- Captive Insurance Investment adviser, Barclays Wealth & Investment Management
“Our view of the economic climate at the moment is that we’re quite positive, whilst remaining aware of the likely risks.”
If we look at the current economic environment, we see a lot of political and economic unrest out there. Politically what’s happening in Ukraine is having an impact across all asset classes. On the fixed income side, it’s lowering yields and we’ve seen the 10-year UK gilt and 10-year US treasury fall from 3% in December to around 2.6% currently – Treasuries/Gilts rally as investors become more risk adverse in periods of volatility and the mood becomes risk off as opposed risk on.
Aside from what’s happening in Ukraine, a lot of financial commentators are drawing economic parallels between what’s happening now and what was happening 20 years ago in 1994. Back then we saw the Fed suddenly raise interest rates. Unexpected rate rises 20 years ago marked the beginning of a prolonged period of underperformance, which resulted in the Asian financial crisis. Well – guess what – we’re in a period of monetary normalisation right now too. The FED is tapering its bond purchases whilst the FED and the Bank of England are amongst developed central bankers discussing imminent interest rate hikes. Whether or not this interest rate rise will happen as soon as some forecast i.e first quarter 2015, is a discussion for another day. The fact of the matter is that there is much volatility in emerging markets at the moment, with all asset classes in the region in negative territory. Some of this volatility is certainly related to monetary conditions in the US, but much of it is specifically domestic in nature to specific countries, China for example. Regardless of these idiosyncratic risks there are a lot of parallels being drawn with 1994 and there is a lot of nervousness in the market as a result.
All this noise aside our view of the economic climate at the moment is that we’re quite positive, whilst remaining aware of the likely risks. We expect a faster growing global economy in 2014 but there will be some bumps along the way.
2) What do you see as the options for captives to generate yield pick-up from assets classes other then cash?
From an investment perspective, really the first step for a captive insurer out of cash is something like a short-dated bond portfolio – typical duration of 18 months, high credit quality. Now the objective of that type of portfolio is first and foremost capital preservation, but it will also provide liquidity, counter-party diversification and hopefully yield pickup. The important thing to remember is that we try to pick up yield but not at the expense of the other objectives. Consequently you may only see a100 basis point return on this type of portfolio.
This won’t help you out-perform inflation but what is important is that it will generate yield slightly better than cash, whilst not being overly sensitive to an increase in interest rates, an increase which is being priced in for early 2015. Remember bond prices are affected by rising interest rates but a short-dated bond portfolio won’t be as sensitive to rising interest rates compared to longer-dated bonds. That’s why short dated bonds are a good first step out of cash for any captive insurer.
High yield bonds are interesting. Again they’re not so sensitive to rising interest rates. What they are sensitive to is credit default but in the current climate of improving data, credit default is less of a concern in the fixed income space in contrast to, let’s say, interest rate risk. However, what I would say is that there’s not terribly much value in high yield at the moment. Prices have got a little bit ahead of themselves and certainly for the captive insurer portfolios we manage, we are reducing high yield exposure.
Equities is an asset class captives could look at. What you’ve seen over the last few years is that captive insurers have endured much opportunity cost through avoidance of any allocation to equities. Of course some would say, “the whole point of the captive insurer is that they can’t take risk with the assets. Those assets have to be available to call upon if there’s a claim.” Absolutely, that’s true. But cash isn’t exactly the risk-free trade that captives perceive it to be. Really, a larger and more mature captive could have a small allocation to equities. The way to do that is to conduct a proper claims analysis. You look at your incoming premiums, you determine if they’re providing a surplus versus outgoings and then you examine those assets and segregate them into different categories - For instance, into core, operating and strategic cash. It’s those strategic assets that could or should be invested in equities. I’ve made the case to many captive insurers to do so.
One way for a captive insurer to invest in equities is through a risk-managed strategy whereby the captive could gain exposure to the upside of equities but limit some of the risk – you hedge out the risk. So, for instance, let’s take 2013 when the FTSE returned 14%. If you were to have employed an equity risk-managed strategy last year you probably only would have returned 7%. Hypothetically assume the equity markets were down 5%, that same risk-managed strategy could produce positive returns. The point is that captive insurers can have an allocation to equities, many do, the key is to manage the volatility, manage those market-to-market movements because captive insurers do not like to see volatility on the asset side. Barclays is offering these types of risk-managed strategies to captive insurers.
The simplest way to hedge some of the equity risk is to construct a portfolio consisting of multiple asset classes. The idea being that there is a negative relationship (correlation) between certain asset classes i.e UK/US treasuries and equities. If markets are falling you see a flight to safety and safer assets will outperform riskier assets. Additionally we invest in volatility indices to diversify our captive insurers equity risk – based on the negative correlation between equity returns and volatility. Finally we manage our captive insurers equity exposure in a dynamic manner and are not beholden to a benchmark which requires at all times a specific percentage allocation to equities. Indeed we could reduce our equity exposure to a zero weighing if we felt the environment warranted it. This allows us to achieve the objectives of capital preservation and hopefully upside to the tune of 4-5% p/a. In short there are ways for captives to invest in equities but the key really is to do it through a strategy that minimises their volatility.
An allocation to cash is always worthwhile in any portfolio. I don’t think anyone – captives included – should underestimate the optionality of cash, meaning that cash on hand in a volatile market gives you that flexibility to purchase assets in the future at discounted prices. It’s a mistake to feel compelled to be fully invested in equities for example in an environment where there are few investment opportunities. However, I don’t believe we’re in such an environment – we’re not in a situation where there are no attractive investment options for captive insurers, because there are. Although a captive should have an allocation to cash, it should not be a 100% allocation to cash. Why? Well interest rates in the UK have remained at 50 basis points since 2009, we’ve got inflation running at close to 2%. Right away that’s a negative net return of 1.5% per annum. If the primary objective of the captive insurer is to preserve the value of its assets, maintaining a 100% exposure to cash is not the way to do so. In addition what I’m seeing at the moment are captive insurers under a lot of pressure on the insurance side. There’s the soft insurance market on one hand and, some parents questioning if they even need a captive when they could buy cover direct from the market, whilst on the other hand the assets are not generating a positive yield pickup to cover what they could do a few years ago, and that is to essentially pay for the running of the captive insurer. One way for captives to add a bit of value is to try and make the assets work harder. It’s all a question of balance.
Investing’ doesn’t mean an increase in the likelihood of a captive losing its capital. What it does mean for a captive is an increased time commitment on their part to examine their investment options. Gone are the days where interest rates are 5% and captives are self-funding and they don’t need to do anything with their assets. Rather now captives are outside their comfort zone and the pressure is on. It’s created a conundrum –assets need to generate a higher return but at the end of the day what is the ultimate objective of the captive insurer? It’s a risk transfer agent – it takes on risk from the parent and if there’s a claim, the assets need to be available. So how do you ensure the assets are there when needed while still trying to generate some kind of positive yield? See my point earlier on risk managed equity strategies.
Furthermore, captives that have been in place for a few years do have the ability to estimate their likely future claims. And on the back of that analysis, they can implement a programme to match assets and liabilities. For example, if the average maturity of the liabilities is five years, the captive could easily invest in a bond portfolio of maximum five year duration. It’s that simple. And I know that the rising rate environment may cause bond prices to fall but it’s the job of an active bond manager to manage that risk. What’s more, in this specific example, the captive is essentially investing in a buy and hold portfolio. As long as that’s the case and they continue to pick up the current yield, which is higher than cash, then it’s a win-win situation. It’s the job of the investment manager to manage the credit risk of the portfolio and pick up that additional yield where available but remain cognizant of the innate need for captive to preserve capital.
Well with the pressure of a soft insurance market going back over the last eight years or so, there are more and more questions around the need for a captive to write insurance risk. There’s also extra pressure on the asset side, where yield has really been squeezed, and we started seeing that from 2009 when interest rates across the globe were slashed. At the same time we saw equity markets begin to recoup some of their sizeable losses from 2008, beginning with positive equity markets in 2009, 2010, 2012 and 2013. Many captive insurers are now seeing the opportunity cost of staying in cash for the last few years instead of investing, and what they could have achieved had they made a small allocation to equities.
In our view it all comes back to my first point – where we are now in the economic landscape. Despite similarities with the market 20 years ago, we do expect growth to continue in developed markets. Whilst we don’t expect the same returns from equity markets as 2013, developed markets should deliver positive returns in 2014. The difference being it won’t be as smooth a sailing as last year.