31 May 2013Actuarial & underwriting

Risk-neutral: assuming a defensive posture

How difficult for captives are the current macroeconomic conditions?

The main difficulty comes from generally low global yields across fixed income markets. A lot of captives are in the habit of having buy-and-hold strategies in fixed income, and are essentially clipping coupons. But now is a difficult environment to receive any income this way. In that sense I would say that macroeconomic conditions themselves are not necessarily that challenging, but that it’s the state of the bond markets driven by the quantitative easing (QE) policies of central banks, that is holding yields extremely low and making returns out of an income strategy quite difficult.

Is there a danger that captive investments cannot provide sufficient asset upside to cover their liabilities?

That’s a very relevant question not just to captives but to a much broader set of institutions, such as the pension industry. If you were to try to cover liabilities in the current conditions it would be probably quite difficult to do so from a purely fixed income standpoint, at this level of yields or with a static strategy. So what’s important in asset liability management is what approach you intend to take.

In the current environment the static approach, which is basically covering your forward liabilities by matching them with your bond portfolio, is probably not a strategy that will work. Again, it’s a function of the size of the liabilities to the capital base. There are two questions: one, how well capitalised is the captive for the liabilities that it carries or expects, and two, what is the yield you can get on a static bond portfolio? If either is insufficient, you have to go to a strategy that is more dynamic and that allows you better to immunise your liabilities. There is a danger of static asset liability-matching techniques leaving most liabilities uncovered, as is presently the case.

Is the liquidity of the portfolio important, and are there shortfalls?

Personally I would avoid getting into illiquid assets or investments on the fixed income side right now, whatever the capital position of your captive. As for young captives or those that have had losses from claims, they’re probably not in a position to invest in more esoteric assets anyway. If we think about the fixed income world right now it is very rich in the sense that yields are low. Yields are low not just on government bonds, but also on credit and high yield and any spread product you can imagine.

Clearly there is more risk on the upside for yields, potentially resulting in capital losses on your bond investments. Hence in this situation it is probably better not to extend, either in credit or in duration . If we were in a situation such as 2009, where you had a widening of credit spreads, with a lot of cheap assets out there, then my answer would be rather different. It’s a question of valuation at this point in time and you often have situations in the markets where illiquid assets depreciate more than liquid assets when there’s stress or increased volatility. So that’s where the risk lies in fixed income markets currently.

Do the financial and insurance market conditions present challenges to those currently running or trying to set up captive entities?

Those are two completely independent points in the sense that setting up a captive is primarily a function of the level of premium that is attributable to the captive versus going to the commercial carrier for covering the same risk. Usually the captive achieves a much greater efficiency of pricing on the insurance contract side.

Obviously in situations where you have a very soft insurance and reinsurance market it probably makes less sense to create a captive unless, of course, you always have very idiosyncratic risks that you want covered. Usually people create captives not necessarily to make money out of such entities but to reduce their costs at the parent level. So investment return is important but it’s not the driver, at least in the commercial captive space.

When people form new captives they are very risk-averse and do not expect much return on their investment portfolios. In this environment, yes, you have lower returns on money market funds, that actually yield negative returns, or on static bond portfolios that may yield a negative return if rates are to go up. So again we come back to the point: what is the right investment strategy for a captive that includes the asset liability management piece? And this is where we come to the concept of the ‘risk-neutral’ state.

What is the risk-neutral state and is it possible to achieve it in the current economic climate?

One achieves the risk-neutral state when the captive is immunised from the known and expected liability stream. On the known liability side,you have a cash flow with a defined schedule to be paid out over time. Clearly one needs to have an immunisation policy which is basically static relative to that. Some static elements there need to be taken into account.

"Once the capital is utilised for the hedging of those streams-- one realised and one expected-- you can achieve a risk-neutral state for your captive."

But the important piece is the expected, but not realised, liability stream. To immunise that piece one requires a different strategy based on covering liabilities when their present value goes up. You don’t want to hedge a liability which is falling apart. As far as the liability is concerned the game is to hedge it when it increases relative to your assets. So once the capital is utilised for the hedging of those two streams—one realised and one expected—you can achieve a riskneutral state for your captive.

At this point the rest of the capital can be invested in a higher return, higher volatility strategy. The risk-neutral state is not really dependent on the economic climate. It’s actually dependent more on the state of the business, of the liabilities and of the captive. Once that state is achieved then the next step is to say: “How can we maximise the current economic climate in order to achieve returns above that?”

What assets are you recommending that captives add to their investment portfolio in order to establish a liability-driven investment approach?

From our perspective at Capital G we have been very positive on preferred equities and high dividend stocks. High yields are also attractive and, although quite rich at present, have the ability to stay there in terms of spreads and total return, propped up by a corporate sector with considerable cash on the sidelines. I don’t see much value right now in going into high grade credit; it’s very much priced in, it’s rich, and has a higher probability of widening than tightening at this point.

Those are our main investment themes. Of course we’re very careful about the credit side, about the sector side of things. There are still some sectors that are not doing as well as others. We tend to have a dynamic approach to the markets so that if the picture changes then the portfolios are adjusted accordingly in order to avoid capital losses.

Do you think you need to be more nimble due to the speed that things are changing?

I have always had that approach. A lot of people stayed with full positions in equities in 2008 and 2009, for example, and that lost them 50 to 60 percent on their equity portfolios. In my mind this is really not the right investment or management approach. You do have trends in the market and those trends tend to last for a few months so there is ample time to exploit those patterns.

You’re asking if now is the time to be more nimble and dynamic? In fact, it’s always been. A whole generation of asset managers have been spoilt by the fact that in their lifetimes there has always been an up-trend in equities. However, there are occasions when they can move sidewaysor down and as such you always have to be nimble. Look at the Nikkei for the last 25 years for example, or at US equities between 1960 and 1980.

How long do you think the sector will have to employ such a defensive posture to investments?

You always have to apply a defensive posture to investments when you are pursuing liability-driven investments. It’s a problem of investment under constraint, so the defensiveness is actually a function of such a strategy, in other words on the ratio between assets and expected and realised liabilities. And as we said before, in some sense putting the captive into a risk-neutral state is a defensive posture because you want to immunise it against the liability risk and the impact of rising liabilities.

In the current state of the market I am defensive on both credit and duration, as there is little value in long duration bonds at this point in time and there is little value in high grade credit. So I have a defensive posture in my portfolios from that perspective, but on the other hand it’s more aggressive on the preferred and high dividend equities that are used for the excess return allocation. It all really hinges on how fast there is going to be an unwinding of governments’ QE programmes, which is expected by 2015 or maybe early 2016, when there will be a return of potentially higher yields.

We also expect higher credit spreads and potentially higher inflation expectations. So the expected decrease in buying speed (the ending of the monetisation of debt) combined with higher inflation expectations that the central banks are trying to engineer are pointing to a higher yield environment and lower pricing of corporate credit. We think that this defensive posture should probably be held for that period of time. But again, things may change. If suddenly there are some inflationary pressures that are building up, the central banks will be much more dynamic in managing that and the removal of QE could come faster.

You always have to keep an eye on the global picture. Last year, for example, a lot of this was driven by European troubles, then all eyes went to the US ‘fiscal cliff’. I would expect that the European issue will come back to the fore again because people will be asking themselves, okay, it’s been a year or so since European Central Bank president Mario Draghi’s speech saying he will do whatever is needed to stabilise the euro system, and has it been done? That’s the question.

At some point the markets will refocus on that issue and potentially create more volatility. This just points to the fact that one has to be continuously watching the markets in order to stay out of trouble as much as possible.

Eugene Durenard is chief investment officer at Capital G. He can be contacted at: edurenard@capitalg.bm