- Captives historically invested in cash which typically yield close to overnight/short-term interest rates
- Potential missed opportunities for captives not investing in bond market
- Parent loan backs remain popular, but following regulations is key
With overnight borrowing rates anticipated to come down this year, captives may be advised to alter their investment strategies and invest in intermediate maturity, high quality fixed-income sectors to maximise returns from a changing fiscal environment.
There are expectations that the US federal reserve will introduce a 25 to 50 basis point cut in September, and another one or two cuts in the months following are anticipated.
The UK is also seeing interest rates fall with the Bank of England’s Monetary Policy Committee (MPC) announcing on 1 August that it had cut interest rates from 5.25% to 5.0%.
Captives have historically invested heavily in cash which has recently yielded close to the Fed funds rate of 5.25%, but investors are actively advising clients to reevaluate their cash allocation and consider locking in yields on longer maturity, high quality fixed-income sectors.
“It’s important to do this now before the Fed cuts rates, as the cash yield is closely tied to the Fed funds rate,” Matthew Sullivan, vice president, senior investment advisor at PNC Insurance Solutions Group, told Captive Intelligence.
He said it’s important to understand that there are asset classes beyond cash and treasuries that can still offer high quality and provide diversification benefits along with long-term capital appreciation.
“By taking on some level of risk, captives can grow their surplus through investments in other high-quality fixed-income sectors, such as mortgage-backed securities, asset-backed securities, and municipal bonds,” he said.
Scott Mildrum, macro & economic strategist at Performa, said investors have grown more comfortable with the idea that the Federal Reserve is effectively working to return inflation to 2%, which he believes has led to a calmer rate environment this year compared to the previous two years.
“At this point in the cycle, we like being neutral duration,” he said.
“After adding duration back to client portfolios, as rates moved higher, we think we are in a good position as we exercise patience, prudence, and discipline while waiting for the next significant market catalyst, as markets tend to overshoot creating opportunities for active investors.”
Jack Meskunas, executive director, investments at Oppenheimer & Co, said that because there is growing conviction that the next move for interest rates is down, he is increasingly advocating for the benefits of extending duration.
“In plain English, this means moving from money markets, which are essentially seven-day instruments, to bonds with maturities of 3 to 5 years,” he said.
“What they’re doing is locking in slightly lower rates—maybe 4.75%, 4.8%, or 4.9%—compared to the 5.25% they might be getting in money markets, but they’re locking it in for five years.
Meskunas said that the advantage here is that when the Fed starts cutting rates, those money market rates will instantly decline.
“So, I’m advising clients to extend duration, and I’m starting to see people not only thinking about it but also taking action,” he said.
He believes it would be a missed opportunity if captives do not get involved in the bond market now, but that there good and bad approached to bond market investments.
“The good way is to hire a fixed-income manager who invests in individual bonds,” he said. “This approach allows for locking in a specific yield and maturity date for each bond, providing stability and predictable returns.”
Meskunas said the bad way is to invest in a bond fund, as although a client might receive a similar yield to an individual bond portfolio, bond funds do not offer the same benefits.
“The bonds in the fund are frequently bought and sold, which means you don’t benefit from the potential capital appreciation that can occur as yields decline,” he said
As interest rates fall from 5% to 4% to 3%, bond prices are expected to then increase.
“If they invested in individual bonds, they could see returns close to double digits over the next two to three years, which is an exciting prospect,” Meskunas said.
Chris Dalziel, executive director and London & Capital, said if we look back two or three years ago, when interest rates were zero, fixed income was not a viable alternative, and equity markets were performing “exceptionally well”.
“It’s natural that the focus was on equities,” he said. “However, the situation has shifted.”
“Equity markets have done very well but look overvalued in some areas, while fixed income now appears fairly priced, offering 5% to 6% yields that can be locked in for a reasonable period.
“Given these dynamics, it’s perhaps not a surprise that captives are not pushing the envelope on investment risk at the moment,” he added.
Colin Donovan, president of STICO Mutual Insurance Company, RRG, said the group has historically conservatively invested in fixed income and equity.
“We have an investment committee on our board that that helps oversee the investments,” he said.
“We have a fixed income investment manager and an equity investment manager, and we get everybody in a room together a couple of times a year to or at least on the phone together to talk through that strategy.”
Different appetites
Wade Meadows, regional managing director, head of insurance and specialised industries at PNC Institutional Asset Management, said that many seasoned captives are not fully aware of how much risk they are taking, or what their risk budget is.
Meadows believes there are opportunities to grow a surplus within that risk budget, but captives often do not realise it.
“We have been working with a number of these seasoned captives that have built up a surplus not earmarked for loan backs or dividends that just keeps building,” he said.
“The question then becomes, what are you doing with that surplus?
“If there is no intention to increase retentions or add new risk lines, how can we most efficiently and effectively put that surplus to work?” he added.
Meadows said that by doing this, captives can continue to grow the surplus, and eventually might be able to support a dividend or increase retentions or risk lines.
Dalziel said that if we look at the smallest captives, especially those with the most conservative risk profiles that have been holding onto cash for the past decade, many have become cautious or uncertain.
“They’ve endured the challenges of the zero-interest-rate environment and are now seeking cash and cash-like strategies to finally put their capital to work and earn returns,” he said.
Dalziel said that banks in smaller offshore domiciles are not quickly passing on the benefits of higher interest rates to deposit accounts.
“Therefore, captives aiming for cash-like returns should consider a segregated portfolio that allow them to plug into to global markets and so able to take advantage of buying cash-like short-dated US, UK or EU. issued government bonds,” he said.
“This approach ensures investment risk is kept low but provides captives with cash returns and, importantly, a toe in the markets which can then be built on over time as they gain confidence or investment priorities change.”
Lines of business
Due to the hard commercial market, many captives have been looking at adding new lines of business, as well as growing existing ones, which is naturally leading to an altering of investment strategies.
“If this is the case, you might expect that captives would be more cautious about taking risks on the asset side of the balance sheet, especially when they are taking on additional underwriting risk,” Dalziel said.
“While captives have benefited from buoyant equity markets, we haven’t seen many captives aggressively pursuing higher-risk strategies on the asset side over the past 12 months,” he added.
Sullivan said the magnitude and type of risk are often the starting points when evaluating a captive and understanding the projected claim payout.
“We focus on building a bond portfolio with maturities aligned to those projected claims, ensuring effective reserve matching within the portfolio,” he said.
“This alignment is crucial to managing the risks inherent in the captive.
“Beyond that, it’s also about identifying the surplus allocation of the portfolio and getting the client comfortable with taking on some additional risk to achieve long-term capital appreciation,” he added.
John James, head of business development at Performa, said that when assessing the liability profile of each captive, the firm considers whether it involves short-tail or long-tail risks, generally aiming to match maturities of their bond portfolio to the overall liability profile and cash flow needs.
“For clients with longer-tail risks, they can often take on a bit more market risk from a maturity perspective in their bond portfolio and even potentially include exposure to other asset classes (i.e., high yield bonds and equities),” he said.
“On the other hand, for clients with shorter-tail risks, we ensure that their bond portfolios have shorter maturities to provide easy access to liquidity and less portfolio volatility,” he added.
James said the firm strives to align the cash flow needs and liability profile of each captive with the investment portfolio they manage for their clients.
“We also take into consideration a number of other factors, including each client’s risk tolerance, lines of coverage, the degree to which they might have a fronted program (Trust or LOC), their reserves vs surplus as well as our view on capital markets,” he said.
James said it is important to always think about building investment programs for clients in the context of the overall captive, looking at how the underwriting side and investment program come together for a “holistic, comprehensive approach”.
“The last thing we want to do is manage money in a silo on the asset side away from the underwriting and liability side of the captive,” he said.
“It needs to be a strategic part of the captive that can grow and evolve over time.”
Loan backs
Captives frequently provide loan backs to their parent companies, allowing capital from the captive to be applied elsewhere within the group.
This can be especially useful if the captive has surplus capital that exceeds its required reserves.
“By borrowing from the captive, the parent company or its affiliates can gain access to additional liquidity without having to seek external financing, which might come with higher interest rates or stricter covenant,” Michael Serricchio, Americas consulting leader at Marsh Captive Solutions, told Captive Intelligence.
However, loan-back arrangements must be carefully structured to comply with local domicile regulations, required approvals.
“They also need to be viewed through the lens of the Internal Revenue Service (IRS) or other relevant taxing authorities to maintain appropriate insurance tax status,” Serricchio said.
“Loans and intercompany investments can attract scrutiny from tax authorities, particularly if they are perceived as primarily a means of tax avoidance or circular flow of cash,” he added.
Peter Cater, head of captive and insurance management and head of climate practice at WTW, said it is important to think about the counterparty risk of the parent when the captive is loaning back funds.
“Typically, this is handled by structuring the loan as repayable on demand, with triggers for recalling the loan on an event such as a downgrade in the credit rating of the parent,” he said.
Carter said companies also need to consider the impact on the captive’s solvency calculation as there may be a different haircut applied to a loan to a group versus a deposit with a bank.
“This will be driven by the parent’s credit rating,” he said.
Malcolm Cutts-Watson, non-executive chair at RISCS CWC, said there have been examples of parent company failures where the captive had lent substantial amounts of funds back to the parent.
Cutts-Watson said loan backs are like alcohol, “ok in moderation but binging increases risk”.
“The captive board should prepare a risk appetite statement that outlines how large any loan back should be and ensures the captive has adequate liquidity,” he said.
Meskunas believes that one of the worst investments a captive can make is lending money back to its parent company, and he said there are several factors for this.
“First, when you transfer money from the captive to the parent company, the captive ends up holding only notes or loans, rather than actual cash,” he said.
“This means that the risk has not truly been transferred, as the captive now relies on the parent company to refund any claims,” he added.
He said that this practice is more common among larger captives, where a sophisticated chief information officer manages the investments and aligns the captive’s portfolio with the corporate investment strategy.
Meskunas also said that the investment needs of a corporate portfolio differ significantly from those of an insurance company portfolio and treating them the same can be problematic.
“In summary, while lending money back to the parent company is a common practice, it may not be the best strategy for managing captive investments,” he said.
Dalziel said the one thing a captive is not doing when they loan-back funds to the parent is diversifying their investments. “In fact, they are compounding the risk,” he said.
“Harry Markowitz, Noble laureate and the father of Modern Portfolio Theory, once famously said that diversification is the only free lunch in investing,” he said
Dalziel said that from a fiduciary perspective, it’s surprising that board directors consider this an appropriate way to manage the asset side of a balance sheet, especially for an independently regulated insurance company.