Madison Scottsdale
Madison Scottsdale is encouraging captive decision makers to shift to a more balanced focus when it comes to investment decisions through investment education and well-conceived investment policies. Jeffrey Matthias explains
What is the current status of financial markets?
During Q3, investment markets reacted abruptly to reports of slowing global growth, lower commodity prices and China’s self-imposed currency devaluation. The ensuing market volatility caused the Federal Reserve enough concern to further delay a shift in monetary policy despite improved domestic economic conditions. As a result, US treasury yields continued to be swayed by technical factors rather than economic fundamentals. In contrast to the prevailing low yields within safe havens, riskier fixed income valuations adjusted to underlying credit metrics and issuer-specific event risk. Global equity markets also experienced lower returns amid an environment of heightened volatility due to the growing concerns about deteriorating global economic conditions.
The prolonged period of global uncertainty has led to increased bouts of market volatility as investors weigh the long-term ramifications of economic and financial developments. Even though heightened volatility may suggest otherwise, the US economy continues to trudge forward with vastly improved employment conditions, favourable housing trends and progressing business conditions. Of course, this could all change as slower global growth combined with a strong US dollar reduced exports and negatively affects the manufacturing sector.
China’s unexpected devaluation of its currency in August triggered a selloff in lower quality assets throughout the world. Investors interpreted the efforts to increase exports as evidence the Chinese economy continues to struggle. Lower growth would likely further pressure commodity prices, thereby threatening both developed and emerging market economies. The European Central Bank (ECB) expressed concern about how persistently low commodity prices may impede the eurozone’s efforts to increase inflation to more desirable levels.
The Federal Reserve also cited foreign economic and financial developments as a primary consideration in its decision to leave short-term rates unchanged for the fifty-fifth consecutive meeting. This is despite notable improvements in the US economy, which is approaching full employment and price stability, although inflation remains slightly below the Federal Reserve’s preferred level of 2 percent. Chair Janet Yellen continued to suggest that the central bank’s policy decisions are data dependent, although the relevant economic and financial dataset has seemingly expanded beyond domestic activity and now includes international happenings.
We believe the US economy will continue to grow moderately in the coming quarters with lower energy prices offsetting a challenging export and inventory environment. Our gradual growth trajectory resides in the nation’s consumer-based economy, which should persist since the country is near full employment, wages are showing signs of acceleration and consumer confidence is high for a variety of reasons. The health of small- and medium-sized US businesses continues to advance and is likely to be a source of growth as additional higher quality jobs are posted and filled.
We remain concerned about the Federal Reserve’s prolonged maintenance of its low interest rate policy. Some economists have suggested the Federal Reserve’s recent decisions may be restraining growth prospects, especially as it relates to banks’ willingness to extend credit. We think investors are beginning to lose confidence in the central bank’s data dependent rhetoric, especially given that the Federal Reserve’s focus on mandate specific data elements seems to have recently shifted to broader, more global-oriented factors. We believe the risk of policy error has risen in recent months and is likely to disrupt markets once the Federal Reserve does begin to increase rates.
How are captives’ assets faring in the current financial climate?
A majority of captive insurers subscribe to a fairly conservative investment policy with the primary objectives being safety of principal and income generation. A secondary objective may be capital appreciation for the purpose of long-term surplus growth. Most maintain a portfolio including an appropriate allocation to very liquid securities to cover unanticipated operating needs, a predominate weight to high quality fixed income securities and a small allocation to equity securities to increase financial stability over time. Since the financial crisis, many captive portfolios have generated historically low amounts of interest income although capital appreciation associated with lower yields has resulted in higher portfolio market values.
The recent market volatility has been advantageous for high quality fixed income portfolios, especially for those heavily weighted toward US government bonds, the most liquid sector of the market. Even portfolios with exposure to corporate bonds rated -A or higher have fared well since the risk premiums on these bonds have increased much less than lower quality paper.
However, concerns about liquidity and issuer-specific event risk is intensifying as some companies continue to use the low rate environment as a means to carry out bondholder-unfriendly activities such as share buybacks, dividend increases and merger and acquisition activity. A recent example is Dell’s acquisition of EMC, a deal that may cause EMC’s credit rating to fall from -A towards Dell’s below investment grade rating of -BB. Thus far, equity market volatility has not significantly affected captive balance sheets since most captive have limited exposure to this asset class.
What effect would an interest rate hike have on their portfolios?
We anticipate interest rates will increase over time as US economic fundamentals improve and the Federal Reserve shifts towards tighter monetary policy. The potential impact on captive portfolios in a rising rate environment will depend on the degree of interest rate sensitivity residing within a captive’s portfolio and the speed and magnitude at which interest rates increase. Portfolios with shorter average maturities would likely experience lesser market value declines than those with longer average maturities. In addition, a slow, gradual rate increase would likely result in interest income largely offsetting any market value decline, whereas an abrupt spike in interest rates could cause a significant decline in market values, particularly in portfolios with longer average maturities.
In general terms, rising rates may cause stock valuations to adjust downward as investors increase the discount rate used to value future cash flows. If conditions prevail and equity markets selloff then active managers with an emphasis on protecting capital and dividend income may outperform market indices.
How attractive are equities to captives?
We have found the amount of captive equity exposure is mainly related to four factors: operational objectives, size in terms of annual premiums written and/or assets, capacity and tolerance for risk, and investment knowledge among the key decision makers.
Equity exposure can be very beneficial for captives wishing to grow surplus over time for purposes of increasing financial stability and flexibility as well as underwriting capacity. However, emotional biases often enter into investment decision making during the most inopportune times, such as elevated periods of volatility, which can disrupt an investment plan and lead to investment behaviours such as buying high and selling low.
Captives that are contemplating adding equity exposure at this time may be well served by crafting an asset allocation policy that is suitable for a minimum five-to-seven year period. Next, a captive must decide which investment strategy or strategies are most appropriate for achieving return objectives within its stated risk preference. A captive must then determine how best to implement these strategies in terms of passive versus active and separately managed account versus a commingled fund, for example, a mutual fund or exchange-traded fund.
Lastly, an investment implementation schedule should be formulated that clearly specifies how quickly the assets slated for the equity market are deployed—all at once or averaged into the market over time. Captives that take the time to devise a suitable investment policy statement stand to reap the benefits associated with owning equity securities over the long term.
However, board members must be willing to endure short-term equity market volatility in order to avoid making emotional decisions in stressful market environments.
Given that they’re risk averse entities, are they capable of using making the most of equity assets?
In general, we view the primary function of insurance companies to be risk mitigation and management. The concept of risk may be meaningfully different among captives given differences among the insurers in terms of risks underwritten, loss experience, financial soundness and overall risk preferences.
Herein lies the challenge—captives are faced with managing two interrelated components within their business, namely insurance and investments. Arguably, the insurance business deserves, and frankly ‘gets’, the vast majority of the focus and attention. Although important, the investment portfolio is often an afterthought when it comes to maximising its effectiveness within the overall business. For many captives, maintaining an abundance of liquidity to guard against sudden unanticipated claims is much more important than generating investment return, whether it be interest income or capital appreciation.
We are encouraging captive decision makers to shift to a more balanced focus by providing base level investment education and working with them on creating and implementing well-conceived investment policies.
