If low level inflation remains, what will be the best approach to take on the client portfolio?
Goard: With regard to captive insurance clients, they typically
aren’t seeking a high-risk or highly volatile portfolio; Munder, for example, believes in building a very well-diversified portfolio that is positioned to deliver solid and consistent risk-adjusted returns. I’ll use a baseball analogy: we position the portfolio such that it will hit a lot of singles, as opposed to swinging for the fences to hit a home run. What this means is that we manage the risk levels very carefully. Currently, our portfolios are overweighted in three different sectors. The first of these is asset-backed securities, in the form of credit card receivables and auto loan receivables. The reasons why we like that sector are twofold. First off, if you look back at the financial crisis, the collateral backing credit card and auto receivable securities actually performed fairly well. Most of the problems came from the mortgage-backed securities sector, so the problems were non-agency defaults, foreclosures and delinquencies that occurred in the housing sector, not necessarily in the auto loans and credit card sector.
On top of that, we believe that we know how these types of
securities will perform through a bad economic scenario. The bottom third of borrowers who used to be able to gain access to credit no longer can, meaning that the current securities being issued today reflect a higher credit quality borrower. In addition to that, because of all the heat the ratings agencies took during the crisis for incorrectly rating mortgage-backed securities, they also increased the amount of credit enhancement it takes to get a high credit rating on asset-backed securities. So we like this sector for two reasons: one, you have a higher credit quality borrower and two, the credit enhancement you are getting now is even better than what you were getting prior to the financial crisis. That, in our opinion, means asset- backed securities offer good value at the present time.
The next sector is commercial mortgage-backed securities. We
have been avoiding the 2006-2007 vintage securities because that is where most of the problems exist. Our focus is on 2005 and earlier vintage loans and securities, which have a large amount of credit enhancement, where the bond holder has a lot of protection from losses or default. We think that due to the crisis, there has been a ‘baby thrown out with the bathwater’ effect, meaning that although the 2006-2007 vintage loans have some problems, the 2005 and earlier loans are performing quite well and offer good relative value.
And finally, we are active in the banking sector. I mentioned
earlier that the banks aren’t lending and making new loans, which is probably bad for overall profit growth and bad for equity holders, but with banks taking less risk, they have repaired their balance sheets; thus from a bond holder’s perspective, we think that the banks represent a good investment at this point.
Lastly, you might ask, what if we do see inflation starting to rear
its ugly head? While we aren’t presently positioned in any of these, given that we don’t believe inflation will be an issue, some of the sectors that we would explore as a hedge against inflation would be: TIPS (treasury inflation protected securities), floating rate debt and the possibility of convertibles.
At what size should a captive consider professional investment management?
Goard: Generally, a captive should hire an investment manager when
its portfolio reaches around $10 million. However, we have seen several captives that were experiencing rapid growth and hired managers at
46 CAYMAN CAPTIVE
the $5 million point. Portfolio size is a major consideration, but captives should also consider future premium flow and expectations, durations of their liabilities and their overall risk profile.
Typically, what happens when a new captive is formed at around
a million dollars in size is that they will invest most often in the money markets. However, as they start to grow and get more premium flow, and once they know how their liabilities are going to react and they get to that $5 million point, they may want to consider a professional investment manager.
Anything smaller than $5 million is very difficult to manage as an
individual portfolio because it would be difficult to provide them with the diversification that they would need. Most investment managers have a minimum investment management fee that correlates with their account minimum, which for example at the $10 million level, can still offer them the ability to earn a nice return, even after paying that fee. Below that level, costs can be prohibitive.
2.6 2.5 2.4 2.3 2.2 2.1 2.0 1.9 1.8 1.7 1.6 1.5 1.4 1.3 1.2 1.1 1.0 0.9 0.8
M J 2007
S D M J 2008
S D M J 2009
S D M J 2010
S
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Core CPI (year-over-year percentage change) Monthly data 12/31/2006 – 9/30/2010
2.6 2.5 2.4 2.3 2.2 2.1 2.0 1.9 1.8 1.7 1.6 1.5 1.4 1.3 1.2 1.1 1.0 0.9 0.8
“ Adding a higher risk security to a low-risk portfolio can actually decrease the risk of the overall portfolio, while potentially increasing overall return. This is due to the low, or even negative, correlations that can occur among certain asset classes.”
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