Crystal ball

A well-defined investment philosophy may help your captive navigate the unpredictable ups and downs of the financial markets. History shows that it is difficult to predict when interest rates will change and when markets will rise or fall, which is even more reason to maintain a disciplined approach to your investments.

Fixed-income investments and interest rates

For seven years, from December 2008 to December 2015, the carnage from the financial crisis and the great recession caused the federal funds rate to remain in a historically low trading range of 0 percent to 0.25 percent. The Federal Reserve Bank began signaling that it would raise the discount rate as early as 2012. This caused many investors to shun bonds, only to miss out on strong bond performance through the second quarter of 2016. Bonds did, however, lose value during Q2 2016 as interest rates eventually rose. Bond prices recovered in early 2017 as interest rates declined once again.

With justification in hand (for example, a falling unemployment rate and gradually rising inflation), the Fed implemented an interest rate increase in December 2015. Since then, the Fed has followed up with three additional rate increases in December 2016, March 2017, and June 2017. The target trading range for federal funds is now 1 percent to 1.25 percent.

From a historical perspective, here is some useful information concerning the federal funds rate (for periods ending 31 August 2017):

  • 5-year average: 0.274 percent

  • 10-year average: 0.495 percent

  • 20-year average: 2.135 percent

  • 10-year average leading up to the beginning of the Financial Crisis (Aug 1997 to Aug 2007): 3.75 percent

  • As these numbers show, we remain in a historically low-interest rate environment. Despite the possibility of future federal funds rate increases, your investment manager should continue to manage your portfolio based on the stated investment policy and avoid interest rate or duration bets.

    A conservative captive insurance fixed-income portfolio may hold investment grade corporate bonds, US Treasury and agency bonds, and municipal bonds. Maturities are typically matched with the anticipated payout of claims to avoid having to sell a bond before its maturity date and possibly incur a realised loss if interest rates rise.

    It is also worth noting that having an allocation to US treasuries, US agency and municipal bonds could have a positive impact on the pricing for letters of credit received from your bank. Your investment manager should be aware of any pricing advantages available to your captive based on the make-up of your portfolio.

    Equities and economic expansions

    If your captive is mature, with a surplus to invest, your investment manager may be able to add stocks to the investment mix. Of course, there is additional risk with equities, however, stocks provide diversification and opportunity for growth, since equities have historically out-performed bonds over the long term. Since the end of World War II, despite the current events of the day, the ever-changing economic and political landscape, and various market corrections, the US economy has managed to overcome it all and the equity markets have moved higher time and again. Here are some examples:

  • The turbulent 1960s saw the second-largest economic expansion in history over 106 months, from February 1961 to December 1969.

  • In the 70s, the Vietnam War ended, and the US lived through Watergate, the OPEC oil embargo, the death of Elvis, and two economic expansions spanning 36 months (November 1970 to November 1973); and 58 months (March of 1975 to January of 1980).

  • In the 80s, we experienced double-digit inflation, the failure of Continental Illinois National Bank and Trust, a stock market crash on Black Monday, the marriage of Lady Diana Spencer and Prince Charles, and a 92-month economic expansion from December of 1982 to July of 1990.

  • The longest economic expansion of 120 months occurred from March 1991 to March 2001. During that timeframe, there was Operation Desert Storm, the beginning of the internet, Russia defaulting on its debt (and Vladimir Putin becoming acting president of Russia), the ‘Asian contagion’ currency devaluations, and the repeal of the Glass-Steagall Act, allowing banks to operate as both commercial and investment banks.

  • After the 9/11 terrorist attacks, a 73-month economic expansion began that ended in December 2007, the beginning of the Great Recession. In September 2008, Lehman Brothers filed for bankruptcy, triggering a global banking crisis; economists, investors, consumers, and politicians all feared we were on the verge of the next Great Depression. The Dow Jones Industrial Average dropped to its modern low of 6,469 on 6 March 2009 (54 percent from its peak of 14,164 on 9 October 2007).

  • The US economy remains on track for an ongoing moderate expansion through 2018. If that turns out to be the case, by the end of 2018, this will be the second-longest economic expansion in US history, although still a few months short of the record 120 months from March 1991 to March 2001.

  • Portfolio management

    Investment professionals should add value by deeply understanding their near-term and long-term goals; clearly articulating the investment firm’s philosophy and process; developing and maintaining the investment plan; and assisting in understanding the investment strategy.

    Three basic principles should be the foundation of any investment management philosophy. The investment professional hired to manage the captive insurance company portfolio should be driven to act in the captive’s best interest as a prudent steward of the investments; believe in a goal-oriented approach to meet the objectives of capital preservation, cash flow, yield, and performance; and provide a well-disciplined, consistent and repeatable process over time.

    Best interest

    An investment professional should be willing to act as a fiduciary over the investment portfolio. Investments should be selected based on the stated needs of the client. The firm should be committed to an open, long-term approach to investing. Its mission should be to act as a prudent steward of investments. Managing investments is highly complex.

    An integral component to the execution of your investment strategy is an understanding that the investment firm is acting in your best interest.
    Goal oriented

    The investment professional should utilise a goals-based approach with a clear understanding of the captive’s objectives and tolerance for market volatility. A written investment policy statement (IPS) is essential to establish the structure of the investment portfolio. If an IPS does not exist, the investment manager should be able to assist the captive with developing one. The IPS serves as a road map toward the investment goals and provides information on the approved asset classes, target allocations, and any restrictions placed on the captive by either banks providing letters of credit or the beneficiary of the Regulation 114 trust agreement.

    Disciplined, consistent, repeatable

    Discipline, consistency, and a repeatable process are key to investing. These are core elements to ensure that the impacts of emotion and reaction are removed from the investment process. Your investment manager should incur only as much risk as is necessary to achieve your objectives. During negative market cycles, your investment manager should maintain a disciplined and consistent approach to avoid the temptation to time when to enter or exit individual investments, asset classes or markets.

    When your investment manager is working in your best interest and to achieve your goals, and has a disciplined investment philosophy, your portfolio will be able to navigate the inevitable swings of the financial markets.

    This is not a complete analysis of every material fact regarding any company, industry or security. The information and materials herein has been obtained from sources we consider to be reliable but Comerica Wealth Management does not warrant, or guarantee, its completeness or accuracy.

    The views expressed are those of the author at the time of writing and are subject to change without notice. We do not assume any liability for losses that may result from the reliance by any person upon any such information or opinions. This material has been distributed for general educational/informational purposes only, and should not be considered as investment advice or a recommendation for any particular security, strategy or investment product, or as personalised investment advice.

    The investments and strategies discussed herein may not be suitable for all clients. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Comerica Bank and its affiliates do not provide tax or legal advice. Please consult with your tax and legal advisors regarding your specific situation.

    Securities and other non-deposit investment products offered through Comerica are not insured by the FDIC; are not deposits or other obligations of, or guaranteed by, Comerica Bank or any of its affiliates; and are subject to investment risks, including possible loss of the principal invested. Past performance is not indicative of future results. Information presented is for general information only and is subject to change.
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