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5 May 2017EMEA analysis

Thinking positive: looking beyond the investment gloom

As with any arm of investment, returns continue to be squeezed and negative yields are sweeping the bond market. Being able to generate a meaningful amount of income from a bond portfolio is becoming more difficult by the day.

Overall, people have been very gloomy about the investment outlook over the past couple of years, but returns have actually far outpaced economic growth—primarily due to Central Bank intervention. The compression in yields has resulted in capital gains across the fixed income spectrum, but future yield expectations have been under pressure, so any positivity needs to be tempered with realism.

As an example, in the EU, a captive with a conservative investment approach could have returned 6 percent over the past 24 months, despite the uncertain political outlook and the fragile economic recovery. In the US a similar approach would have achieved returns in excess of 10 percent, significantly more than the 2.5 to 3 percent annualised GDP growth seen in the US, so the picture is not quite as gloomy as current sentiment suggests, and there are certainly opportunities out there.

That said, return expectations should still be somewhat reserved for the next few years as it will take a while to come out of this cycle. A flexible approach will enable investment managers to make the most of the opportunities that do arise.

Practical steps
Here are four practical steps that boards should be taking to overcome the current challenges.

Review your asset allocation and investment policy
Are you making the most of the capital available? Does Solvency II or any other recent regulatory change have an impact on your portfolio? Are you reviewing your investments based on projected future returns rather than historic returns?

Is your investment policy statement or investment guidelines set up in a way that reflects your current risk appetite and allows your manager some flexibility to take advantage of market opportunities? Are you controlling risk or are you chasing yield without an underlying investment process?

Ensure your asset manager has flexibility
Your asset manager needs to have the ability to assess investment opportunities across asset classes but still be in control, with fixed income remaining the biggest focus for your captive. That said, buying an ‘off the shelf’ fixed income fund may not cut it, especially if you’re matching short-term liabilities with short duration and low yielding fixed income.

You need to find an asset manager with more creativity and a genuine specialism to best take advantage of current market conditions. You also need to be cognizant that regulatory restrictions (for example, Solvency II considerations) may limit your available options.

Exhibit full control over the investment process
Good governance and transparency are essential. Do you understand the investment process being followed by the manager or is it a black box service? Does your investment manager provide enough reporting and risk analysis for the board to make informed decisions?

Reduce the fees you’re paying
Captives need to make sure they’re getting value for money. That has always the case but is more important in this low-yield environment. I would suggest reviewing all the fees of the investment manager, custodian bank, and any other account fees and trading costs.

The board’s focus should be on how much it costs to run the investment portfolio, not just headline fees. Most important, captives invested in funds need to find out how much they’re paying. Usually, funds publish a total expense ratio which you pay on top of every other cost.

You may not recognise this fee and it may be much higher than you thought. If your asset manager is explaining that your portfolio is likely to return 2 percent going forward but that the cost of running the portfolio is north of 1 percent, that should focus the board on looking again at the underlying costs.

Maximising returns
Each board will take a different approach to investment. Some of my clients are very explicit about wanting to make their capital work hard, while others prefer to see the investments take a back seat to allow the board to focus on underwriting standards and achieving a return from the liability side of the balance sheet. In general, boards with more time to review the investments tend to take more investment risk.

Delegation, not abdication, of board responsibility is appropriate when it comes to investments. However, boards should still be able to identify what risks they’re taking and what kind of changes in the investment environment would warrant a change in direction. Boards still need to set the direction of the portfolio, risk budget, asset allocation, etc, although they may need the investment manager’s market insight to allow them to make those decisions.

Managing capital wisely should be an integral part of any insurance business plan, so the investment manager is absolutely in the position to contribute to the success and strategy of the captive. Boards should not view their capital as a standalone pot and should be asking their investment managers to add value to the process of managing the money; not simply selling their generic bond fund in order to meet a sales target.

Thinking about risks
Return on capital is very different from a headline investment return number, and this discussion can often get lost in the detail of the day-to-day running of a captive. Captives, like all insurers, receive insurance premiums upfront on the basis that they’ll be required to pay claims in the future.

This basic model leaves captives holding large sums of money, relative to the capital on the balance sheet, which will be eventually paid out as claims. However, those claims do not need to be paid today and in the meantime that money is available to be invested for the benefit of the captive.

If a captive holds $4 in reserves for each $1 of capital, an annual return on the portfolio of 2 to 3 percent produces a return on capital of 10 to 15 percent—and that’s assuming underwriting profit amounts to zero.

With a long-term outlook, you can quickly see that shrewd investment management can contribute meaningfully to the overall business strategy of the captive.

Since 2006, when its institutional division was established, London & Capital has taken these considerations into account when building each investment portfolio for our captive clients, with a clear focus on capital preservation, risk management and transparency. In these turbulent times, it’s a conservative approach that will win out for captives.

Chris Dalziel is executive director at London & Capital. He can be contacted at:

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