As capital flow into captives continues to rise, Nigel Allen considers how this is affecting asset management strategies.

At one point in the history of the captive, the concept was considered by some to be a one-dimensional asset management tool, a one-stop shop with limited general use. Place the captive of today in a line-up of asset management vehicles and the likelihood of it being 'picked out' based on this perception is slim.

The captive is an extremely malleable and responsive entity, with a corporate appeal unrivalled in the alternative risk transfer (ART) marketplace. Speculative and exploratory in a soft market, conservative and traditional in a hard, the captive can be found on the horizon of any financial landscape. However, as capital flow into such entities increases on a daily basis with parent corporations seeking to further exploit their captives in the continuing hard market, sound asset management strategies are paramount.

Ken MacDonald, Group Managing Director of IRMG, the risk finance consulting arm of Aon Captive Services Group, said: "The key for a captive, especially one underwriting large retentions, is cash flow stability." While the long-term commitment and flexibility of a parent towards its captive is vital in terms of capitalisation, so too is the ability of the entity to generate underwriting leverage, whether through investments, premium writings, reinsurance or other asset-producing channels. Establishing and maintaining a sturdy capital base provides a barrier to unforeseen major events or dramatic market fluctuations, enabling the captive to continue to meet financial obligations even in extreme situations.

Gaze of the regulators
Those captives operating at present with high levels of underwriting exposure, retaining large proportions of illiquid assets and lacking any real diversification of risk are liable to increased attention from regulators and rating agencies alike. The current market demands a balanced approach from asset management strategies, one which wraps assets and liabilities in a conservative investment blanket. Take a cursory glance at recent bulletins from rating agencies either reaffirming positive ratings or announcing improved ratings for captives and you will not fail to spot the increased usage of words such as 'prudent', 'sound', 'strict' and 'disciplined'. Prudent in reserving, sound in levels of capital, strict in underwriting control and disciplined in risk management, these attitudes are forming the backbone of successful captives.

"The majority of our clients invest in cash and fixed income investments," said Mr MacDonald. "As such, investment policy tends to be very conservative, something which has paid handsome dividends in recent times." Such investments normally account for between 50% to 100% of a captive's liquid assets. However, Mr MacDonald is quick to point out that their experience has shown that short-term investments such as cash and fixed deposits can sometimes be subject to a higher degree of inefficient management, which could result in the loss of basis point returns.

Pooled fund strategy
One strategy to increase diversification within a captive is through the establishment of pooled funds, a move which can also facilitate greater returns. By creating a collective pot of assets, one other advantage afforded is the ability to exploit the fund as a means of collateral for a letter of credit facility. At the present time, with returns on short-term investments at a low ebb, the appeal of creating a pooled fund is clear.

In October 2001, a cash fund for Aon captives was launched, which at present holds more than $500m in invested assets. Aon's captive clients hold over $65bn in total assets. "The launch of this product was timely for clients given the current low returns on short term investments, together with the rapid escalation of captive security requirements that has been exacerbated by a crisis in fronting insurance," said Mr MacDonald. The use of a cash fund can also offer other advantages.

Increased efficiency
Establishing a fund can enhance administrative efficiency - a key driver behind the recent rash of captive consolidations - by reducing time spent dealing with banks, and can result in an improved rating for the entity. The cash fund is not a new concept, but is one which carries much more weight in the US market, where it accounts for almost $1.7trn, than in Europe where take-up rates have, until now, been slow. However, competition is beginning to hot up and growth is expected.

As is normally the case in a hard market, captive managers are turning their attention towards the more traditional lines of business, such as property and general liability. Achieving stability is the name of the game in this market, and with prospective clients becoming ever more reliant upon the announcements of ratings agencies, this stable approach could well form the cornerstone of asset management strategies for some time to come.

By Nigel Allen

Nigel Allen is the assistant editor of Global Reinsurance.