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  • Colleen McHugh
  • Role
    Captive Insurance Investment Advisor for Barclays
    Location
  • “As well as the insurance management programme, captive insurers provide a host of financial benefits for their parent.”

1) To what degree should captive insurance be a profit centre for its parent? And how can captive companies improve their returns?

2) When interest rates eventually rise, what impact could this have on captive insurance assets? And what action could they take to address?

1) To what degree should captive insurance be a profit centre for its parent? And how can captive companies improve their returns?

Captive insurers have two sources of income – underwriting profits and investment income. But to understand how these work, we need to take a step back and consider what captive insurance really is. Its objective is to finance risk from its parent or affiliated groups – essentially, it’s formalised self-insurance. It is, however, much more. As well as the insurance management programme, captive insurers provide a host of financial benefits for their parent.

One of these is the concept of the captive acting as a profit centre. Increasingly, captive owners are trying to find niches in areas where they have a particular expertise to extend captive insurance company use. They can then use this to extend their captive insurance use and create profit centres by extending coverage to third parties, not owners or affiliates. Captives can be designed to offer certain insurance to existing customers, thereby creating a profit centre. For example, auto dealerships have long done this by offering car buyers extended warranty coverage through dealership owned captives.

The other facet of a captive becoming a profit centre for its parent is to focus on the assets and make them work harder. Premiums build up within the captive and are only paid out in the event of a claim. You can make the argument that the assets don’t need to stay in cash. Depending on the type of risk the captive is underwriting, short tail or long tail for instance, those assets can be invested outside of cash to try and maximise returns.

Indeed maintaining 100% exposure to cash is not effective. Over long periods cash is a poor asset class (its optionality aside), but especially in today’s era of financial repression.

The Barclays Equity Gilt Study 2014 reveals that since 1899 cash in real terms has returned about 0.80% per annum, compared to 1.2% per annum from gilts and 5.1% from equities. In the decade to 2013 shares have returned 5% a year, gilts 2%, while cash has lost 0.5% a year, albeit that we must recognise the risks of loss of capital for non-cash investment. If the idea is to make the captive a profit centre then at some point the prevailing conservatism around investing the captive’s assets need to abate.

The degree to which a captive becomes a profit centre for its parent is ultimately determined by the parent. As the captive moves through its life cycle and evolves and matures from its original form of collecting premium and covering limited risk to an experienced underwriter with confidence in the ability of capital markets to drive returns on assets and acceptance of the investments risks, income from underwriting as well as investment income increases and in doing so the captive becomes a profit centre.

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2) When interest rates eventually rise, what impact could this have on captive insurance assets? And what action could they take to address?

Rising interest rates will be good for a captive’s cash assets. Balances held on call or term deposit with banks will earn more interest. The reality though is that rates will rise far too slowly and at such increments to merit any benefit.

At the moment markets are pricing in a 25 basis point rise in UK rates around the first quarter of 2015 bringing base rates to potentially 0.75%. But what reprieve does an extra 0.25% offer captives whose running costs are creeping higher and whose underwriting profits remain under pressure in what is still a soft insurance market? Interest rates need to move north of 2% to at least keep pace with inflation to make any real difference to captive cash assets. And we may need to wait until 2017 to see rates reach that level.

For captive insurers with bond portfolios, once rates do begin to rise, low bond yields look less attractive, as prices tend to fall and yields rise. There are two possible outcomes therefore for captive insurers with bond portfolios. Captives who buy bonds at low yields could be locking in uncompetitive returns or face a capital loss if they sell before maturity.

To address the first scenario, it’s imperative that the duration of the bond portfolio be kept relatively short and be actively managed to take advantage of the rising rate environment when it finally arrives, whilst being firmly focused on any potential credit risks. The use of Floating Rate Notes and SWAPS will also minimise duration risk.

Finally an active bond manger will take advantage of global monetary policy divergence, which will lead to policy dispersion. Specifically tighter monetary policy in the UK and US (rates going up in these regions) might see a manager buy shorter dated bonds in these regions and looser monetary policies in the Eurozone and possibly Japan would allow longer duration positions in these regions and thereby maximise the cumulative yield on the bond portfolio.

Realising a capital loss on bonds if they are sold before maturity can be avoided by formulating a bespoke investment strategy for the captive – matching assets with liabilities etc. But also remaining vigilant around credit risk (something an active bond manger is paid to do on behalf of the captive). Remove the need to sell a bond prior to maturity and avoid a capital loss in a rising interest rate environment – implement a buy and hold to maturity strategy.

When all is said and done though, central banks appear in no hurry to raise rates. Indeed in Europe and Japan bond-friendly monetary policies are still being actively pursued and as a result will continue to offer bond investors in these regions uplift.

The issue is that captive managers aren’t really incentivised to look for new ways to make profit. This is because their primary function is to underwrite the risks of the parent and keep assets safe. They won’t necessarily be rewarded for risking the assets. Ultimately captive managers provide a very good service but it’s commoditised. Managers need to ask how can they differentiate themselves? The answer is to be more proactive. You could use the treasury expertise within your captive team to look at assets and drive business.

What we have to keep in mind is that there are a lot of changes at work in the money market industry. In the US, the SSC has announced changes in how money funds are operated – some of them are moving from a constant Net Asset Value (NAV) to a floating NAV, which is quite a big change. And whatever happens in the US eventually makes it way to Europe. There are lot of captive assets in moneymaking funds. This is a development that’s worth keeping an eye on.

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