Captives facing asset risks

2012 has been a successful year for new captive formations in the Cayman Islands. But for captive insurers, which are naturally conservative investors, focused on the protection of cash, the prolonged low interest rate environment is becoming a risk to their asset portfolios. The Cayman Captive Forum debated investment alternatives. 


Gordon Rowell, head of Insurance Supervision at the Cayman Islands Monetary Authority, is bullish about the insurance market in the Cayman Islands. Even though the global economic recovery was not making great strides, 2012 “has been the busiest year for new business in recent memory” for the Cayman insurance industry, he said.  

CIMA received about 60 licence applications in the first ten months of 2012, a 57 per cent increase on 2011. As of 31 October there were 737 captive insurance companies registered in Cayman with US$88.1 billion in assets and US$11.8 billion in premiums written. Premium growth has remained stable, Rowell said. 

He also noted 780 segregated portfolios resulting in a total of about 1,500 insurance entities CIMA has to regulate. In addition Cayman saw a number of redomiciliations into the jurisdiction in the commercial insurer space.  

However, Rowell also pointed to challenges for captive owners in certain areas of both assets and liabilities. On the insurance risk side it is very difficult to attract participants to come into a group captive, when the insurance market is so soft. Fronting, a specialised form of reinsurance frequently employed in the captive insurance market, is still as limited as it was five years ago. Moreover, forming a captive in a tight cash flow environment is very difficult and tort inflation still runs at 3 to 4 per cent over the consumer price index, Rowell said. 

As far as the insurance market is concerned, he said, the industry is living of higher redundancy and capacity, with some $560 billion in terms of capital surplus. “In simple terms the insurance industry and the commercial industry has money to burn. That makes it difficult for captives to foster and thrive in an environment where it is so competitive.” 


Asset risk  

On the asset side the prolonged low interest rates have resulted in limited investment options. Asset risk is becoming a problem and naturally conservative captive owners have to think about new strategies. Equity investments have already increased from 13 per cent of invested assets to 19 per cent in 2012. But Rowell encouraged asset managers to look for areas and opportunities to increase risk on the asset side. 

Hugh Barit of Bermuda-based asset manager PRP Performa confirmed that the firm’s clients in Cayman, which consist mainly of healthcare captives, are very conservative. But the old dictate that low risk equals fixed income is no longer accurate in the current environment, he said.  

“I think we are all beginning to realise that sometime over the next five years you are going to lose money in investment grade fixed income.” 

As rates have been declining since the early 1980s very few people in the industry have experience with this kind of market environment, he said. Interest rates will have to rise at some point and bond prices will come down with no yield protection. This means captive owners have to diversify their portfolio away from interest rate risk. 

While this could include allocating 5, 15 or 20 per cent to long equities, the volatility in today’s equity markets is much higher than pre-2008 and generally too high for captive owners. 

The alternative in Barit’s opinion is the mature high yield bond market, where interest rate risk is somewhat reduced because of the higher interest rate cushion of 7, 8 or 9 per cent and replaced with a greater exposure to default risk.  

In addition, he said, it is possible to add an absolute return, market neutral hedged equity approach to reduce volatility, but the objective would not be to outperform all equity but from a captive client’s standpoint to outperform fixed income.  

In any event captive owners will have to lower their expectations. Historic returns of 5 or 6 per cent for a captive portfolio are now unrealistic, he argued, and target returns should be more in the region in the region of 3 to 4 per cent. In the investment grade fixed income portfolio the objective is to beat the rate of inflation, which is currently between 1.5 to 1.7 per cent. 

Butterfield Asset Management’s Andy Baron also said that a 100 per cent investment grade fixed income portfolio is no longer advisable.  

He agreed that parts of the high yield market remain attractive as the low interest rate environment has allowed many companies in the high yield space to refinance their debt and balance sheets and cash positions have improved. Many companies have satisfied their borrowing needs for several years and leverage is reasonable.  

Compared to equity investors, he explained, high yield investors are relative value investors and more concerned with company fundamentals, balance sheets and the company’s ability and willingness to pay than earnings and cash flow.  

However, Baron warned captive investors and individual investors to take any duration risk, ie the risk regarding the sensitivity with which bond prices react to interest rate changes based on the average time to maturity of its interest and principal cash flows. “It is OK to take duration risk if you are compensated on the yield side,” he said. “[Currently] the risk reward is skewed massively the wrong way.” 



Despite these challenges, Rowell’s forecast for the future of the Cayman insurance industry is bullish due to the implementation of the new Cayman Islands Insurance Law, which is “designed to be responsive and to allow business to flourish” and Cayman’s regulatory framework, which “addresses entities based on the nature, scale and scope of the risk”.  

He contrasted this with what is happening in other jurisdictions, where “over-regulation, or poorly thought-out regulation creates additional costs and can kill the production efficiencies required to spark the necessary growth”. 


Soft market 

For a more impressive growth of captive formations near the highs of 90 to 100 new captives per year, the insurance market needs to see significant rate increases in order to make self-insurance more attractive, Rowell said.  

Since 2003 the insurance and reinsurance industry has experienced the longest period of a soft market. And while there were also long soft cycles prior to 2003, the difference today is that the balance sheets are that much stronger and companies are more disciplined in their underwriting, said Kim Morgan of Endurance Specialty Insurance. She said there are slight rate increases in the property and casualty lines, but “whether that trickles to other lines remains to be seen”. 

Rowell added that for a hardening of the market, capital and surpluses in the commercial market need to see a significant decline and a sustained period of underwriting losses. 

Panellists agreed that the soft cycle is likely to persist over the next 12 months and there continue to be question marks over significant economic growth.