Investment Management

Captives are insurers, but special insurers. They have objectives and requirements that differ from those of standard insurers. In an industry characterised by its lack of standardisation, captives represent a particularly idiosyncratic sector. In providing asset management services to captives, firms must recognise that no one size will fit all clients. While there will always be scope for captives to invest in pooled investment funds (notably liquidity funds), these products must be developed and packaged recognising the particular nuances of this market. When formulating investment strategy, a captive insurer will consider- 1 .Factors common across all insurers-, and 2. Specific issues for captives (and for this captive in particular).

Defining and evaluating risk

In the classic 'risk/return' trade-off to which all investors are subject, the difficulty lies for insurers in defining and evaluating 'risk'. It is a much subtler concept than simply 'standard deviation of asset return' or indeed than GAPM portfolio beta, which typically suffice for many asset management clients. Elements of risk for insurers include-.

• profit and loss account volatility
• VAR-type capital measures
• the risk of regulatory intervention (for example due to breach of minimum capital thresholds)
• accounting risk-, which part of the accounts is affected by market value variability?
• liquidity risk
• operational risk

Any investment management decision should be assessed in the context of its impact upon whichever risk measures are relevant to this insurer.

The first and most important decision is how to invest the two separate components of the balance sheet:

1. reserves
2. capital

Matching

The question of investing assets in respect of reserves is one of matching assets to liabilities. The greater the mismatching risk, the greater the residual volatility that cascades through to profit and loss, and capital volatility. It is also worth noting that in certain jurisdictions, discounting of some claims reserves is allowed but only under condition that they are demonstrably matched. For a significant portion of the short-tail claims to which an insurer may be exposed, the most appropriate matching asset is cash. It is therefore vital for an asset manager to be able to offer a range of liquidity funds, covering all major currencies, of sufficient size and quality (credit rating) to be able to meet insurers' needs.

Investing for return

The investment of those assets that relate to capital is typically less restricted. It represents a strategic decision depending ultimately on a risk/reward trade-off decision by the insurer's board. The view of this trade-off varies widely between insurers. Some consider capital to be surplus to policyholders' requirements and are willing to invest with quite a high degree of risk, touching some 'alternative' investment classes like property, commodities, and hedge funds. Others take the view that an insurer's role is to take insurance risk but not investment risk, and they will not be willing to take more risk than looking for extra yield by investing in corporate bonds. The following illustrates this approach showing the functions of the different asset classes in meeting both the matching and the risk/return needs for captives.

Specific issues for captives

The most important distinction to note is that, for most captives, the policyholders and shareholders are one and the same. This may mean a more fluid approach to matching and return maximisation, with less distinction between matching liabilities and investing for return. The distinction between investing reserves and investing capital is still important, however, as local regulators will almost certainly consider the two components separately. A captive may take more or less investment risk in aggregate than an otherwise similar third party insurer. On the one hand, if the captive is in a low-tax jurisdiction the parent firm may wish to ensure that a small but stable profit is made, because it is a waste of the tax status to take the risk of a loss which it is not able to offset fully against taxable profits elsewhere. On the other hand, some parent companies take advantage of the lower regulatory control of some captive environments and are keen to seek higher rewards (and hence risks) from the investment of their captives' assets. This is especially so if the parent is willing to undertake to recapitalise the captive should it be required. Captives represent a form of 'insourcing' for their parent companies, but are themselves seldom able to take on the burden of all aspects of running an insurer. As such, outsourcing is a way of life for captives and they consider carefully the quality and quantity of their service providers. Arrangements that combine captive management services, financing and investment management in one scheme, such as that offered by Aon, Barclays Offshore Financial Markets and Barclays Global Investors, can provide a high quality service with a lower administrative burden.

The modern approach to investing

Recent trends for institutional investors have been clearly in the direction of reducing unrewarded risk through matching assets and by optimising the residual risk/return trade-off. In matching, several new asset classes have been developed, resulting in synthetic bond-like structures that exploit the ever deepening swaps market. This enables investors to match expected cashflow with far more accuracy than with physical bonds, which is an advantage in reducing risk when there is a high level of certainty in those cash flows. In addition, swaps can also be used as an efficient way of altering the duration of a portfolio of physical bonds without having to trade the physical portfolio. In investing for return, the burgeoning of the hedge-fund market, assuming investors choose genuinely market-neutral funds, provides an opportunity to generate additional returns without exposing the investment portfolio to the potentially high levels of volatility associated with quoted equities. However, accessing these new opportunities can be challenging for captives, while not all investment managers have the knowledge, infrastructure and systems to manage these new strategies successfully. Fortunately developments in pooled funds aimed at liability matching and multi-strategy hedge funds can make it much easier for captives to implement an effective liability-led investment strategy and hence drive greater value in the captive's overall operations.