In response to the financial crisis of 2008, central banks across the world opened their monetary floodgates to stem the deluge and revive their economies.
In response to the financial crisis of 2008, central banks across the world opened their monetary floodgates to stem the deluge and revive their economies.
It was half a decade ago that both the Federal Reserve and Bank of England lowered their respective base rates to the unprecedented levels of 25 and 50 basis points, where they have languished ever since.
As interest rates are already close to zero, the next move can only be upwards, although we cannot predict when that will happen and how fast they may go up. Economic indicators are forecasting 25-basis point rate rises in the UK and US at some point in 2015, with commentators suggesting that the Bank of England may raise rates first.
In Guernsey and throughout the developed world, savers, investors and creditors alike await the reversal of monetary stimuli and with it the long expected uptick in interest rates. The eventual interest rate rise, when it comes, will affect each group differently.
For savers, an interest rate rise will bring some relief, but it will not unfortunately allow these assets to keep pace with the level of inflation. Investors, but particularly creditors, are unlikely to welcome the rise in rates.
Reading the financial press, it is not unusual to see many articles attributing the stock market rally since 2009 to nothing more than the super-easy monetary policies of various central banks.
Obviously, near-zero interest rates and the Federal Reserve and Bank of England’s quantitative easing programmes have provided rocket fuel for the stock market. Central banks’ ‘put’, as it has been called, makes stocks (and particularly stock dividends) attractive relative to bonds and cash.
Investors have been encouraged to buy riskier assets as global central banks unleashed unprecedented monetary stimulus. Indeed, recently Daniel Tarullo, a Federal Reserve governor, said that loose monetary policy might encourage investors to take dangerous risks as they “reach for yield”.
Concern that policies will be reviewed as economic data both in the US and UK proves strong is causing increased volatility in global markets. In February, many asset classes experienced marked sell offs with the S&P and FTSE 100 falling more than 4 percent from their January starting points (later recovering these losses).
The VIX index (a widely used measure of market risk more commonly known as the investor fear gauge) spiked at 22, a level not seen since January 2013.
Data in the UK, for example, shows unemployment has now fallen below 7 percent for the first time since 2009. In the US, inflation—the great enemy of both stock and bond investors—is low.
The economy, following the most severe economic downturn since the Great Depression, is finally gathering strength and consumer spending is up.
Unemployment is high but coming down and the real estate market is on the rebound. US household net worth has just hit an all-time high and corporate balance sheets are healthy with more than $2 trillion in cash.
We are also in a period of record corporate profits and record profit margins—even if many believe such corporate profits are due exclusively to zero short-term rates and quantitative easing.
Economic data aside, much of the current volatility we see in global markets can also be ascribed to political instability. The uncertainty in Ukraine is having an impact across all asset classes.
Positively on the fixed income side, it’s lowering yields and we’ve seen the 10-year UK gilt and 10-year US treasury fall from 3 percent in December to around 2.6 percent currently.
A combination therefore of improving economic data and political unrest is causing jitters among investors, with some calling the end of the equity bull market we’ve been in since 2009.
What’s ironic is that the improving economic data, which theoretically is good and means the economy is finally coming off the life support machine, is having a perverse negative impact on asset prices, at least in the short term.
Guernsey, as the fourth largest captive domicile in the world with some £23 billion of assets in the jurisdiction, has not remained immune to the economic dislocation. Prior to 2008, captives could achieve 5 percent-plus on a 12-month fixed deposit.
The yield on cash deposits alone was often sufficient to cover the operating costs of a captive, and therefore many were self-funding.
The interest rate environment is very different today and although we may see a small uptick next year, realistically, we are many years away from 5 percent. Indeed, the Economist magazine recently predicted that short-term rates in the UK will still be just 2 percent in early 2017.
How, therefore, have Guernsey captive insurers managed their assets these past six years? According to analysis from the Guernsey Financial Services Commission, currently a little over half of gross assets held by international insurers (excluding life assets) are loans to parents.
This is hardly surprising given the low yield currently available on cash, as well as the supportive regulatory regime for captive insurers in Guernsey, which permits such loan backs.
Loan backs aside, there are alternative options to consider for a captive insurer’s assets. Cash will continue to form the core of many captive insurers’ assets, as cash does something no other asset class does—it protects. While providing high levels of security and liquidity, as I have already pointed out, it currently yields low returns.
A short-dated bond portfolio is another option with a typical duration of 18 months, and high credit quality.
The objective of such a portfolio is first and foremost capital preservation, but it will also provide liquidity, counterparty diversification and hopefully yield pickup in excess of cash. The important thing to remember is that the portfolio tries to pick up yield, but not at the expense of the other objectives. Consequently, you may only see a 100-basis point return on this type of portfolio (duration dependent).
This won’t help you out-perform inflation, but it will generate yield slightly better than cash, while not being overly sensitive to an increase in interest rates. Remember, bond prices are affected by rising interest rates, but shorter duration portfolios won’t be as sensitive to rising interest rates compared to longer-dated bonds. That’s why short-dated bonds are a good first step out of cash for any captive insurer.
High-yield bonds are interesting. Again, they’re not so sensitive to rising interest rates. What they are sensitive to is credit default, but in the current climate of improving data, credit default is less of a concern in the fixed income space in contrast to interest rate risk, for example. However, I would caution that there isn’t as much value in high yield at the moment, and prices have got a little bit ahead of themselves.
Importantly equities are an asset class that captives could look at. What we’ve seen over the last few years is that captive insurers have endured much opportunity cost through avoidance of any allocation to equities. Of course, some will say the whole point of the captive insurer is that it can’t take risk with the assets. Those assets have to be available to call upon if there’s a claim. But cash isn’t exactly the risk-free trade that captives perceive it to be—even with benign levels of inflation.
A larger and more mature captive could have a small allocation to equities. Such captives have the ability to estimate their likely future claims, and on the back of that analysis, they can implement a programme to match assets and liabilities.
Incoming premiums must be examined to understand if they’re providing a surplus versus outgoings. Assets are then segregated into different categories—for instance, into core, operating and strategic cash. It’s those strategic assets that could be invested in equities.
As many captives cannot tolerate typical equity-like volatility, one way for a captive insurer to invest in equities is through a risk-managed strategy, where the captive could gain exposure to the upside of equities but limit some of the risk through hedging. Captive insurers can have an allocation to equities, but the key is to manage the volatility by managing those market-to-market movements.
The phrase ‘a rising tide lifts all boats’ springs to mind when examining the impact of an eventual rising interest rate environment for Guernsey-domiciled captive insurers. Certainly, the improvements in the general economy will benefit captive insurers. However, without any dramatic uptick in interest rates, and even with benign levels of inflation, captive assets will continue to produce net negative annual returns.
A diversified approach to investment management must be employed. Incorporate a blend of instant cash, term deposits, money market funds, short maturity bonds, and risk-managed equity strategies. This will enhance returns with only limited impact on liquidity and risk.
