The sun shines on the Cayman Islands – that’s a given. But it also shines on Cayman’s captive insurance industry, despite record global yields. Within a week of the Brexit vote on June 23, global yields hit record lows on stimulus bets. It felt like only yesterday that we were gawking at a 10-year U.S. Treasury yielding just 2.19 percent, but that was in January. Fast forward six months and the 30-year U.S. Treasury yielded 2.19 percent and the 10-year reached a record low at that time of 1.378 percent.
Most Cayman captives are U.S. dollar denominated and managed according to conservative investment mandates – i.e., they hold a lot of low-yielding U.S. dollar denominated bonds. Negative interest rates would clearly cause for a lot of pain – thankfully, that’s not expected in the United States. Cayman employs internationally accepted best practices and a risk-based approach with favorable insurance regulation that can allow for a greater level of investment management flexibility, when compared to other jurisdictions. With low yields likely to persist, this flexibility, innovative money management solutions found locally, and low costs are more important than ever.
For captive insurance companies, the “captive life cycle” tends to drive investment policy. The captive typically starts by holding deposit-type products (cash) while insurance premiums flow in and the company gains an understanding of its expected claims. Once the captive has built up an asset base, they will then tend to look at fixed income solutions (bonds) that offer yield, some safety and liquidity. As the captive starts to build up surplus funds, they should consider adding modest exposure to equities to further enhance portfolio returns and diversification.
Low-interest rates and expectations for below average returns are causing captives to consider diversification opportunities into other areas, namely dividend paying equities and capital protected structured notes. Capital protected or buffered structured notes, issued by high-quality banks, are not understood as well as they should be by captive owners and captive managers in general. Structured notes can add value in the current investment environment, as they can offer the risk and return profile of both bonds and stocks, which can be a logical next step for captives investing in low yielding bonds with potentially higher inflation in the future.
The investment climate matters for captives
The combination of sluggish growth and too-low inflation has the world’s major central banks responding with highly accommodative monetary policies. Negative interest rates and full-fledged quantitative-easing programs are now the norm in Europe and Japan, but we have not seen significant pick-ups in economic activity or inflation in those regions. It appears that monetary stimulus is becoming less effective, leading us to question whether central banks are running out of options for generating meaningful growth. Of the world’s major developed economies, only the U.S. seems fit enough to warrant a tightening of monetary conditions. However, given the U.K.’s recent vote to exit the European Union, and other upcoming geopolitical pressures, any tightening is now likely to be put on hold for a while longer.
Our base case scenario is one where the economy is able to work its way through the many challenges and avoid a global recession. In this scenario, economic growth should be sufficient to allow for a modest increase in interest rates over time. Even if distributed over a long period of time, rising rates will act as a headwind to fixed-income returns. Our total-return expectations for bonds are either negative or in the low single digits over the year ahead – it does not take much to produce negative fixed-income total returns as long as coupon income stays so low. Our asset mix continues to favor equities as our forecast of slow growth and low inflation should be supportive of further gains in stocks.
In my opinion, as Brexit scenarios come into view, it is a good idea to take a step back from recent wild market swings and put the risks into perspective. Rather than beating a hasty retreat, equity investors should reconfigure portfolios. Great Britain’s limited position within the global economy should contain any Brexit fallout. While the U.K. is the fifth-largest economy in the world, it represented only 3.9 percent of global GDP in 2015. Just 3.8 percent of U.S. exports and 2.6 percent of Chinese exports flow to the U.K. The U.S. also has less exposure to the EU (ex-U.K.) than one might assume, with 14.3 percent of exports going to the region.
The S&P 500 is highly dependent on domestic revenue. S&P 500 sales attributed to the U.K. averaged a mere 1.2 percent of total sales from 2012 to 2014 and sales to Europe ex-U.K. averaged only 6.7 percent, according to Standard & Poor’s. If we incorporate foreign sales for companies that do not break out data by country or region (referred to as “foreign non-attributed” in the chart), the above figures probably would not even double. Moreover, should Brexit negotiations become protracted – not a given – U.S. sales to the region would not disappear, they would just be lower. If the U.K. slides into a recession and continental Europe’s growth rate slips, the hit to the global economy and S&P 500 earnings should be manageable, in our assessment.
The expectation that short-term interest rates may remain lower for longer is being reflected in long-term bond yields. The yield on the U.S. 10-year Treasury has traded below 2 percent over the past quarter, something that has occurred only twice in the past 146 years – in 2012 during the European debt crisis and at the onset of the Second World War. Our expectation is that bond yields will rise from these unusually low levels over time, but current economic conditions likely do not foreshadow a sharp upward adjustment in the near term.
Supporting the need for higher U.S. short-term rates have been labor-market improvement and firming inflation. The U.S. unemployment rate has fallen considerably since the financial crisis to a level where rate hikes would have been well-advanced by now in a more robust economic recovery. The Fed, however, has preferred to err on the side of caution with respect to raising rates given that the economic recovery is progressing more slowly than it expected and that there’s little evidence of an overheating economy. In this context, the pace of fed funds rate hikes is likely to be gentle – not likely until 2017.
Inflation will drive the future Fed rate path
Investor complacency is not surprising. Seven straight years of economic recovery following the financial crisis and efforts by central banks to bolster the economy through asset purchases and negative interest rates have so far failed to stop inflation from falling, so it is no wonder that investors have turned so sanguine about the inflation outlook.
Let us recall that inflation is the main variable driving the performance of bond markets. Over the past 50 years, the U.S. inflation experience can be divided into two distinct periods.
Between the mid-1960s and the early 1980s, inflation soared to double-digit levels and required a deep recession to bring it under control. This painful period was followed by the “Great Disinflation,” a 30-year period over which the yield on the 10-year U.S. Treasury bond fell as low as 1.4 percent in 2012 from its high of 15 percent in 1982. During this period, a 10-year Treasury bond delivered an average annual return of 8 percent, according to Citigroup. We do not expect a repeat of these superb returns since they would likely require decades of outright deflation.
In our opinion, the clear and present risk of higher U.S. inflation outweighs investor fears of another financial crisis. We expect the U.S. business cycle to last a bit longer, as household and bank balance sheets are in much better shape after six years of repair. The employment figures are also looking up, with 13 million jobs created since the financial crisis. With the U.S. economy near full employment, some inflation is likely to emerge, especially given that deflation did not surface in the core goods-and-services basket when economic activity was weak and the unemployment rate was high after the 2008 crisis.
Why captives should consider Cayman
The annual captive insurance forum held each year in Cayman currently hosts more than 1,400 conference-goers, the largest of its kind. Over 30 separate topics are discussed, and the forum hosts almost 100 speakers. Many of these delegates bring their families on holiday and pack the hotels and condos on Seven Mile Beach, in late November and early December each year. Cayman is an enjoyable place for investors to visit. Frankly, the size of the conference facilities and the country’s airline capacity are the containment factors.
With careful government supervision, backed by a stable political environment and solid professional support services, Cayman has become the second largest offshore insurance domicile in the world. As of September 30, 2015 the total number of captives domiciled in Cayman was 742, with total premiums of US$12.5 billion and total assets of $58 billion under the Cayman Islands Monetary Authority’s supervision. Cayman remains the leading jurisdiction for healthcare captives, with 34 percent of the domicile’s captives falling into this classification; however, Cayman captives are diverse, and span across many industries and lines of insurance coverage.
It is not uncommon to hear misconceptions that small domains, such as the Cayman Islands, would find it difficult to match the level of financial sophistication offered by other finance centers such as London, New York, Zurich or even Singapore. Being a major financial hub, Cayman can and does offer the same level of service. Local money managers for instance have access to the same quality information and investment opportunities, while branches of global entities rely on the same centralized research expertise as branches in larger financial centers. Given the sizable overweight to conservative, low-yielding investment grade bonds, Cayman’s captive industry continues to deal with low interest rates and will for much longer.
Improving mind and management in the same country as the captive, there is a role for locally based investment managers, who have the sophistication to navigate this investment climate by presenting cost efficient solutions and alternatives.