Toughing it out - portfolio management
As a global captive insurance banking team, we are regularly introduced to captive owners who are either frustrated by low returns on their captive’s assets or worried about investment risk and volatility. This is especially the case where some or all of their captive’s assets are pledged as collateral for letters of credit (LOCs) or insurance trusts. While each captive’s circumstance is likely to be unique, a common theme is that returns have been sacrificed either because of a collateral requirement, or from a fear of entering the market and diversifying away from cash. A surprising number remain with holdings in money market funds that are paying (in their words) ‘nothing’.
Certainly captives must, first and foremost, focus on their primary purpose as insurance vehicles and should respect their obligations to meet their claims and their solvency criteria, as required by their regulators. But against a background of rising costs—especially credit costs, limited credit appetite from banks and low investment returns— many captives are reviewing their portfolios and cash holdings and asking whether a better deal could be struck.
For some, the solution has been to look for cheaper credit options, for example by switching their LOCs to banks quoting lower prices or by moving to insurance trusts and thereby removing credit costs. The next step is to seek out investment managers who can partner with the new arrangements. But these routes should be followed only after an extensive consideration of the restrictions imposed on the assets by the LOC or trust provider/beneficiary. The potential asset returns—even in today’s very low interest rate environment—could be far more significant than the LOC or trust expenses. So one really important question for all captives to ask is ‘what are our full options and what is the right deal to strike with a bank or investment manager?’.
Ongoing financial turmoil and prolonged economic weakness across the developed world make it harder for captive insurance companies and their respective parent companies to balance their core objectives of stability of value, while growing at an internal rate of return that exceeds the rate of inflation and internal liability costs. These things have become somewhat contradictory, with interest rates at all-time lows and the costs of operating a captive or any other insurance programme at, or above, those of previous years. The core question that continues to be asked, and one we think will continue to be asked based on our forward macroeconomic outlook, is: ‘how do I grow my capital base when growth is so hard to come by?’.
Let’s begin with some basics relative to a captive operation and mandate. First, the more it costs a captive or other insurance programme to operate, the less cash it retains to invest and thus use to fund current and future operating costs. These costs typically include, but are not limited to, management fees to captive managers, costs related to insurance trusts or LOCs, and internal operating and compensation costs, to name just a few. If investment returns remain relatively low for a prolonged period—which we expect—captives should reconsider the proportion of their total assets that are allocated to ‘no’ or ‘very low’ risk investments, in addition to their overall investment approach. This almost always begins with a thorough review of the captive’s specific investment policy statement and its true need for liquidity.
Cash and other low volatility, short-term fixed income investments will always be part of a core investment strategy within the captive world, given the strong need to protect and preserve capital in a way not dissimilar to many other types of insurance companies or vehicles. The traditional view of fixed income investing has focused most often on yield, with little consideration for capital appreciation. But now, more than ever, we believe investors should think in terms of total return, a focus historically intrinsic to institutional investors that are charged with managing endowments, pensions, or large life or property and casualty portfolios.
Total return investing is straightforward. It is easily expressed as: Total return = income return (from interest/dividends) + capital appreciation (or depreciation if investment value falls)
With fixed income securities interest rates near all-time lows—and even negative in real terms—we believe investors should cast a wider net in search for income.
Sub-asset classes to consider within fixed income include developed investment grade and non-investment grade bonds, convertible bonds, and preferred stock. As we mention above, a review of your overall investment approach is also key. More and more captive entities and their parents are looking for assistance with a more formal asset allocation approach. This translates into how best to integrate other risk assets, such as high quality dividend paying stocks, real estate and emerging market debt, into portfolios.
Developing a more tactical and formal investing approach provides opportunities to generate incremental yield and total return, while keeping the desired volatility of the portfolio low.
The value of cash
"Specifying the perpetuity objective in this way allows us to focus on the trade-off between the costs to operate the captive and short-term investment risk."
Let’s examine cash as an asset class. With market volatility near all-time lows and many significant economic and political concerns swirling globally, investors may be tempted to keep a larger than usual amount of cash on the sidelines as protection against the risks facing the market. As an example, US inflation is approximately 1.4 percent, so the only thing guaranteed by holding a lot of cash is loss of purchasing power. Holding $100 cash in, say, a US Treasury-only money market fund will produce in five years a statement balance of $100.05 (assuming that current yield remains the same).
When opening your investment account statement in September 2017, it will initially appear that you’ve not lost money over the preceding five years. However, once you go to spend those dollars, you’ll quickly realise that you have actually lost nearly 7 percent in purchasing power (assuming the inflation rate stays at current levels). Effectively the market will have picked your entity’s proverbial pocket.
A recent client situation put all the above into practice. A US-based middle market staffing company with a Cayman-domiciled captive had a high cost LOC with a US regional bank. They were invested in deposits of that LOC-issuing bank and in various US government money market funds and direct US Treasuries and agencies. Capital surplus was positive and premium dollars were being added each year with very little ‘loss pick’ needs.
After a thorough interview with the client, along with a comprehensive review of its investment policy, we realised several things. First, the client’s policy was outdated and needed formalisation. Second, the captive’s sole allocation to cash and short-term liquid investments was too high relative to its level of liquidity, excess surplus, and internal annual cost hurdle of approximately 3 percent. Third, the cost of its LOC facility was too high, based on the effective over-collateralisation of the facility itself. Subsequently, we broadened the client’s investment policy within its regulatory framework, created a customised investment allocation across various asset classes and within a conservative risk profile, and ultimately lowered its LOC costs by utilising excess collateral more efficiently to back the facility. Clearly a ‘win-win’ for the client.
Most parent companies want their captives to remain in existence for a long time. This usually suggests investment goals that we can define as the perpetuity objective—namely, that the real (inflationadjusted) value of the entity’s investment portfolio and the real level of distributions from that portfolio should not decline over any period of years. Specifying the perpetuity objective in this way allows us to focus on the trade-off between the costs to operate the captive and short-term investment risk. In particular, we can identify the optimal level of portfolio risk—determined principally, but not solely, by the average proportions of cash, bonds, equities and other asset classes included in the portfolio—that gives the captive a good chance of meeting its objectives.
Colin Freeman is the manager of the Barclays Captive Insurance Team based in the Isle of Man. He can be contacted at: firstname.lastname@example.org