Captives have over the years given up significant additional returns by not paying sufficient attention to the asset side of their balance sheets. David Ezekiel discusses some features relevant to their investment decisions.
Ask any captive owner, director or manager to name the most important item in their financial statements and the chances are that the overwhelming choice will be the loss reserve number. And they are probably right - loss reserves usually have a fair degree of subjectivity and uncertainty attached to them, and in many cases a 15%-20% deterioration in loss reserves can render a company insolvent or reduce its capital and surplus below the statutory minima. The use of actuaries to assess the loss reserves helps reduce the uncertainty, but in many high severity/low frequency classes, this process is as much art as it is science.All of this led to such a strong focus on the liability side of the balance sheet that quite often the asset side has remained almost an after-thought. Given, however, that the dominant component of the asset section is usually the investment portfolio, companies have over the years given up significant additional returns by not giving the asset side sufficient attention. This is changing fairly rapidly, and the following is a broad brush discussion of some factors affecting the investment decisions facing captives.
Increased returns always come with increased risk.
This is largely true, although there are many companies who can improve returns simply by increasing the maturities of their investments without changing quality. The yield curve usually provides higher returns for increased duration, and while this may increase the “volatility risk” of the portfolio, most companies can deal with this risk if they are protected from “loss of capital” risk.
Each company is different
There is no such thing as a “correct” asset allocation for all companies.
1. A company writing short-tail property risk may not be a suitable candidate for investing in equities or long-term fixed income instruments, whereas a company writing long-tail coverages (medical malpractice, general liability, etc) should use the long duration of its liabilities to generate additional returns on the asset side.
2. Investment decisions cannot be based solely on the size of the asset pool. For instance, a company with $30 million in assets and $10 million in free surplus is better placed to accept more investment risk than a similar company with $30 million in assets but only $3 million in free surplus. The company with the $10 million in surplus is able to withstand sustained periods where the portfolio value may be impaired, whereas the latter company has little margin for error.
“Ideal” asset allocations such as 70% bonds/30% equities, cannot, therefore, be assessed in a vacuum, but most take into account the liability duration of the company's loss reserves and its free surplus. The most important investment decision is the asset allocation decision. Too many companies spend an inordinate amount of time and money on manager selection and not enough on determining an appropriate allocation.
Depending on the asset class, the asset allocation decision will produce anywhere from 80%-95% of the eventual return with the remainder coming from the selection of particular stocks or securities. Manager selection, therefore, is usually given a lot more focus than it deserves - though having said that, it is one of the most interesting functions in the investment process!
Attempting to time the market, in terms of entry or exit, is not recommended. The key to successful investing is to establish one's long term goals and stick with them. Most investment decisions are based on historical returns, but these assume that one stays in the market long enough for historical patterns to repeat themselves.
Diversification usually reduces risk
This is true and sometimes applies even where one diversifies into a “riskier” class, as long as the new class is not strongly correlated to the existing one. A good example of this would have been in 1994 where a company with a 100% fixed income portfolio would not have had a good looking balance sheet at year end. Companies should, therefore, look for diversification into new asset classes and then within those classes. In fixed income, for example, one can invest in treasuries, gilts, corporates, asset-backed or high yield bonds. In equities, one can choose domestic, global, emerging market, growth, value and large or small cap, each of which will have a unique risk/reward profile.
There are, of course, other items to be considered in the investment decision-making. Good investment strategy requires a real commitment by the board of directors to the process, followed by a detailed look at the alternatives with the use of independent experts wherever applicable. Establishing a sound strategic approach, and then following it with discipline, usually produces the right result.
David Ezekiel is president and managing director of International Advisory Services Ltd. (IAS), an autonomous unit of Mutual Risk Management Group (MRM). He is a chartered accountant and holds a masters degree in business studies majoring in investment analysis. Mr Ezekiel is responsible for the strategic allocation of the invested assets of a number of IAS client companies. Tel: +1 441 295 3688 Fax: +1 441 295 2584 E-mail: firstname.lastname@example.org