Neil Jamieson
Return on investment remains secondary to protecting capital, according to Gordon Anderson and Neil Jamieson
How do investment strategies in North America and the Caribbean differ from those in Europe? Does this change from domicile to domicile?
Gordon Anderson: The parent companies using somewhere like Guernsey are predominantly from the UK and basically borrow back all of the money. Their investment strategies are cash and very short-term—they tend not to go into equities and are not long-term insurance portfolios. The only equivalent would be a lot of the Canadian oil and gas companies that do the same thing. They keep it very liquid, putting the premiums in and borrowing the funds straight back to the parent company, which is often overseas. In Barbados, a lot of the parent companies actually invest the money and leave it there, looking at a long-term, typical investment strategy. That is a big difference.
Neil Jamieson: Other than the oil and gas companies, most of the Canadian parent organisations retain the capital. Notionally, the assets would be domiciled in Barbados and managed either from the domicile itself by an investment manager, or contracted by the Barbados-domiciled company to a fund manager somewhere else, such as Hong Kong, New York or Toronto—depending on which asset class they are investing in.
Is this also the case in the US?
Anderson: The originator of half the world’s captives is the US, so they have a lot of capital to invest. It is fairly normal for midium-sized companies to use an 80/20 (fixed income/equities) split, provided there is no encumbrance with fronting requirements to restrict them. Large, multinational companies such as McDonalds or BP tend to do all of their investment decision-making at parent-level and be absolutely conservative.
They choose to invest in short-term, liquid assets, much like their counterparts in Europe.
Are equities a more popular form of investment on your side of the Atlantic, or is the mood more conservative?
Jamieson: It’s a really interesting dynamic. As we go into the fifth or sixth year of really low interest rates, with yields low and corporate spreads having tightened a lot, boards are looking at different investment strategies.
Without increasing premiums or capital bases, or completely deferring any dividend stream back to the parent, investment portfolios are generating less and less.
The risks are not going away so you have the same kind of actuarial requirement to maintain capital. The parent likes to see a little return now and then so you have these competing elements. One of the things that is under discussion, certainly on the boards that I am involved with, has been yield enhancement—the riskiest level of which is equities.
The parent companies are very different, too. The degrees to which captive insurance companies are looking at equities is directly related to the risk profile of the parent. If you are running a commodity business used to ups and downs in your core activities, you are less likely to take more risk in the captive.
A different parent organisation with steadier revenue might look at encouraging the board to look at a slightly broader risk profile. However, it is important to point out that this is a concept that is still under discussion, and far too early to be called a trend.
Anderson: The investment strategy for a captive will also change depending on its lifecycle. When you start, you put your capital down, say $125,000, in cash, treasuries and money in the bank. When the first premium goes in, say $5 million, you might typically go for fixed income as you are a new captive that doesn’t know its claims history yet.
As the captive builds up its premiums over time to around $15 million, the investment committee for the board may start to feel like it should look to pick up a better return. If your return from fixed income is 1.75 percent and inflation is 2 percent, you are effectively eroding your capital.
Alternative, low-volatility strategies on the fixed income side that aren’t correlated to interest rates have been doing much better in the last three to four years now that rates have bottomed. Canadian bonds have averaged 2.5 percent in the last three years, total return, while you are probably looking at getting 7 to 10 percent on other fixed income alternative strategies.
On the equities side, captives start to look at a benchmark of around 30 percent in equities. Sophisticated captives in the Caribbean will look to long/short strategies so long as they are liquid and there is no risk of being locked in. Safety and liquidity is paramount, but in these economic times captives are looking to branch out.
Of the 300 or so captives I have worked with, the highest equity weighting I have seen would probably be around 60 percent in equities. This was a US parent that was privately owned and in real estate—they are used to taking risk. That is unusual, as the average would be around 25 percent or lower.
Would this dynamic change with an increase in interest rates?
Jamieson: If the time came where 6 percent could be achieved from a bond, I’m sure they would migrate back. I don’t think a 50- or 100-basis point uptick in bond rates would disturb too much, as those that want to look at equities will continue to do so. If you are talking a 500-basis point rise back up to 7 percent, then this may convince people to back off equities.
The capital in a captive has already gone through the risk cycle of the core business and has generated profitability, so chances are that they are looking for a safe haven for their premium. I don’t think there will be many cases like the previously mentioned real estate company investing 60 percent in equities.
As a board member, when you look at the core business of a captive—which is assessing, underwriting and pricing risk—you don’t want to take the chance. If you roll 60 percent of your capital into an equity portfolio and it doesn’t work, then you have blown the primary role of the captive right out of the water. Investment management in an important but secondary role of the captive—safety first, return second.
What is the regulatory guidance for these kinds of portfolios?
Anderson: The rules are not very helpful in Barbados and other domiciles that I have looked at. As far as they are concerned, you can have cash and equivalents or bonds and equities on a regulated exchange. It’s very old and unsophisticated and when they do the annual review of all the captives they just examine the statements to see if it ‘looks ok’ to them, before focusing on capitalisation and ratios.
Jamieson: Deciding the proper asset mix is really one of those areas that is monitored by a captive’s board. There is an investment policy statement created for every captive that dictates the confines within which the board and investment manager can work. I don’t think there is any outside regulation of the asset mix itself.
With regulations becoming more stringent upon the majority of other sectors, is there any chance that regulators will target captive investment strategies next?
Anderson: Nobody asked anything more of captives after the events of 2008, though it was good to see some of them look back at their collateralised debt obligations and asset-backed securities. Board members are quite conservative by nature and experienced enough to prioritise captives’ safety.
I am not aware of an investment blow-up occurring in the Cayman Islands, Bermuda or Barbados in the 20 years that I have been in the industry, so the regulators have clearly not been obligated to step in or throw any rules at anyone.
Jamieson: It could happen, but it would be unlikely. Firstly, it could be perceived as inappropriate for a financial services regulator to become more stringent on a captive’s asset mix. Moreover, the simple fact remains that there is a lot of choice for captives, and if all of a sudden one domicile said that they were going to regulate investments more intently, it could be the kiss of death for them.
