The most effective method for a captive to enhance its risk-adjusted returns is by taking on additional risks that will diversify the vehicle’s overall portfolio, as discussed in the latest episode of the Global Captive Podcast.
Captives should not evaluate operations from purely an asset or liability point of view, but rather through an integrated approach which can reveal where new exposures can reduce overall volatility while still improving returns.
“Having a more diversified portfolio is effectively the only way to get a “free lunch,” Rob Ceske, partner and global captive leader at Oliver Wyman, said while speaking on the most recent GCP Short.
“By improving diversification, a captive can enhance its risk-adjusted performance.
“Just as a broader investment portfolio improves risk-adjusted returns, a more diversified captive portfolio spreads exposures, reduces overall volatility, and creates opportunities for higher long-term performance.”
Comprehensive capital modelling enables this strategy by identifying correlations between asset and liability portfolios, showing where diversification can enhance returns without increasing the overall risk.
“When we think about the asset side of the equation, the first thing is understanding the risk profile of the captive’s assets versus any liabilities,” Ceske said.
“Appropriate and comprehensive capital modelling will allow you to look at the correlation between the asset portfolio and liability portfolio.
“You can then see whether you can take on assets that have a greater return over time but may have more volatility in the interim.”
Liquidity is another key factor when it comes to investment returns as more liquid assets generally have lower returns.
“Captives often focus more on the liquidity needs of their liabilities than on the liquidity profile or duration of their assets,” Ceske said.
“There is often an opportunity to improve returns by giving up some liquidity – when the asset and liability liquidity profiles are balanced, higher returns can be achieved while still meeting obligations.”
Also speaking on the most recent Global Captive Podcast, Michael Atkinson, principal and actuary at Oliver Wyman, said many captives’ investment approach often follows the corporate strategy.
“If we think about the risks underlying the two different business operations – the corporate side and the insurance/captive side – those liabilities are very different,” Atkinson said.
“They have different durations and different mechanisms behind them.”
He added there is also often a more hands-off approach, where nobody is paying proper attention to the investment side of the captive.
“Many of the people running the captive are more focused on risk management, so investments aren’t necessarily in their wheelhouse,” he said.
“Having a firm grasp of the portfolio that works most effectively between the assets and liabilities is the approach many companies will want to take, rather than simply letting the corporate strategy flow through into the captive.”