In the aftermath of the financial crisis that impacted global markets over the past two years, a number of captive insurance companies experienced losses in their investment portfolios and are now contemplating strategies around unrealised losses on their equity and even some bond portfolios.
At the same time, there are other captive boards quietly patting themselves on the back for staying in cash and high quality fixed income during this volatile period for world markets.
Holding cash and high quality fixed income during this time resulted in capital preservation, something of paramount importance for many captives. Heavy exposure to riskier assets such as equities and alternatives over this period would have led to substantial losses. In this article, we will explore the various different investment options available in the context of the risk appetite of a typical captive at different stages in its life. We will seek to draw some conclusions about optimal asset allocation for captives in the context of the financial crisis, both in the seemingly more volatile short term and in the longer term.
Firstly, in terms of risk appetite it should be said at the outset that the needs of captive insurance companies tend to differ substantially from those of other investors in the way that they evolve over time. If one considers the average private client investor, for example an individual planning for retirement, in the most basic terms they would typically tend to be more risk-seeking at the outset of their investment relationship and more risk-averse toward the end.
The rationale for this is fairly simple: investment theory tells us that it is better to hold riskier, higher-yielding assets at the outset in order to achieve higher returns. Volatility is relatively unimportant as there is plenty of time to make up any losses. As the investment plan nears its conclusion and the individual approaches retirement, this is not the case and the scope to sustain losses is substantially reduced.
In contrast, for captive insurance companies the “captive life cycle” (shown below) typically prevails. After incorporation the fledgling captive generally starts by holding deposit-type products (cash) while insurance premiums flow in and the company gains an understanding of its potential future expected claims. Once the captive has built up an asset base, they will then tend to look at fixed income solutions designed to generate higher returns while at the same time offering some safety and liquidity. As the captive starts to build up surplus funds, they may consider adding modest exposure to equities to their investment portfolio to further enhance portfolio returns and diversification.
Depending on risk tolerance, at this stage some captives may even consider diversifying further into areas such as alternatives. The final stage for a captive comes when premiums cease to be paid and the company enters ‘run-off’. Here, assets are retained to cover potential future claims and once again preservation of capital becomes paramount. In this scenario, the captive will typically seek out some sort of asset-liability matching arrangement, for example utilising a laddered bond portfolio. (See Figure 1)
In addition to the considerations set out in the “captive life cycle”, many captives will have to factor in additional considerations when making their investing decisions. For example, the parent (or members in a group captive) may require dividends to be paid to them on a regular basis providing that the captive is successful in its underwriting programme. A consideration such as this can restrict the ability of a captive to diversify into riskier assets because they may lack the surplus they need in order to assume additional risk in their investment programme. It can also mean that the captive requires a greater focus on income generation throughout its life, for example by investing largely in coupon-bearing securities.
Another consideration might relate to letters of credit. In this scenario, the captive could well be using their investment portfolio as collateral to back a letter of credit (LOC) to cover the deductible on an insurance policy with their reinsurer. Most banks issuing LOCs will allow cash backing at 100 per cent of the value of the LOC, but as the captive moves into riskier assets the loan-to-value ratio typically goes down. So a captive with an LOC facility and only a small surplus might be limited in terms of the amount of risk they can take on. This may mean that they have little choice but to hold cash or cash equivalents irrespective of where they are in the life cycle.
Finally, regulatory considerations will inevitably play a part here. The Cayman Islands Monetary Authority has not established any prescribed limits on the asset mix for captives and each case is considered on its own merits. However, changes to a captive’s asset allocation beyond agreed limits generally require CIMA’s approval and the regulator will likely want to review the captive’s financial strength and balance sheet in the context of their risk tolerance before sanctioning any changes. Needless to say, a similar approach is likely to apply to regulators in other reputable jurisdictions also.
In practice, considerations such as this mean it is unlikely that a captive insurance company will stray far beyond an asset allocation of 80 per cent fixed income and 20 per cent equities. In our experience, there are a few larger entities that are willing and able to take on more risk than this, typically within the group captive space. However, for all but the largest single parent captives an allocation to equities of more than perhaps 30 per cent of the value of the portfolio seems unlikely. Fortunately investment theory and history tells us that this is not necessarily a bad thing.
The chart below shows the “efficient frontier”: the set of investment combinations over the longer-term that have produced the best combination of risk and return. It can be seen that the 80 per cent fixed income/20 per cent equities allocation discussed above sits on this frontier. Not only that, in comparison with a portfolio consisting solely of fixed income assets, over this time horizon the 80/20 portfolio has produced superior returns for fairly minimal additional assumed risk.
Once an investor moves beyond the 80/20 allocation and diversifies further into equities, it is possible to achieve greater expected returns, but risk also increases significantly. Given the focus of many captive insurance companies on preservation of capital, this is not necessarily desirable. While volatility is not such a concern if an investor remains fully invested for the long-term, this is often not the case for captives.
Many will see significant withdrawals and contributions throughout their lifespan and timing issues come into play here. The worst-case scenario for a captive is the need to withdraw funds to pay a claim at a time when the markets have dipped substantially (as occurred over the last two-and-a-half years). Someone heavily invested in equities clearly faces greater risk in this regard. This suggests to us that for most mature captives, modest exposure to equities with the bulk of the assets invested in high quality fixed income is likely to make the most sense from a risk/reward perspective. (See Figure 2)
So if investment theory tells us that modest diversification makes sense for captive insurance companies over the longer term, how has this worked out in practice? In order to assess this, it is worth looking at the performance of a number of asset mix combinations over the short-term (the last three years) and the longer-term (the last twenty years). It is worth mentioning that both timeframes encompass the worst period for equity markets since the Great Depression of the 1930s. In other words, not exactly a representative sample of what we would expect to see from that asset class. However, the thinking here is that if a captive investment portfolio with modest exposure to equities can fare reasonably well over such a challenging period, it is well positioned to see good performance through most sets of market conditions.
With this caveat in mind, how did captives with this sort of approach to investing fare during the recent financial crisis compared with their peers either holding cash or invested solely in fixed income? The answer seems to be not too badly at all. The table below shows returns for a number of different asset allocation scenarios over the three year period up until the end of June 2010. It is clear that a captive holding solely fixed income over this period would have fared best, generating annualised returns of 5.7 per cent. However, we can also see that a captive invested in 80 per cent US fixed income and 20 per cent global equities would have returned 2.5 per cent annually over the same period, ahead of the 2.1 per cent return achieved on cash. In other words, captive insurance companies that remained fully invested over what was arguably the worst financial crisis since the 1930s fared better than those who held cash.
Of course, there are issues here around the need to access the assets of the investment portfolio over this period. The maximum drawdown for the fixed income portfolio was -1.4 per cent while maximum drawdown for the 80/20 portfolio was -10 per cent. In other words, if an investor in the 80/20 portfolio had needed access to all of their funds at the worst point in the crisis, they would have experienced a 10 per cent loss at the worst point in the crisis. This may not be acceptable to many captives and is certainly something that needs to be borne in mind when considering the various investment options available. (See Figure 3)
If we turn to the longer term and look at performance over the last 20 years, we can see that post-financial crisis, including equities has really added very little apart from more risk to the model portfolios analysed. Returns from the 100 per cent fixed income portfolio are virtually identical to those achieved by the 60 per cent fixed income/40 per cent equities portfolio. The only difference is that risk is higher for the portfolios with equities and the maximum drawdown is higher. Additionally, these numbers are before the deduction of fees and fees are typically higher for an equity portfolio versus those for fixed income.
So does this mean that captive insurance companies should abandon equities and focus purely on cash and fixed income investments through their life cycle? While it is true that the decision has become more finely balanced over the last three years, we would argue that the answer to this is still no. As we highlighted earlier, this period has been one of the worst on record for equities and an exceptionally good one for high quality USD-denominated fixed income. While equities were sold off sharply on fears of global recession and the risk of a depression, high quality bonds (notably US government issues) rallied sharply on a flight to quality as investors sought a safe haven from the market turmoil. This period of extreme divergence in asset class performance remains baked into the long-term data for each asset class. (See Figure 4)
If we were to exclude this period of exceptionally volatile market conditions, we see a slightly different picture. The table above shows performance of the various different model portfolios in the 20 years to 31 December 2007 (in other words prior to the start of the financial crisis). While we would be cautious in using selectivity in the presentation of data, it is certainly the case that the last three years of data continue to skew the long-term numbers for asset class performance. A t the same time, our perspective is that valuations for equities remain at historically depressed levels while we believe return prospects in the near-term from both cash and fixed income remain modest. We would suggest that both captive insurance companies and indeed other investors should consider this in the context of their investment decision-making.
So what does all this mean for captives?
We have looked at what investment theory tells us about asset allocation decision making and we have examined the impact of the financial crisis over the last three years. Our overall conclusions are that
(1) modest exposure to equities remains a sensible approach for a more mature captives, depending on their risk appetite and financial position;
(2) while this exposure was detrimental to performance over the financial crisis, it certainly was not disastrous; and
(3) looking forward, relatively little has changed in the way that we view asset allocation decision-making, albeit that the decision to diversify into equities and other asset classes is perhaps a little more finely balanced than before.