Barclays Wealth & Investment Management
Whether at the mercy of Solvency II or not, Colleen McHugh of Barclays says it is imperative that the captive insurance industry remains aware
What are the most popular ways for a captive to employ an investment strategy in Europe? Has this been the case for some time?
The majority of captive insurers here in Guernsey underwrite risk for UK-based parents, so most of the potential liabilities are sterling-denominated. Therefore, a Guernsey captive will often implement a sterling-denominated investment strategy. Prior to 2008, in any captive jurisdiction, cash was king and could achieve a decent return. The 5 percent-plus yield on that cash alone was often enough to cover the operating cost of the captive, making it self-funding.
In honesty, there was probably no need to move away from cash as an investment strategy, but the prevailing low interest rates over the last six years and concerns with concentration risk have led captives to actively seek yield while trying to minimise the risk of maintaining all their assets in banks.
In order to do that, captives have embraced this concept of segmenting their cash reserves into different classifications—operating, core and strategic. While operating and core need to be liquid, the strategic cash can be used to invest in longer-dated securities. That is where yield pickup can be maximised while minimising volatility.
The first step for such a captive would be something like a short-dated bond portfolio, which has very high credit quality and typically has a duration of around 18 months. The objective of that portfolio is, first and foremost, captive preservation, although it will try and pick up yield as well. There might be a 100-basis point return on that type of portfolio, which is of course better than cash, but the crucial fact is that the captive is getting counterparty diversification by investing in a portfolio of high-quality, short-dated bonds.
We do not see much European investment in equities, but I believe that the larger, more mature captives should look at dedicating a very small allocation to them.
Are these investment strategies gaining widespread popularity or are many captive owners still unaware/uninterested?
It varies from domicile to domicile, but we are seeing more and more captive entities and their parents looking for assistance around formalising an asset allocation approach. This translated into how best to integrate non-cash assets into a portfolio. I am seeing an increased level of investment engagement by captive managers and owners here in Guernsey, but the Guernsey Financial Services Commission (GFSC) statistics show that more than half of the gross assets held by captives are still tied up in loan-backs to parents. This is something of a trend within Europe, Guernsey and the Isle of Man at present.
What are the main reasons a captive would employ these kinds of investment strategies?
In terms of the revenue streams available to a captive insurer, it has underwriting profits and investment income. For a number of years, captive insurers have been adversely affected on the insurance side of things by the protracted soft insurance market, which affects underwriting revenue. On the asset side they are suffering too, thanks to the protracted period of low interest rates. If you throw into the mix the fact that the cost of running a captive is creeping higher—the pressure is really piling up to drive returns on assets and avoid the captive being squeezed.
Certainly then, developing a more tactical and formal investment approach can show captive managers the options available in order for them to generate that elusive yield and total return, while keeping the volatility low.
We are constantly reminded that investing for captives is different to other types of clients in that the primary purpose of a captive is to act as an insurance vehicle to meet the claims responsibility of its parent. As a result, the assets need to be invested in safe, liquid investments in order to ensure that they can meet any future claims. That is the conundrum facing these captive insurers.
What are the main investment considerations for captives?
It all comes back to the fact that a captive has a unique profile, and this means that the investment guidelines of the parent become a primary consideration. For example, a UK-based FTSE 100 company with a captive in Guernsey will have a desire to have some input into the investment strategy itself, despite the fact that it is only a subsidiary.
Another differential is the captive’s life-cycle. This impacts the captive’s investment requirement and dictates what their investment strategy can be. A newly formed captive would require all the assets to maintain predominantly in cash as it is initially funded but, in contrast, a more mature captive could engage in an investment programme of matching assets and liabilities—looking to risk the assets and potentially even allocate to some equities.
The actual line of insurance that is being underwritten can also affect a captive’s strategy. For instance, if a captive is underwriting long-tail risk where the claims might take years to emerge (such as casualty risk) then it could be afforded a more developed and sophisticated investment strategy. This would be in direct contrast to, say, property risk, which is short-tail and limits the investment universe for a captive.
The collateral requirements or fronting restrictions that a captive is subject to could also affect the investment considerations, as do the complex regulatory requirements.
What is the attitude of regulators towards captives employing an investment strategy? Are there strict guidelines to follow?
Again this varies as each domicile’s regulator will have different permissible assets that captive can invest in. The GFSC has recently published risk-based solvency rules that require insurers to hold capital in relation to their risk profiles and access insurance risk, credit risk and market risk. In Guernsey there is no longer an approved asset regime.
Of course, an investment strategy can still be employed but it is crucial that the adequate capital is maintained to meet the risk posed by that investment strategy.
Given its freedom from Solvency II, is Guernsey an ideal domicile in which captives can invest their assets?
Solvency II will not affect us like it will other European domiciles after it is implemented next year. In terms of the impact from an investment perspective for European captives and/or their parent companies, the reality is that the Solvency II rules will encourage the diversification of investment, which is a good thing.
The reason for that is because different capital charges will apply for different levels of concentration risk.
If we look at the proposed regulations, they give a zero-spread weighting to all AA-rated sovereign debt. This would mean that a captive could be tempted to reduce its holding of long-term corporate debt in favour of sovereign bonds, as it would get better capital treatment.
The problem here is that European governments are trying to reduce their levels of borrowing, despite corporate balance sheets being in good health. A shift from corporate paper to government paper at this point in time is somewhat counterintuitive.
The world is a very different place than it was even a couple of years ago, and it is incumbent that the industry remains constantly aware of these regulatory changes.
