Performa
Derek Martisus of Performa tells CIT why investment funds are a viable solution for small- to mid-sized captive companies
What do you think are the biggest challenges for the small to mid-sized captive market with respect to their investment portfolios?
This segment of the captive market struggles to obtain service from quality institutional investment firms. Captives with sizeable investment portfolios will attract the attention of the large insurance asset managers that cater to traditional insurance companies. These firms, however, do not play in the smaller space. This leaves firms with retail investment platforms to provide service. By this I mean those firms that are suited to invest assets on behalf of high net worth individuals.
The largest issue, as we see it, is the attempt of small captives to purchase individual bonds. In order to achieve proper diversification within their bond portfolios, these companies need to buy sufficiently small amounts of individual bonds. In this scenario, pricing is significantly affected on the purchase side with the increased cost flowing directly through to the captive’s portfolio performance. Perhaps a more troubling scenario is the need to liquidate these small holdings in a hurry. Should there be a market event that necessitates the need to liquidate a small bond holding or a captive specific cash need, the potential buyers of the captive’s holdings will sense the urgency and require pricing appropriately. This scenario is one that few captives think of in advance and many investment advisors do not explain as a possibility.
Direct cost of service is another issue. Managing the assets of small institutional investors is time consuming. Advisors address this by either employing a buy and hold strategy or charging very high fees or both.
How can these captives work around these challenges?
We believe that bond funds provide an excellent solution to the above challenges. Funds can be managed in a large pool granting diversification and liquidity, all while enabling the cost to be controlled as individual clients pay fees as though they were a much larger investor. Should a credit event occur with a particular bond holding, a position in a fund can be liquidated much more easily and cost effectively than a smaller holding.
Are there downsides to fund solutions?
Once a captive reaches a certain size, a fund solution may actually be more costly than a separate account solution. This will usually occur between $25 and $50 million. We frequently run into captive clients that really want to directly own bonds as opposed to owning shares of a fund. There is also a loss of customisation as funds require that your investment guidelines match those of the funds being utilised. The analogy I use when explaining how funds can work in this scenario involves crayons. A big 64- pack gives you many options of colours and you can choose the exact colour you like. However, if you buy a standard eight pack, you can create all of these colours by combining several crayons and experience significant cost savings.
What do you currently see in the portfolios of small- to mid-sized captives?
The short answer is everything! If I were to generalise, I would say that there are two primary types of portfolios that we see where significant improvements could be made. The most prevalent portfolio type we see is the cash or cash-like portfolio. Captives are sitting on millions of dollars in checking accounts, money market funds or cds. The explanations that we get are pretty consistent. These captives aren’t quite ready for a managed investment portfolio and feel secure knowing that their assets are liquid. In this case, I would lobby for the captive’s managers to add a line to the income statement that says ‘opportunity cost’. This stance has cost captive owners potential investment returns and will continue to do so.
We also see captives invest heavily in treasuries to the exclusion of other asset classes. Rather than opportunity cost, we see many captives that are not fully informed of the risks involved in such a portfolio. Extending beyond cash, captives believed that treasuries should be the next logical move as credit risk is limited. While we aren’t concerned with credit risk, investors need to be concerned with interest rate risk. As interest rates rise, the value of these treasury securities will fall. This is simple bond maths, but it is not on the radar of many investors.
Do you believe the financial crisis had an impact on the investment portfolios or investment habits of captives?
Most certainly an impact was felt. My answer to the last question is often a result of the captive’s fear of another meltdown. We see many captives clinging to cash despite opportunity cost and we see others avoid asset classes such as structured product due to residual fear. Proper diversification is the key to any portfolio’s performance and eliminating asset classes for investment will impede a captive’s potential return and increase risk.
According to a recent Marsh benchmarking report, more than half of the investments made by captive insurance corporations consist of loans to their parent companies. Do you believe this to be the case and why?
I’m an actuary by training and have spent a good deal of time studying statistics. One must always look at a poll and resulting statistics with a skeptical eye. I have no doubt that Marsh’s study is accurate. However, we must remember that it is looking at their pool of captives.
As the largest captive manager in the world with clients that are captives of large financially strong parents, their experience will differ from a small independent captive manager. I expect that the study overstates this percentage a bit for all captives worldwide, but the point is valid.
From our perspective, these loan-backs remove assets from our prospect base and push back to the treasury department of the parent organisation. We think that while not fast moving, the trend will be for this loan percentage to drop over time due to market movements.
If you look at the opportunity in the captive space, it resides with the middle-market 831(b) captives in the US. These captives would be wise to do little to have the IRS question their tax status as an insurance company. Loan-backs could be viewed as a transaction that is not arms length. We think that while loan-backs will continue, these small captive formations will lean towards a conservative stance on the loan-back front. As they make up an increasingly larger percentage of active captives, the industry-wide statistics will move accordingly.
What does an investment advisor need to know about a captive that differs from other client types?
Captives are insurance companies. The investment advisors need to understand the business of the captive and the liabilities that they incur. Collateral solutions and their impacts on investment portfolios are critical to captive success. Advisors must also understand how captives operate on a day-to-day basis. The captive manager is the quarterback of the entire operation and it is critical that an advisor understands this. Communication can be challenging in a captive relationship with captive owner, manager, auditor and regulator all having a say in the investment portfolio of the captive. A good investment advisor will be nimble in navigating this landscape.
