1 January 1970Asset management analysis

European investment blues

If you have picked up a newspaper anywhere in Europe over the past few years it would have been difficult to avoid the dire headlines describing flat-lining European economies and the imminent demise of the European project. While things haven’t quite gone the way of Greece, there have been—and still are—worrying signs for the health of European economies. Europe’s markets have been similarly afflicted by the malaise, with sovereign debt denting confidence in previously safe instruments, while corporate returns have been far from pre-crisis levels.

European captives have found themselves caught up in the drama and they face a troubled investment environment. Traditional conservatism has been augmented by concerns over previously safe instruments and close attention from parents looking to pep up their own balance sheets. Much like for the wider economy, the last five years have been difficult for the captive industry, but what exactly are their exposures, can they insulate themselves from the worst of the crisis, and will events prompt a change in their investment approach?

Fortunately, captives’ exposure to the worst of the European underperformers—the so-called PIIGS of Portugal, Iceland, Ireland, Greece and Spain—has generally been limited, explained Anandi Nangy- Kotecha, associate director of analytics at A.M. Best Europe. Nevertheless, Europe’s insurers face exposure to troubled eurozone economies “both through their investment exposures to sovereign, financial and to a certain extent corporate debt, and their business exposure to markets where consumer demand has been curtailed”, said Nangy-Kotecha.

Regulatory demands are likely to place an additional burden on captives, she added, with Solvency II capital requirements adding further pressure on captives to “explain the maintenance of any assets that have been severely downgraded over the last year or so”. This is something they need to do in conjunction with their parent as they “review their risk appetite and tolerance levels with the view to maintaining a certain level of capitalisation”.

"Operating and core cash needs to be liquid, whereas strategic cash used to invest in longer-dated securities to maximise yield pickup, while minimising volatility."

Captives are also facing pressure from parents looking to minimise costs and maximise investment returns, said Colleen McHugh, corporate investment adviser at Barclays. Doing so in the present environment will be no mean feat. As McHugh explained, “The risk:return theme is forcing captives to reassess the benefits of higher potential yields, if these yields can only be achieved through unacceptable risk.” Such returns might well have been possible prior to the financial crisis, but now captives need to “protect their reserves and be more selective and informed when placing deposits and making investment decisions”.

Navigating troubled waters

Key to navigating the troubled investment waters will be those relationships built with trusted investment advisers, said McHugh, with such partnerships enabling captives to make better informed investment decisions. Discussions can help captives to understand “where risks are heightened and discover how asset allocation and diversification can add to investment returns while minimising volatility”.

McHugh said that captives are looking to conform to the current mantra of “‘return of capital’ as opposed to ‘return on capital’”, with “few investments fitting this category more than a portfolio of shortdated bonds. Short duration, fixed income strategies have proved very successful for captives”.

“Captives have also embraced the need to segment their cash reserves into the different classifications of operating, core and strategic,” said McHugh. “Operating and core cash needs to be liquid, whereas strategic cash can be used to invest in longer-dated securities to maximise yield pickup, while minimising volatility.”

Loan-backs, which are a feature of the captive-parent relationship, have also received an unexpected boost from the eurozone crisis, with parents pursuing such an approach for liquidity purposes and captives exploring the option as an alternative to low-rated bonds, said Nangy-Kotecha. This, coupled with cash or money market-type investments, fits well with a conservative investment strategy, even if they provide less attractive investment returns. Nevertheless, there are risks associated with loan-backs when the parent is itself financially stressed by economic conditions, she said, with captives having to tread carefully in the current market.

Parents are also introducing greater oversight of captive investments in response to troubled conditions. As McHugh indicated, with captives necessarily needing to respond to unpredictable claims emanating from the parent, and with the economic crisis “compounding this aversion to investment risk, parents are vying for increased insight and dialogue in connection with their captive’s investment strategies”. For some captives this will extend as far as requests for contributions to “fill any liquidity gaps in the group”, said Nangy-Kotecha. What is clear is that greater scrutiny of investment strategy is inevitable.

Solvency II and its implications

Captives are facing further constraints on their investment strategies as a result of Europe’s impending Solvency II regime. Although its final details and application to the captive sector have yet to be finalised, the regulation will inevitably “encourage diversification of investments, as different capital charges will apply for different levels of concentration risk”, said McHugh. This will lead to a change in investment behaviour.

Captives that pursue riskier investments can expect to “attract additional capital charges under Solvency II”, said Nangy-Kotecha, with the sector needing to pay close attention to solvency capital requirements and minimum capital requirements as set out by Europe. As she explained, “Captives that present a good buffer over their capital requirements will have more flexibility in the investment choices they make.” Those that don’t will find themselves inevitably impacted by the European regime.

McHugh added that regulations outlined under Solvency II would, however, “give a zero spread weighting to all AAA/AA rated sovereign debt, so captives could be tempted to reduce their holdings of longterm corporate debt in favour of sovereign bonds”. This is in spite of the relative health of corporate balance sheets, and the dire state of some European government debt, said McHugh. Captives will evidently need to establish their own view on individual risks and investments, with the help of investment advice.

Looking further afield

With ructions continuing in Europe, some investors have begun to look further afield—to developing market debt and equities—as a means to perk up their portfolios. But are captives well-placed to explore such alternatives? McHugh said that emerging market debt is likely to play an increasing role as the industry looks to diversify its holdings, but suggested that the initial focus was likely to be on emerging market debt, rather than equities. She added that such markets display considerable potential and that captives “ignore this market at their peril. Furthermore, as corporations in emerging markets become bigger and more sophisticated, this will lead to a surge in new captive formations, themselves insuring the risks of their emerging market parents”.

Nangy-Kotecha spoke in rather less glowing terms about the potential of emerging markets, arguing that opportunities for debt investment in cash-rich emergents are “not as abundant as in developed countries”. The second factor limiting captive involvement in the emerging market space is that “many emerging countries’ sovereign ratings on a foreign currency basis are unlikely to be very high. However, exposure through equity funds in emerging markets is not uncommon”. Emerging market investments are evidently worth exploring, even if captives need to be aware of their limitations.

Improving their rating position

Ratings are an attractive way for captives to improve their interface with the commercial market and strengthen their corporate governance framework. Investment behaviour inevitably forms part of the rating decision, with events in Europe testing the rated captive universe. As Nangy-Kotecha explained, “A captive’s investment risk appetite and tolerance is seen in combination with both its available capital on a risk-adjusted basis and the management’s ability to monitor and take decisions when a critical level (on capital erosion) is more apparent.

“Conservative investment strategies focusing on the A-range rated debt liquid funds attract lower capital charges and, therefore, leave the company with a larger capital base for other risks such as underwriting and reinsurance credit risks,” she said. Close attention to investment quality will play its part in the rating decision.

Addressing what captives can do improve their rating, McHugh said that “conservative investment bias” and economic turmoil in Europe had “impressed upon captives the need to tweak their investment strategy”. “What is important though is the need to look forward and not peer through the rear view mirror. In today’s market this means a certain acceptance of fundamentals which are clearly pointing to stretched valuations for sovereigns. In contrast, equities are undervalued and are currently offering an interesting entry level for captives to add a small allocation to this asset class.

“Continued assessment of a captive’s investment portfolio and aligning this to economic fundamentals will strengthen overall returns. This will in turn lead to enhanced capital strength, something appreciated by both the parent and the rating agencies,” she added.