Originally published in the Captive Review, Guernsey Report, October 2008

Charles Allen Of Heritage Insurance Management Urges Captive Managers To Look At Their Investment Strategies And Securities In Place.

In these uncertain times captive owners and their managers should be taking a long hard look at the strategic importance of their insurance vehicle and the threats and opportunities that present themselves from the financial market mayhem surrounding them.

There are many areas that need careful consideration and review given the current phase of the insurance market cycle and the impact the economic situation will have on the insurance markets. There seem to be daily predictions from all manner of experts in the market as to the point at which the cycle will turn upwards and rates at last harden. The elongated soft market we have seen in many classes will undoubtedly come to an end, but the question is how soon and how rapid the upturn in rates will be and which classes will be most affected.

The professional indemnity market for example, is already showing signs of movement and especially so for financial institutions, mortgage brokers, IFA's, and accountants. However, solicitors where there are more than, say, four partners are still able to renew with no great changes to expiring rates. Yet the likelihood is that the assigned risk pool for those unable to buy cover elsewhere and supported by the major underwriters in a pro rata manner will pick up a massive chunk of the market, and this will undoubtedly lead to a hardening of rates.

Captives should, therefore, be doing everything possible to be in a position to take advantage of the higher rates, adjusting their strategy to be ready to include larger retentions, and ensuring they have the capital and funding from the parent in place to do that. But the uncertainties that abound in so many areas also present a threat to captives, and, as mentioned earlier, owners and their managers need to be aware of and deal with these additional factors.

For renewals that are coming up immediately it may be too late to factor all this in this time round, however, at the very least, clients should be seriously looking at the effects of the current situation on the year end and 2009 renewals.

With this in mind, it is unsurprising that the resultant questions directed towards captive managers come not only thick and fast but with an added sense of urgency. The two queries that follow are, possibly, the most pressing of our current predicament.

Is Our Current Investment Strategy Appropriate In These Very Quickly Changing Times Or Do We Need To Change It?

As a result of the changing markets, captive clients need to look at their investment strategy and, perhaps, change some of their existing business plan criteria. For example, exposure to any one entity should now be reduced significantly. It is clear the risk profile of even the major institutions is no longer fully understood, and even if we don't expect any of the major banks to completely fail it would almost be negligent not to diversify and hedge the captive funds to spread the risk as far as possible.

The investment strategy for any captive has got to be linked to its exposure and its likely claims pattern, but, much more fundamentally, it must have investments and cash ready to meet its potential underwriting liabilities.

A captive has got to be conservative by nature, avoiding as much risk as possible of a diminished asset base other than by the normal payment of claims. Therefore, investment strategy, which for some has been unexciting (especially so for some of the larger and older captives), now becomes a much larger part of the daily discussions.

Gilts and Treasury bills are in strong demand and the overriding advice that has to be given is that preservation of capital has become a primary objective and absolute return secondary in these uncertain times. No one can predict the next failure or twist in the roller coaster markets and all those that have tried seem to be proved hopelessly wrong on an almost daily basis.

If captive clients are not asking these questions then it is the responsibility of the manager to ensure this topic rises immediately to the top of the agenda.

How Do We Look At Security As A Captive Owner? In Light Of Recent Events, Can We Still Regard The Acceptable Lists Of Major Brokers As Being Acceptable?

Clearly, reinsurance security is absolutely critical now, and probably one of the most difficult areas to clearly understand. It's not too difficult to rearrange a portfolio of investments in a short space of time, but this relative ease of strategy change does not follow for the security that the captive is using for its existing underwriting arrangements generally fixed on an annual basis.

In many cases a reasonable sized captive will have a broker able to advise on reinsurance security as a result of its own security committee's deliberations; a team of well-deployed analysts whose job it is to look at the different reinsurance companies analysing their balance sheets, talking to rating agencies and generally using their market contacts to understand the quality of the company's balance sheet.

However, what value can an owner attach to all of this which includes a very strong reliance on the rating agencies, when a company such as AIG explodes within a very short space of time and, in effect, goes from hero to government owned zero in the space of a few weeks? It is understandable that the spotlight should quickly move to the agencies themselves.

What detailed analysis is available to the credit agencies to make informed judgement on the strength or otherwise of these underwriters? Don't worry, it's not a silly question – not when people have known for some time about the overheated nature of the housing market on both sides of the Atlantic. Many commentators have been predicting a correction at some point given the fact that asset leveraging and lending in recent years had become very free and easy, and pretty irresponsible.

If you were an analyst in a particular sector, and you were looking at an insurance company's accounts/balance sheets, you'd want to be aware of what their exposure might be to non-insurance securities. However, the complexity of financial statements and the often impenetrable web of underlying transactions makes this task almost impossible. It's no different in the captive sector. We don't have to lose faith in the rating agencies, but what this has highlighted is that we shouldn't be using their ratings without understanding the depth to which they themselves have penetrated the affairs of the company in question.

Perhaps as relevant a question is the relationship between the agencies themselves and the companies they are rating because they are the clients and pay the fees that keep the agencies in business. The need to downgrade if information to affirm the strength or otherwise of a company is not forthcoming is a difficult decision for an agency where there must be some conflict of interest. However certain agencies have become so powerful that any downgrade from them, especially in the renewal season, can cause a run on the bank. Remember SCOR? Think of Scottish Re, did they spot the dangers arising from the acquisition strategy? The company was wrecked within a year with a total snarlup of cashflow. This is not to say that the agencies don't do a generally excellent job, but their advice must be considered against the general economic background pertaining at the time and the possible effects on the investment strategies of the companies under review.

We need to better understand the level to which these agencies really appreciate the financial instruments and the financial structuring of these insurance companies. The agencies need to understand what areas the companies are entering that might put them more at risk from certain failures in other, non-insurance areas.

Consider New Strategies

We have addressed a couple of the more important and urgent questions that need to be considered by captive owners and their managers. However, in the current situation there are many other questions that should be addressed and many other strategies that should be reconsidered, not least the insurance underwriting strategy of the captive in the light of the likely hardening of rates across many classes of business.

What else can captives do when the market hardens? Move into other areas of insurances, where positions can be taken that will either save the company money or create additional revenue streams. One building company, for instance, has offered to insure the purchases of potential clients for a three-year no-devaluation clause. In other words, they would offer the purchasers of their houses a guarantee that they would underwrite any devaluation of the cost of the property over the next three years. For parents with property-based interests, it's a classic captive policy; a way to contain any potential downsides while developing profit.

There are captive owners that have waited during many years of soft market conditions to realise the full benefits of their captives. By addressing the concerns facing the industry at large and re-strategising in light of market conditions, now, in fact, can be the time for such an opportunity.

For more information about Guernsey's finance industry please visit www.guernseyfinance.com.

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