Ensuring your captive’s capital is working for you

James Bailey and Anjanette Fowler of PNC Asset Management on how to approach captive investment portfolios in the current economic environment


With high inflation prompting central banks to raise interest rates, investors of all kinds are starting to reconsider the role of cash in portfolios for the first time since the financial crisis of 2007-2009. For captive insurers, these changing conditions require a rethink of investment portfolios to ensure they are getting the most from their holdings.

There is a delicate balance to be struck between liquidity, yield and risk. Finding that balance is no easy task. As James Bailey, managing director at PNC Bank, and Anjanette Fowler, managing director for insurance solutions at PNC Institutional Asset Management, explain, there are several implications to consider. “For both seasoned and start-up captives, cash management is critical,” says Fowler. “Given where yields are today, it can help offset a significant portion of a captive’s operating costs.”

Is cash king again?

In the years leading up to the 2007-2009 financial crisis, US interest rates averaged 4.1%. After the crisis, and following the huge stimulus projects enacted by the Federal Reserve, interest rates fell to near zero.

Over the course of the past 12 months, rates have risen sharply again as the Fed has sought to battle inflation, with the terminal rate hitting 4.5%. As Fowler and Bailey explain, this means a sudden change for the attractiveness of cash and investment-grade bonds.

Bailey says: “There are numerous options, from demand deposit or checking accounts with a financial institution, to investment sweep vehicles like money market funds or even a portfolio of commercial paper or staggered maturity Treasury bills. Not all options are created equal though, as fees and rates offered may push yields below the ‘market’ rate, so it’s critical to understand each and optimise your cash position so that it generates the most income possible for the captive.”

It’s also important to keep options open, Bailey adds, as interest rates are unlikely to remain at the current high levels, especially if the Fed is successful in lowering inflation.

Back to bonds

As well as cash, fixed income has been significantly affected by the rapid shift in interest rates. The yield on the 10-year US Treasury bill rose from 1.51% at the start of 2022 to 3.88% on 1 January 2023, a rise of 237 basis points.

“Fixed income is back from the dead,” says Fowler. “Off of near zero yields, bonds are relevant again. Newly formed captives now have greater opportunity costs for not effectively leveraging their capital to generate investment income – even if it only offsets the captive’s operating costs.”

She highlights areas such as the lower end of the investment-grade credit spectrum, with “opportunities to add yield” through exposure to BBB-rated bonds – an area of the market that has grown “substantially” in recent years.

However, investors should “be selective” as there are still risks that need to be managed.

Looking further afield

Investment opportunities in cash and fixed income are unlikely to be enough to protect captive insurers against the effects of inflation, particularly if it remains elevated around current levels.

Even if it falls back to the Fed’s target level of 2%-3%, the portfolios that have succeeded over the past 10-15 years will need rethinking. Equity markets may seem attractive after a year of volatility driven by the conflict in Ukraine and rising inflation.

The S&P 500 index fell by 19.4% during 2022, while valuations across many markets have fallen below 20-year averages.

This makes for “an attractive entry point for long-term investors like seasoned captives with healthy surplus levels”, says Fowler.

However, those that are newer or without a strong surplus position may not be able to take on a meaningful equity allocation, she adds.

“Valuation levels, while below 20-year averages, are still above the price-to-earnings multiples you might expect given inflation levels and rates,” Fowler continues. “That’s not to say we expect multiples to contract to those levels, but when managing the capitalisation levels of a new captive or those with little surplus, the potential risk is there.”

A new normal for volatility?

One feature of markets last year was volatility, whether in equities or bonds. As Bailey says, volatility is “no longer the exception, it is now the rule”.

“While it may not remain ‘elevated’, volatility will likely settle in higher than it was over the past decade given the large amount of liquidity from both monetary and fiscal support,” he explains. “This presents challenges for non-seasoned plans and those with little surplus. Capitalisation becomes precious.”

For captive insurers, a focus on downside protection is important. In equities, captives should look for low beta options that can participate in rising markets but protect in downward periods. Moreover, diversification will be vital.

As demonstrated last year, bonds and equities become correlated in times of market stress, which can be a nightmare scenario for undiversified investors.

Bailey highlights alternative strategies such as hedge funds, private credit and private equity that can all add important sources of diversified returns to a captive insurer’s portfolio.

An investment portfolio that successfully navigated the past decade may not be positioned to do the same over the next 10 years. Captives will need to reassess their strategies and consider how best to set themselves up for future success.

12 August 2024
5-6 November 2025

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