Captive insurance: an investment profile

Achieving long-term captive investment goals

16 November 2018

Why captives should remain calm and invested in today’s turbulent global economy

Despite trade wars, rising US interest rates and the threat of inflation, captive insurers should remain invested to reach long-term objectives, Barclays in-house captive insurance experts argue.

Inflation expectations have been rising in the US, an area many captive owners focus on, which is a big driver for changes in policy from central banks.

“Inflation has been reasonably benign in the short-term. Part of that has been globalisation and technology disruption,” explains Henk Potts, Director of Investment Strategy at Barclays.

“But, after years of recovery, there's very little slack left in terms of the US economy,” he adds.

Tight US labour markets are pushing up wages, this in turn bolsters inflation, as will higher commodity prices and the weaker dollar.

“We've seen the Federal Reserve hike interest rates in 2018 and we expect four hikes in 2019. Very quickly, we're starting to really think about US interest rates getting above 3% once again,” says Potts.

This is a concern among captive clients as captive boards tend to be cautious, explains Colin Freeman, Relationship Director in the Barclays captive insurance team.

“Before they go into investments or link investments to a letter of credit, they're very conscious of the advantages and perhaps some of the challenges around doing that.”

How do rising interest rates impact captives?

A rising interest rate environment has interesting effects on bond portfolios, which are often the next step for captives after they move on from cash holdings, says Simon Phillips, Head of Captive Insurance, Barclays.

“In very mechanical terms, in a rising interest rate environment, the interest rate goes up and the bond price can go down. This can feel quite painful on what we call a mark-to-market basis,” he says.

“But, it’s really important to stay invested through this period to achieve the long-term objective of the captive. That is, ensuring it has the correct security, potentially for a letter of credit.

“When you look at the liability profile of the captive and maturity profile of the bonds that we put in place, then the mark-to-market becomes much less relevant. A captive would hold those bonds until they mature, similar to holding a deposit account for a one-year period to repay the capital at maturity,” Phillip explains.

For this reason, mark-to-market is not something to be overly concerned about, he argues.

In today’s turbulent global financial markets, Potts says: “From a captive perspective, the key is to maintain your composure, be invested, be diversified, don't panic.

“There's nothing that we see within the global economy, within financial markets that really suggests that captives won't be able to achieve those long-term investment goals,” he adds.

Does size matter?

When considering a captive’s investment strategy, it’s important to focus on objectives over size, says Phillips.

“The objectives rarely differ because of the size of the captive. Therefore, getting good investment advice is essential. And within investment advice, I'd include even your cash management policy,” he explains.

“In the smaller captive space we typically find that we're able to advice into funded solutions, for example, so using funds to give diversification. A real growth agenda that may well exist in a smaller captive,” Phillips adds.

The argument for active management

Regardless of the size of your captive, when investing Phillips advises captive owners to ensure their investment policy is dynamic and flexible enough for an investment manager to be able to help make decisions around duration risk or term premium that we would look at from a bonds perspective.

It is also important to make sure regular reviews are in place with your investment manager so that they can readjust the portfolio as required, he says.

“We believe in the value of active investment management in two different areas,” says Phillips.

The first is around asset allocation.

“There are very low-cost options available in the market, there are trackers available, but how you then define how much capital goes into each asset class is absolutely critical,” Phillips explains.

Changes to the global financial economy are unpredictable, therefore, diversification is critical.

Phillips argues that getting the blend right between different asset classes should be delegated to a professional, for example, having the right mix of equities and bonds.

The second area is positive security selection.

“Positive security selection, being very deliberate in the securities that you purchase and the ones that you don’t, adds a lot of value,” Phillips says.

“At the moment we’re seeing stock correlations starting to fall, so as interest rates start to rise, quantitative easing starts to unwind.

“We’re seeing those correlations between the good and the bad securities really start to widen out again. That means, that it is very easy to pick a bad security,” he adds.

It is therefore important for captives to remain very active around their investment portfolios at the moment to reach the desired investment policy objectives, Phillips concludes.

For more on key economic themes and how they are impacting captives, watch our captive insurance team’s panel discussion: