“What we anticipated seldom occurs; what we least anticipated generally happens.”
-- Benjamin Disraeli
Among his many talents, which included being an astute social and political critic as well as a better-than-average novelist, the famous Prime Minister Disraeli might have had what it takes to be an adept captive insurance manager. Managing risks entails an ability to anticipate what others either cannot readily see or have a reluctance to view closely, while assisting them in turning it to a profitable opportunity.
Fortunately for captive insurance companies, it isn’t necessary these days to hold out for the next Disraeli. Those seeking an investment manager are equipped with several options, the suitability of which can vary with the sophistication or even age of the captive itself. Before we survey the various options for selecting an investment manager, the first step is to identify the needs of your captive, which are affected by where you are in the captive life cycle.
The 5 Fundamental Needs Of A Captive
The criteria for selecting your investment manager depends significantly on how you perceive the needs of the captive. There are five key areas to think about.
Solvency. Especially when the captive is just being established, solvency of the captive itself is the overriding objective. The success of the captive is equally dependent on both the operating side and the investment side of the structure.
Liquidity. Staying liquid matters more in the beginning, since only investment of principal is allowed in the initial stage of a captive’s life. Thus, sound financial management will command more of the captive owner’s resources at this point than eventual operations.
Collateral. The investment manager must be conversant with all the various instruments and demands of collateral including reinsurance, letters of credit, Regulation 114 trusts and others. The demands of collateral must be met along with those of liquidity, in order to protect the partners from the liabilities of having insufficient collateral.
Income. Of course, eventually the captive must have income in order to achieve and maintain success. The expenses of running a captive, including attorneys and accountants, are not trivial, and failure to earn income can lead to difficulty recovering costs. Insufficient income can lead to eventual failure of the captive.
Value. Building sustainable long-term value is the area in which the success of the investment manager really comes home to roost. The more successful the manager, the more opportunities he will find to save the parent organization money.
The 3 Options For Investment Management
Selecting the option that is right for your captive will be affected significantly by the relative complexity of the captive itself. Making this determination is complicated currently by the difficulties of a low interest rate environment now heading into its seventh year. Said another way, it is inherently difficult to distinguish between solvency and liquidity based on 30 basis points!
For this reason and for others, there is a scarcity of good traditional options for an investment manager. Success often eventually comes down to the quality of services that can be offered that may save the parent company money.
This strategy for investment management can be a sound one, especially in cases where the captive is well established and has already accrued surplus sufficient to cover the additional expenses associated with most consultancies. You should be aware that, as a consultant, your investment manager should be completely unbiased. As you will discover below, there are ways to determine if that is indeed the case.
Consultants typically charge a fee based on the total amount of assets on which the owners of the captive are being advised. Since the advisor is independent, he or she should be in a position to know all the investment managers available on a dynamic basis in order to fairly determine which is most appropriate for the particular captive. In this role, the advisor may be thought of as a quarterback who helps the parent select from the available options and makes the correct calls, or allocations.
Are there downsides with using this approach? It depends. For younger captives, the options are limited. Since there is very little initial value involved with a start-up, it becomes difficult for the owners to justify the consultancy fees. In addition, unlike individual investment managers, consultants tend not to be subject to performance comparisons. Nor need they be complaint with the Global Investment Performance Standards (GIPS), instituted for investor protection in the post-Madoff era.
Although a consultant should be unbiased and devoid of potential conflicts of interest, there are a few warning signs you should look for. A consultant should never seem to be advocating the use of a custodian owned by their parent firm. Nor should they offer to do trading or consummate transactions at a broker dealer owned or affiliated with their firm. They should never in any case be compensated in any form by an investment manager. And, any offer to bundle or wrap services should be immediately suspect. Any and all of these behaviors should be red flags to the captive owner.
Selecting a dedicated investment manager is typically the option preferred by many captives today, especially those without significant levels of surplus or complexity. One reason is that this type of investment manager generally offers the highest and broadest level of customized services for the lowest cost, as well as a high level of tax optimization.
Just as important, the investment manager approach satisfies the demand for transparency that owners should be seeking in today’s complex financial world. Typically, all investment managers submit their audited performance for review on an annual basis. Their reporting and accounting should be seamless and provide for a relatively low risk of conflict of interest.
As a final consideration, investment managers must comply with the Global Investment Performance Standards (GIPS). This safeguard, with the added demands of independent auditing, assure the best overall strategy for maintaining “checks and balances” between the banks, independent brokers and the investment manager.
In some cases, mutual funds may make an attractive option for investment management, especially where the captive decides it wants its liquid investments made through such a fund. Or, it may decide on diversification of investments through various funds.
There are, however, pitfalls with this approach. Using mutual funds can complicate the tasks of reporting and accounting and cannot help with tax optimization at year end. Because of this, there is a rather large area of ignorance about the tax advantages captives typically provide, as well as the tax objectives and strategies of their owners.
In addition, captive insurance is a form of commingled funds in as much as all the monies are mixed in a single pool, an arrangement that’s more typically offered by banks rather than mutual funds. Because of the commingled nature of the funds, it is impossible to customize tax management or optimization strategies.
As a final note, captive owners should understand that a mutual fund’s fees are typically twice those of a dedicated investment manager.
Researching Your Investment Manager
Fortunately, many changes in recent years have improved the abilities of captive owners to vet and compare investment manager options. The first should come from within; it is up to the captive owners to demand that their investment managers submit to a third-party audit once a year. In addition, owners should insist on monthly accounting and reporting. These must be done within very tight time windows.
Captive owners should insist that their investment manager be GIPS-compliant. For those looking for an additional risk management strategy in addition to GIPS-compliance, a number of national databases exist for comparing investment managers. Two of these, OSN and ENVestNet, cover over 80% of the investment manager market. In addition, peer review is available through several national databases. Taken with GIPS compliance, these very basic risk management tools are your best assurance of transparency!
Importantly, the same rigor should be applied to researching investment manager fees. With the supply of investment managers at what must be approaching an all-time high, determining the propriety of fees is incumbent on the savvy captive manager. Because it is essentially a buyer’s market in today’s environment, the ability to negotiate fees is of critical importance.
Your Best Practices
Today’s captive manager should be seeking the lowest fees commensurate with the highest levels of risk management in an investment manager. To assure the latter, both GIPS compliance and peer review resources must be insisted upon. A captive’s priorities should then extend to minimizing reporting costs, minimizing collateral costs and maximizing tax optimization.
In all cases, investment management for captive insurance companies rests on a trio of sound fundamentals. The bank exists to hold the assets and provide reporting. The independent broker exists to conduct the trades. And the investment manager exists to maximize the long-term value of the captive. At the end of every month, all three should reconcile independently to the penny.
And when they do, you’ll know you’ve done well.