The mechanics of an informed decision
Let us start with the basics. For a parent, setting up a captive is an exercise in improved risk mitigation at better cost. Your captive is supposed to be the optimal insurer for the dominant risks in your business. Hence choosing your captive manager and your reinsurance programme wisely are keys to a successful optimisation of your liability coverage at reduced costs.
Liability and asset risk
Liability risk is not the only risk a captive should focus on. The asset side is as important as the liability side—after all, they are part of the same balance sheet. When the assets of a captive are invested they are subject to market risk, credit risk and liquidity risk.
This is why many captive owners take what they think is an ultraconservative route and invest in money market funds. The problems with money market funds, however, are threefold. First, they are still heavily tilted towards credit instruments, despite the fact that in 2007 and 2008 some money market funds had to close down because they ‘broke the buck’ and had to be bailed out by their sponsors in the credit meltdown. Second, even if they are invested in credit, their yields are still very low and they barely cover their fees. Third, the most important problem is that money market funds do not provide the correct hedging instrument for captives—they do not put them into a risk-neutral state.
Engineering a risk-neutral state
So what is the risk-neutral state for a captive, and how does one achieve it? The correct approach comes from research into optimal asset-liability management (ALM) strategies. Essentially the concept is: hedge your declared liabilities with static fixed income portfolios, and hedge your expected unrealised liabilities with dynamic fixed income strategies; only after this can you use some excess return strategies with care.
This sounds complicated so we’ll explain the three parts. Take, for example, a medical malpractice captive. It has a few claims outstanding and they are already estimated with a high degree of certainty. They will take eight years to be completely paid off and their value is estimated at $2 million. Other claims have not occurred yet, but actuaries have already projected that for this particular business one should expect a series of claims that will have an average duration of six years and a severity of $10 million.
If we then assume the captive is capitalised to the tune of $15 million, the ALM research we conducted suggests that the optimal strategy is the following:
• Hedge your $2 million of declared future losses with a high-quality bond ladder;
• Invest the $10 million of expected but unrealised claims in a managed duration strategy with an average duration of six years. Managed duration strategies are dynamic fixed income strategies that act as interest rate risk management tools. They buy longer-term bonds when yields fall and reduce the maturity of the bond portfolio as rates rise. They use only the highest credit government and supra-sovereign securities. (We speak from first-hand experience in this matter as we have developed, and have been managing, such strategies for the past six years.); and
• The $3 million that is left can theoretically be invested into a higher risk, higher return strategy, for example an equities, commodities or alternatives fund. However, it is very important to make sure that the risk:reward characteristics are worth it. The main focus is on maximal potential losses and whether those losses can negatively affect the captive paying claims. One has to study very carefully the potential confluence of business and financial risks to make that decision. The key is not so much to choose the right asset class to diversify into, but to choose an investment management strategy that has the relevant reward:risk characteristics and low or negative correlation to the underwriting cycle of the captive.
Dynamic ALM: the feedback loop
An investment strategy cannot be seen as a separate activity from the business’s overall needs. The two have to be coupled, and the business needs—in particular the underwriting cycle and the occurrence of unexpected large claims—should be the driver behind the risk-taking on the financial side, particularly when it comes to excess return strategies outlined in point three above. It is important that the investment manager has continuous contact with, and feedback from, the captive client. When business circumstances change one should adapt the client’s portfolio accordingly.
Addressing credit risk
"It is important that the investment mangager has continuous contact with, and feedback from, the captive client. When business circumstances change one should adapt the client's portfolio accordingly."
We have touched already upon credit risk in a captive’s portfolio, but it is important to highlight the importance of the investment manager’s credit research in helping steer clients away from trouble. It should be both a top-down and a bottom-up approach. One should study the bond issuer’s domicile and what is happening on the macroeconomic and political fronts. Then one should drill into company specifics, covenants, collateral, guarantees and the like to get a solid fundamental picture of the issuing company. Finally, one should focus on the markets and figure out whether the bond is trading in a compatible way to its ratings. The trouble is when it is not—and this is the signal not to touch it.
Choosing an investment manager
Follow the suggestions outlined and the decision to choose an investment manager should be a simple one. The main focus should be on choosing an investment manager who is acting primarily as an investment risk manager, someone who functions as a fiduciary both on the asset and the liability sides of your balance sheet.
Why opt for a Bermuda bank?
First, let’s address the question: ‘Why opt for Bermuda as a choice of domicile?’. Bermuda is the largest and oldest centre of captive management expertise. The word captive was coined here and you have a large contingent of lawyers, trust practitioners, accountants, actuaries, captive managers,administrators, reinsurers and investment managers all specialising in captives here on the Island. This depth of expertise has helped to create a collegial atmosphere in Bermuda, one in which people help one another and those firms that call the Island home. Bermuda banks are an integral part of this captive industry—all of them play a role in it, albeit with different edges.
Dr. Eugene Durenard is a consultant - head of research and product development at Capital G Investments. He can be contacted at: email@example.com Andrew Marsh is head of institutional and fixed income management at Capital G Investments. He can be contacted at: firstname.lastname@example.org