risk management tools. They buy longer-term bonds when yields fall and reduce the maturity of the bond portfolio as rates rise. They use only the highest credit government and supra-sovereign securities. (We speak from first-hand experience in this matter as we have developed, and have been managing, such strategies for the past six years.); and
• The $3 million that is left can theoretically be invested into a higher risk, higher return strategy, for example an equities, commodities or alternatives fund. However, it is very important to make sure that the risk:reward characteristics are worth it. The main focus is on maximal potential losses and whether those losses can negatively affect the captive paying claims. One has to study very carefully the potential confluence of business and financial risks to make that decision. The key is not so much to choose the right asset class to diversify into, but to choose an investment management strategy that has the relevant reward:risk characteristics and low or negative correlation to the underwriting cycle of the captive.
Dynamic ALM: the feedback loop An investment strategy cannot be seen as a separate activity from
the business’s overall needs. The two have to be coupled, and
the business needs—in particular the underwriting cycle and the occurrence of unexpected large claims—should be the driver behind the risk-taking on the financial side, particularly when it comes to excess return strategies outlined in point three above. It is important that the investment manager has continuous contact with, and feedback from, the captive client. When business circumstances change one should adapt the client’s portfolio accordingly.
Addressing credit risk We have touched already upon credit risk in a captive’s portfolio,
but it is important to highlight the importance of the investment manager’s credit research in helping steer clients away from trouble. It should be both a top-down and a bottom-up approach. One should study the bond issuer’s domicile and what is happening on the macroeconomic and political fronts. Then one should drill into company specifics, covenants, collateral, guarantees and the like to get a solid fundamental picture of the issuing company. Finally, one should focus on the markets and figure out whether the bond is trading in a compatible way to its ratings. The trouble is when it is not—and this is the signal not to touch it.
t
The Global Symbol of Financial Strength
g n e M E rt c e l l e
A.M. Best Company is the leading credit rating organization dedicated to serving the global insurance industry, including the alternative risk-transfer market. Best’s Credit Ratings are a means of assessing the financial strength and creditworthiness of captives, risk-retention groups, self-insurance pools and trusts, large-capacity facilities, protected cell companies and specialized reinsurers.
n
For more information about obtaining a Best’s Credit Rating, please call (908) 439-2200, ext. 5576, or e-mail
ratings@ambest.com
A BElST x
S a
www.ambest.com
40 bermuda captive 2012
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