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Captive insurance asset investments warrant conservative approach

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Captive insurance company sponsors, long accustomed to taking on a wide range of property and casualty risks, are far more cautious when it comes to investing captive assets.

“We take risk on the insurance side. We want to minimize our risk on the investment side,” said Pamela Davis, Santa Cruz, Calif.-based president and CEO of the Vermont-domiciled Alliance of Nonprofits for Insurance, Risk Retention Group.

Captive executives and investment consultants say investment strategy has to follow two overriding objectives: ensuring sufficient cash flow to pay claims as they are due, and protecting the value of captive assets.

“We are not looking to make up for losses on the insurance side” when making investments. “The money must be there to pay claims,” Ms. Davis said.

“Market risk is not something” with which most captive sponsors are comfortable, said William Dalziel a partner with U.K.-based London & Capital Asset Management Ltd., which provides captive investing services.

In trying to meet those objectives, the overwhelming majority of captive assets are in fixed-income investments, such as U.S. Treasury bonds and notes, state-issued bonds and high-grade corporate bonds, experts say.

For example, about 99% of Alliance of Nonprofits' assets are invested in fixed-income instruments, such as U.S. Treasuries and highly rated corporate bonds.

Other captives, though, have invested a small slice of assets in equities.

For example, the Vermont-domiciled National Catholic Risk Retention Group Inc. has about 17% of its assets invested in equities.

Including equities in the investment mix is “a good way to achieve a level of investment diversification without injecting too much volatility,” said Michael J. Bemi, the RRG's president in Lisle, Ill.

Captive investment strategies, though, involve more issues than the mix—if any—of equities and fixed-income investments.

Another key consideration is the duration of fixed-income investments.

In general, the maturity lengths of captive investments should be tied to when claims are paid, experts say.

For example, captives with short-tail risks, such as property, should hold investments with short maturities, while those covering risks with longer tails should hold more investments with longer maturities.

“You have to look at loss patterns,” said Les Boughner, executive vp and managing director of Willis Group Holdings P.L.C.'s North American captive practice in Burlington, Vt.

A “best practice is to match duration” of investments with claims payout, said Carl Terzer, founder and principal of CapVisor Associates L.L.C. in Chatham, N.J.

For example, “the bond portfolio representing reserve assets should be constructed in a manner such that liquidity matches the projected payout patterns and other cash requirements. This is typically accomplished through the appropriate design of the portfolio's maturity structure,” Mr. Terzer said.

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Through duration matching, captives can reduce the likelihood of being forced to sell investments—before maturity—at a loss when they need money to pay claims, experts say.

If interest rates have risen sharply since the captive purchased the bonds, the captive will incur a loss if the bonds are sold before maturity, eroding its asset base.

For that reason, captives should shy away from fixed investments with very long maturities.

For example, fixed-income investments held by the Alliance of Nonprofits' RRG have an average duration of four years, with no maturity exceeding 10 years, Ms. Davis said.

Another key component of a prudent captive investment strategy is to diversify investments geographically and by industry.

“You want diversification” of debt issuers, Mr. Dalziel said.

Captive investment consultants also strongly advise not investing in mutual funds that hold fixed investments, such as corporate bonds. Instead, they recommend purchasing the corporate bonds directly.

“By definition, there is no control over what a mutual fund holds. Some hold derivatives to enhance yields, and fees tend to be much higher than with separately managed accounts,” said Claude R. Parenteau, president of Parenteau Associates L.L.C. in Easton, Conn.

Meanwhile, the European debt crisis has captive investment advisers recommending that—at least for now—captives should steer away from investing in bonds issued by countries with great financial strain.

“I'm much more comfortable with U.S. debt issues,” Mr. Terzer said.

“There is a shying away from investing in European countries,” Mr. Dalziel said, adding that U.S. fixed-income markets are so diverse that there are plenty of investment opportunities for captives.

For example, Ms. Davis said the RRG invests “strictly” in fixed-income investments whose issuers are in the United States.

Generally, captive domiciles do not have formal requirements on how or where captives, especially single-parent captives, can invest their funds.

Still, regulators say they scrutinize captive investments and, where appropriate, suggest and sometimes insist on changes.

Jeff Kehler, program manager of alternative risk transfer services in the South Carolina Department of Insurance in Columbia, recalls a situation in which state captive regulators found during a routine examination that a captive had more than 90% of its assets invested in illiquid securities. The captive was told to divest the investment.

“You need to be conservative and prudent,” Mr. Kehler said of the state's order to divest the risky investment.

In Utah, the nation's second-largest captive domicile with 239 captives at year-end 2011, “gentle persuasion” is applied to prospective captives in situations where their proposed investment mix is not, for example, sufficiently diverse and conservative, said Ross Elliot, director of the Utah Captive Division in Salt Lake City.