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2018 Musings on Captive Insurer Investments

Investment graphic-SF
January 24, 2018

What does 2018 have in store for captive insurer investments? While we don't claim to have a crystal ball, we offer up some thoughts on issues captive insurers need to be focused on within their investment portfolios. The new year offers an opportunity for the board and management to have an in-depth discussion with their investment manager regarding how their portfolio is positioned and what return expectations are for the year.

We'll begin our musings with a look at investment return expectations. An article by Jason Zweig published January 19, 2018, in the Wall Street Journal prompted our thoughts on returns. As many of you know, Mr. Zweig writes a column for the Journal called "The Intelligent Investor." This week's story was titled "Can We Be Brutally Honest about Investment Returns?" (Login credentials are required to read the article.)

The article is a cautionary tale about investors' expectations for market returns. Mr. Zweig opens his commentary with the following sobering warning.

With U.S. stocks at all-time highs, it's more important than ever that investors be brutally realistic about future returns. Some of the most purportedly sophisticated investors in the world, the managers of giant pension funds for state and local government employees, might not have absorbed that lesson yet. You can learn a lot from these folks—if you listen to them and then do the opposite.

Mr. Zweig bases his commentary on a research paper titled "The Return Expectations of Institutional Investors" published by the Stanford University Graduate School of Business. The authors look at the disclosures filed by US public pension plans concerning expectations for future returns. The average long-term (defined as 10–30 years) return for these plans is 7.6 percent. By dissecting the returns for various asset classes, including cash, fixed income, equities, real estate, and alternative investments, Mr. Zweig concludes that these return expectations are more wishful thinking than any realistic attempt to arrive at a reasonable number.

The question for captive insurers is, How realistic are your own expectations for what your investment portfolio is likely to produce? The old axiom—past performance is not a guarantee of future returns—still holds true, and yet many rational investors refuse to live by this maxim. So, the next time you sit down with your investment manager or adviser, have them clarify how they determine the predicted returns for your captive's investment portfolio. Are the returns based on recent evidence, or are they more aggressive in nature and require a host of things going right to be borne out? What is the downside to your captive if the returns are more aggressive and fail to produce? Does it impact your ability to pay claims and expenses? Erring on the side of conservativeness is a great hedge against being disappointed in the long run.

While captive insurers escape many of the regulations that traditional property and casualty insurers must comply with, they unfortunately do have a way of becoming accepted best practices. In that light, we offer some thoughts drawn from a recent article titled "Happy (and Not So Happy) New Year Changes for Insurer Investments," written by Alton Cogert and posted on the Strategic Asset Alliance website.

The first item concerns accounting changes and how changes in market value and credit losses need to be recognized. The first change comes courtesy of Accounting Standards Update (ASU) 2016-01, whereby generally accepted accounting principles (GAAP) filers will be required to report changes in the market value of equities above the net income line versus where it has historically been reported, which is below the other comprehensive income line. As Mr. Cogert points out, this change will lead to an increase in earnings volatility, which will then have to be explained. This pronouncement is a big step down the path of marking the entire balance sheet to market. 

While this regulation is in effect starting in 2018 for all public entities, it will impact all other filers in 2019. For single-parent captives of major corporations, this will be a required change. For other captive insurers who file using a modified GAAP basis, within their domicile, it will probably become applicable as well as driven—we suspect—by the independent auditors. While many captives do not have large equity portfolios, those that do will want to be aware of these changes.

Because most captives hold a majority of their investments in bonds, the second change is likely to be more significant. It entails how credit losses on fixed income securities are reported. ASU 2016-13 takes the idea of loan loss reserves that banks have traditionally been required to establish and report, then applies it to expected credit losses for bonds as a result of downgrades and defaults. 

As Mr. Cogert explains, "This ASU requires that the full amount of expected credit losses (not just losses expected in the next year) be recorded for all financial assets measured at amortized cost. Once that reserve is set up, changes in it will go through net income. For publicly held insurers, this ASU is effective 2020 and for all other insurers it will be effective in 2021." While obviously a ways out, captive insurers would be wise to begin having discussions with their investment managers concerning how they will report these estimated losses. Also, it would be a good idea to have them run a historical analysis of the captive's investment portfolio to ascertain what the reserve would have looked like and the impact on net income.

Another item worth mentioning concerns the impact of the new tax law. As everyone is aware, the corporate tax rate has been lowered from 35 percent to 21 percent. However, for any captives that are carrying a deferred tax asset on their books, the changes will require this asset to be written down due to the new tax rate. This requirement will, in turn, result in a reduction in surplus. In the event your captive insurer has a rating, this change will also negatively impact your A.M. Best's Capital Adequacy Ratio. We have not spoken with Kroll about how it plans to deal with this change.

While captive insurers have always needed to discuss pricing and loss reserves, the changes to investments now add another item that warrants additional scrutiny in board meetings.

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