Contributed by Carl Terzer – ICCIE Board Member and Instructor
Captive insurers undoubtedly have noticed that 2022 has brought an unprecedentedly challenging investment environment. Investment grade bond portfolios, which typically make up between 60% and 90% of a captive portfolio have generated negative returns. In fact, as of this writing (April 12th), the Bloomberg Aggregate Bond index, an index representing the US investment-grade bond universe, had a – 8.39% return year-to-date. Many captives have diversified their portfolios to include US large cap stocks. This asset class has near zero correlation to investment grade bonds, meaning that bond price movement has no effect on stock price in response to changing market conditions. The benefit of utilizing negatively, near zero, or uncorrelated asset classes is simply that such diversification usually results in improved overall risk-adjusted returns. However, this year’s market conditions are anomalous with US large cap stocks also producing problematic returns of approximately – 7.88% YTD.
Insurers are different from most investors in that they face claims obligations which continually and most often unpredictably, place a burden on either premium inflows or the investment portfolio or both. When collecting $1 in premiums today, captive insurers are expected to invest that dollar wisely so that three to five years in the future, or whenever a claim is made, this “reserve” for future claims has grown to more than $1. Under present market conditions, nominal returns for both stocks and bonds are deeply negative as mentioned above. When coupled with an inflation rate exceeding 8%, “real” returns are very deeply negative. If these circumstances continue for an extended time into the future, as they are expected to, insurers will have less than $1 in buying power to pay the future $1 in claims, representing a probable hit to their surplus.
Many years of historically low interest rates, coupled with fiscal policies designed to provide liquidity to avoid or recover from recession, has flushed the market with too much cash. While such policies worked to keep the economy on a steady path, unintended consequences included asset price inflation such as real estate and equity markets. Many observers believe these markets to be in a bubble status. These policies which began shortly after the 2007 Great Recession have also served to fuel today’s record-breaking inflation rates: rates not seen for nearly 40 years. Of course, the Covid pandemic and its supply chain interruptions along with the war in Ukraine have added additional fuel to the fire.
Unfortunately, even as some of these issues will be resolved, the most significant underlying conditions directly affecting the markets are unlikely to change for some time. With interest rates expected to rise over the next couple of years in an effort to tame inflation, bonds will continue to be hard pressed to produce positive “real” returns. Equity market volatility is expected to continue under the doubt that the Fed can engineer a soft landing in which rates are not raised too quickly nor too slowly to gain control over the inflationary environment. In a rising interest rate environment, GDP growth and corporate earnings are expected to slow. This will pressure U.S. equity markets due to the historically high PE ratios of today’s equity markets driven primarily by growth stocks that are particularly sensitive to rising interest rates.
There are few solutions to this environment for captive insurers. However, for bond portfolios, adding marginal credit risk and shortening duration (interest rate exposure) should be considered. In fact, short duration high yield bond portfolios could be added in small 5 or 10% increments to the fixed income portion of the investment program to improve overall fixed income returns. With regard to equity investments of the surplus component of a captive portfolio, non-US exposures particularly those of developed economies are expected to provide superior returns over the next several years. And finally, for those in a position to sacrifice some liquidity, there are many “alternatives” available which are designed specifically for insurance companies. These ALTs strategies may include investment-grade rated notes with relatively short lockups providing more liquidity and in some cases significantly higher returns than would be expected for most alternative investments. They could also provide additional diversification to core bond and core equity portfolios.
The bottom Line: Investment strategies that have worked over the last several years will more than likely suffer over the next several, as we have reached an inflection point in the interest rate cycle, and perhaps in the equity bull market cycle as well. Captive insurers would be strongly advised to review what new strategies should be considered given their liability structure, financial strength and unique risk tolerances.