Restructuring investment

We ask five experts: What key advice would you offer captive managers as they look at amending their investment strategy during a period of global economic instability and financial market volatility? Is it time for them to be bold or play safe?

April 2008

Robert G. Quinn, Wells Fargo Insurance Trust
I work with captives on their collateral requirements. There are investment managers who are managing the entire captive’s money to maximise yield; while in my world, captives take a portion of their money and put it into reinsurance trusts, which then fulfils captives’ collateral requirements. As a trustee holding assets for captives, I am seeing an incredible flight to safety. Most of my clients don’t want to take on risk with their collateral at the best of times, but particularly with such market volatility as there is now, they understand that the collateral they put into a trust account with us is there to pay claims in the event of an emergency. The last thing they want to happen is for volatility in the overall market to make their collateral worth anything less than it is supposed to be worth. From an overall standpoint, most companies are probably fleeing to safer investments. In the trust environment, I am certainly seeing an incredible flight to safety, such as treasuries and money market funds, and companies are probably well advised to do it.

I think this flight to safety is going to last for some time, because there are a lot of people still smarting from recent economic events. They are going to be more skittish once the market starts to settle and are not going to want to jump in head first again. They are going to look at this and recall what happened the last time they tried to invest more aggressively in an effort to pick up yield.

I see them playing safe and, while I’m not so sure about what the investment managers are advising their clients to do, my own clients are very hesitant to invest in things they are not familiar with, rejecting out of hand anything that sounds like a creative kind of investment or a securitised investment such as a securities mortgage or a mortgage-backed investment. They say they have heard too many bad things about structured investments. From a lay person’s point of view, it’s the structuredinvestments that are having the problems. Of course, they are not all having problems, but the layman’s viewpoint is influenced by the stories that last year mortgage-linked securities had record downgrades, and the slowdown in the CDO market.

Larry E. Fernandes, Wells Capital Management
Whether or how a captive should change its investment structure in response to a change in market conditions depends very much on the individual captive. Each situation is unique. I know it’s a soft market, but it matters if the parent is going to continue to use the captive during that soft market, and to an extent, the question of whether they decide to do more or less with the captive during this cycle is going to make a difference as to how the money should be invested.

Some things should always be in place no matter what the environment is like, such as being properly diversified, and not having a big gap between the duration of the liabilities and the duration of the assets. However, I also think there are times when you have to be smart as regards to the investment market. There are a lot of things going on in the US bond market today, for instance, that need to be factored into the way in which bonds or fixed income investments should be managed. I think that it’s important to have in place an investment policy that promotes diversification and has a lot of granularity, including a high level of detail about securities that would be allowed. For example, you might have an investment policy in which you invest in asset-backed commercial paper, and maybe that should be directly listed as a security that’s either allowed or not allowed within the investment policy, rather than simply a blanket statement that allows commercial paper.

With regards to the soft market, it’s more about what that means in particular for the premiums and the claims actions within the captives, and therefore how those monies should be invested.

Paul Deeley, Congress Asset Management
There are two issues facing us—the soft market and the current turmoil the markets are facing—so any investor is going to have to take a look at whether their long-term strategy is good. If they accept that it is not working for them then they should look at their short-term strategy.

In the shorter term, our recommendation would be that you would not want to be holding a lot of financial names such as investment banks. These have shown some poor decision-making, some excessive risk-taking, and they are probably not going to be recovering any time soon. But there are certainly some good, high-quality companies that can survive in these times of market turmoil.

On the fixed income side, the market is very pricey, especially on risk-free assets. The TIPS (US Treasury bond) is now in a negative yield position, because the government is expecting inflation and so these risk-free assets are providing us with unprecedented low yields right now. You can see the thinking of the market is that we are facing inflation, and we have to pay attention to that.

On the inflation side itself, you need to diversify your portfolio. You may want to stay away from some more risky names, but I wouldn’t make any long-term shifts in terms of asset allocation, but instead, focus on quality.

Most of our captive portfolios have some allocation to equity even if it’s a small one, and that of course is a hedge against inflation and also allows for sub-growth of the portfolio.

Carl Terzer, Principal Global Investors
The soft market conditions in the insurance industry suggest that many captives may expect lower premium volumes and slower growth levels. Some may even be put into run-off or hibernation. Certainly, one would expect lower formation levels, but concerning a captive’s investment strategy, consideration of the volatile investment market will drive decision-making more than the soft or hard cycle.

A captive can be in one of two situations as it enters a soft market. First, we will look at the scenario that is typified by a relatively new captive, one without years of claims experience. It could also be an existing small captive with a low level of surplus and slow prospects for growth. In any of these situations, captives are more than likely to be considering an investment objective of conservative growth through maximisation of yield or income. On that assumption, one would expect a portfolio focused on high-quality fixed income securities. Given present market conditions, US Treasuries should probably play a diminishing role in favour of a tactical strategy that increases credit exposure, while maintaining only high-quality investment grade securities in order to benefit from better returns as markets normalise.

In terms of strategic asset allocation strategies, these low surplus or new captives ought to consider adding an international fixed income component to the portfolio, which would better diversify the portfolio while enhancing the overall risk/reward characteristics. Remaining conservatively within the high-quality sector, they could take credit risk with foreign corporation debt, or if still too wary of the global markets, they could just add non-US sovereigns.

Another idea would be to add an allocation of preferred securities—i.e. fixed income securities that are subordinated debt issued by either US or non-US companies, which pay a semi-annual interest payment just like a regular bond. Some preferreds can have characteristics that skew them towards equity. These are called hybrid preferreds and can provide tax-efficiency for captives that may elect to be US taxpayers. Preferreds have been gaining momentum as an allocation in insurance portfolios as they have historically been the highest-yielding investment grade allocation in the US fixed income spectrum. A ‘specialty’ investment manager can easily assemble a portfolio of ‘investment-grade only’ securities to complement an existing core fixed income strategy. The way for a very small company to get exposure to those allocations would probably be through a commingled vehicle or a mutual fund, while a larger company should look to have the allocation individually managed to take advantage of any particular preferences.

In our second scenario, we will consider the case of larger, more mature captives, or perhaps a newer captive that is expected to grow aggressively despite the soft market environment. These captives should first look opportunistically at making certain tactical asset class additions to their existing high-quality fixed income portfolio. Considerations should include commercial mortgage-backed securities (CMBS). The historically high spreads of CMBS make them a very attractive portfolio addition right now. My caution is to select a manager experienced and deeply resourced in real estate investment management. My second suggestion would be for these larger captives to also consider a discrete allocation to preferred fixed income securities. If the captive’s board is a little more cautious and wary of the credit markets, they might also wish to inquire about private placement fixed income, a great place to get enhanced yields over a comparable corporate, with covenant protection in the event of continued market pressures or issuer financial difficulties. Finally, principal-protected notes (PPNs) are worthy of close examination as they can enhance returns while remaining within a captive’s ‘investment-grade only’ credit risk guidelines. PPNs typically are issued by a special purpose vehicle with an underlying portfolio that can contain a variety of investments to create a yield advantage.

As a larger, more mature captive evaluates its equity exposure, I suggest they increase or add an international equity allocation, perhaps to include an emerging equity component. It is a flat world after all!

While I do not advocate market-timing strategies, selected entry periods to sectors can make a difference. For example, for those leaning toward a quick economic recovery, another area they could look at is whole loans commercial real estate mortgages.
Going a bit further out the risk spectrum, alternatives are playing a larger role in portfolios of larger, established captives and, for many offshore entities, they have been a significant contributor to return for years. In the alternative categories, naturally, consideration should be given to hedge funds. I would also suggest a look at infrastructure funds, which are becoming very popular due to global economic growth patterns.

Dawn S. Silvia, Dwight Asset Management Company
For captive insurers facing a weakening underwriting cycle, the focus will once again turn to the income from the portfolio to make ends meet. Turning away from a total return focus toward adding yield will make up for the shortfall in underwriting profits.

For the past several years, adding yield has been challenging. Treasury yields have been historically low and yield spreads have been narrow. This has forced many insurers to step out in the risk spectrum, often without being properly rewarded for it.

The playing field has changed recently. While treasury yields remain low, the spread that is being offered on bonds has widened dramatically.

Last August, the asset-backed securities (ABS) market faced a dramatic turning point. Years of weak underwriting standards on home mortgages, combined with investors’ need for yield, forced many market participants to buy riskier assets. Investors were looking at the ratings of these bonds, many of which were ‘AAA’ rated, and assumed they were safe. That wasn’t the case, and the ABS market essentially seized up. The rating agencies have since changed the way they look at the collateral behind these assets and have downgraded thousands of ABS bonds. While many of these securities will not lose any principal, the market value fluctuations have created fear in the hearts of many bond investors.

This fear worked its way through other sectors, causing a repricing of risk across the fixed income markets. The balance sheets of Wall Street firms were severely weakened through their exposure to some hard-hit sectors, such has subordinated ABS and structured investment vehicles (SIVs), and this further caused liquidity issues in the market as the Wall Street firms were not willing to take in any inventory.

One of the more dramatic changes has been within the investment grade corporate bond market. For years, these bonds were priced at spreads below 100 basis points to treasuries. With the recent crises in the fixed income market, some of those same bonds are now being priced at 250 basis points over treasuries.

This spread widening is also true of other sectors such as mortgage-backed securities (MBS) and commercial mortgage-backed securities (CMBS). CMBS spreads have reached levels never seen before in the sector. While there is some evidence that subordinated CMBS might experience some downgrades, fundamentals within the higher-quality parts of the CMBS market remain strong.

While this may seem like the perfect time to add yield, it still must be done with a fair amount of caution. The likelihood of the US economy remaining in a recession for an extended amount of time would put pressure on consumer-based sectors—so a fair amount of fundamental analysis must still be completed—but once a level of comfort has been reached, it should provide an opportunity to add yield.

Much of the market has been repriced appropriately for risk, but there are many subsectors that have been punished—a sort of ‘guilt by association’ phenomenon. For investors with cash available, parts of the market continue to offer terrific yields for shoppers with strong stomachs, and these securities should outperform in the long run.
There are sectors where we still see a lot of value. Sectors such as ‘AAA’ rated super senior CMBS bonds we believe to be very attractive, with less chance of default. We also like short high-quality bonds within certain parts of the ABS market, as well as certain regional banks that have maintained a diverse lender base.

While there may be some pain in the short run, we think buying securities at these wider levels based on strong fundamentals with an eye towards a weakening economy may provide portfolio income and add to returns over time, thus helping to mitigate a soft underwriting environment.

“I think this flight to safety is going to last for some time because there are a lot of people still smarting from recent economic events.”