheet sensitivity to market shocks and liability events.
The regulatory environment can present other challenges for captives. In some domiciles they must rely on prescribed regulatory capital calculations, due to the lack of resource and inherent complexity of using available bespoke methods. This can limit their flexibility in terms of available asset classes, as prescribed methods tend to be more punitive for certain assets such as unrated debt, even where larger insurers rely on bespoke methods to justify a less punitive treatment. This is certainly true for many risk-based regulatory regimes such as Solvency II.
Four steps to sustainability
The insurance market has become more complex to navigate, but this presents captives with an opportunity. There are four areas in particular where captives can quickly and efficiently realise value in their investment portfolios (Figure 1).
1. Balance sheet and risk budget review
The world in which captives operate has gone through a seismic shift over the past decade, making it increasingly important to perform a comprehensive review of their risk appetite and risk exposure, to ensure they are not exposed to unrewarded risks.
Captives have been forced to reposition their portfolios to take into account low interest rates, high asset values and paltry bond yields. The next step is to consider how the future economic risks specific to the insurance industry, such as falling premiums, increasing reinsurance rates and rising long-term interest rates, may affect their balance sheet.
The key objective is to understand how the asset and liability risks behave relative to one another and how this could be categorised.
2. Update the risk management statement
After reviewing risk budgets, captives should reflect any changes in their risk management statement. This needs to be articulated in a quantitative and measurable manner that can be understood and easily repeated. For example, captives may want to consider whether the risk budget between investment and underwriting risk reflects the evolving environment as well as the most applicable capital measure to reflect these risks.
3. Review asset liability management
Given the importance of profit levels and balance sheet strength, captives should conduct a review of asset liability management. This involves identifying key scenarios and stresses that may have a significant negative impact on profitability and balance sheet strength. It is particularly important to identify any liability risks that may be correlated to investment risks in the portfolio and manage these relationships.
4. Position portfolios to reflect new risk appetite
The final step is to position the investment portfolio to reflect the changes identified in the earlier steps, maximising the margin over required investment returns. Captives do not always have the resources or budgets to invest in a broad range of asset classes, so this is crucial for them. A good asset manager should provide access to assets in a capital-efficient manner and be able to understand the business while managing the asset-liability risks.
Straightforward solutions with clear benefits
- A focus on “low-hanging fruit” reduces the cost and time required to strengthen the captive.
- A more robust balance sheet is somewhat immunised against the most adverse outcomes.
- In most cases, a natural outcome of this type of approach will be a lower and more efficient regulatory capital position (Solvency II focuses on the one-in-200 event which would systematically be accounted for with this approach).
- Working with an investment manager that understands and can execute investment strategies in line with insurers’ liability requirements creates a positive feedback loop that should result in a stronger portfolio and balance sheet over time.
- A more efficient capital position allows release of assets that may be used to improve asset and liability management or seek extra return.
Kate Miller is a partner and head of institutional, and Shadrack Kwasa is executive director, at London & Capital. They can be contacted at: email@example.com