Weak economy teaches some tough lessons

BONITA SPRINGS, Fla.—Investment market turmoil during the past year has offered several lessons for captive insurance company investors, not the least of which is not counting on investment market liquidity, one expert says.

Speaking about captive investment strategies in troubled times at the 19th Annual World Captive Forum this month in Bonita Springs, Fla., Clifford Axelson, managing director at Prudential Financial Inc. in Newark, N.J., said, “You have to assume that liquidity will not be there when you need it.”

In today's environment, Mr. Axelson said captives should look to cash for their liquidity needs, and suggested they rely on sources such as dividends and income from their captive operations for needed liquidity, rather than expecting to be able to sell securities.

Other lessons offered by the investment climate include viewing investment diversification from a long-term perspective.

“My advice to you would be not to give up on diversification. It works, but it's a longer-term phenomenon,” Mr. Axelson said.

Recent events also have shown that bond investments have risks beyond interest rates, Mr. Axelson said, and that “securities lending is not a riskless investment.”

The current market also has offered lessons about the role of risk assessment tools that measure value at risk, he said. “Risk tools in the marketplace like value at risk are just that: They're tools,” Mr. Axelson said. Those tools are based on economic fundamentals, he said, “and do not work in predicting shocks to the economy.”

“Frankly, tools should never dictate anything,” Mr. Axelson said. “They should be a guide. They should help you make decisions.”

In dealing with a captive's investments, “There is no substitute for a sound fiduciary process,” he said.

Among the most important considerations in captives' investment programs are the captive's liability stream and the company's appetite for risk, Mr. Axelson said. “For cyclical companies that go through a cash squeeze when the economy takes a downturn...(they) probably need to set cash aside, be a little more averse to risk,” he said.

At the same time, however, Mr. Axelson challenged captive owners to “consider the opportunity cost” of focusing exclusively on extremely short-duration investments.

“While the investments will not make a captive be successful, they can certainly hurt the chance for success,” Mr. Axelson said.

Another speaker on the investment panel, Chris DeMeo, division practice leader-East at Watson Wyatt Worldwide in New York, noted investment risk appetite of captives often changes over time. Unfortunately, however, “Those risk appetites often change at the wrong time,” he said. “The last thing that a successful captive wants is to trade a risk that they have that they don't want for a new risk that they don't know about.”

Noting that he has some clients whose investment policies are “just paper,” Mr. DeMeo said it's important that a captive have an investment policy it actually follows.

He advised captives to “be true to thyself” and their governance structures. “Where we've seen investors get in trouble is where they have low governance and a highly complex portfolio,” Mr. DeMeo said. It's important that captives align their level of governance with their investment approaches.

In discussing investment strategies, Mr. DeMeo said he looks to engage clients in discussions of, “What's the worst that could happen?”

If captives have set long-term investment plans, market turns alone don't suggest that those strategies are inappropriate, Mr. Axelson said.”If you put an asset allocation in place for the long-term, the fact that the markets correct or move up or back abruptly doesn't negate its validity,” he said.

Wendy Liu, senior consultant at Towers Perrin in New York, moderated the panel.

Tell us what you think. Log in below to weigh in on this story.