Yousif Capital Management
With interest rates in flux, captive insurers must take a nimble investment strategy to preserve capital and seize opportunities. Ed Goard of Yousif Capital Management discusses how dynamic asset allocation, disciplined rebalancing and prudent risk management can help captives thrive across economic cycles
Why is dynamic asset allocation important for captive insurers, particularly in a rising interest rate environment?
Dynamic asset allocation is an investment strategy that adjusts the mix of asset classes based on prevailing market conditions.
This differs from a static asset allocation which is unresponsive and may miss the opportunities that a shifting market cycle may present.
For example, rising rates often lead to depreciating bond values, necessitating shifts in investment strategies to preserve capital and optimise returns.
A dynamic approach allows insurers to adjust their portfolios in real-time, reducing exposure to assets negatively impacted by interest hikes, such as long-duration bonds and increasing allocations to more favourable options.
This also includes short-duration securities or equities less sensitive to rate changes.
Conversely, during falling rate environments, this strategy facilitates shifts towards longer-duration bonds to capture higher yields and enhancing exposure to growth-oriented equities that benefit from lower borrowing costs, ensuring a balanced and responsive asset allocation through varying interest rate cycles.
Given our analysis, we believe the current rate hiking cycle has run its course, indicating a strategic pivot may soon be in order.
This strategy not only mitigates risk but also capitalises on opportunities arising from economic fluctuations.
By proactively managing the asset mix through business and interest rate cycles, captive insurers can better navigate the complexities of a changing economic landscape, to ensure financial stability and the capacity to fulfil their obligations.
What strategies can captive insurers use to adjust their equity-bond mix when interest rates rise? How can they determine the right mix?
When interest rates rise, captive insurers can adjust their equity-bond mix by reducing allocation to long-duration bonds, which are more sensitive to rate hikes. Additionally, they may increase investment in short-duration bonds or floating rate instruments less impacted by rising rates. They might also shift towards sectors resilient in a higher rate environment, such as financials or commodities. In a falling rate scenario, in contrast, reallocating towards longer-duration bonds to capture higher yields and growth-oriented equities can be advantageous. Based on our assessment, the present cycle of interest rate increases is at or near its conclusion, suggesting that a recalibration of strategy could be imminent.
Determining the right mix involves a careful analysis of the insurer’s liability stream, risk tolerance, investment objectives and the economic outlook. This includes evaluating the potential impact of interest rate changes on different asset classes and adjusting the portfolio to balance risk and return optimally. Regular portfolio reviews and stress testing can also help captive insurers remain aligned with their strategic goals in the face of fluctuating interest rates.
How frequently should captive insurers consider rebalancing their portfolios? What factors should drive rebalancing decisions?
Captive insurers should consider rebalancing their portfolios at least annually or semi-annually, though more frequent reviews may be warranted in volatile or rapidly changing markets. The decision to rebalance should be driven by significant deviations from the target asset allocation that exceed predetermined thresholds, typically between five and 10 per cent. These deviations can occur due to market movements that disproportionately affect the value of different asset classes within the portfolio.
Factors driving rebalancing decisions can include changes in the economic outlook, interest rate shifts and modifications in the insurer’s liability stream, risk tolerance or investment objectives.
Additionally, regulatory requirements, liquidity needs and operational considerations, such as the availability of capital or the need to fund claims, should also inform the timing and extent of rebalancing actions. By systematically reviewing and adjusting their portfolios, captive insurers can ensure alignment with their strategic goals and risk management parameters, optimising performance over time.
How can maintaining adequate cash reserves help captive insurers adapt their asset allocation more nimbly? What is a prudent level of cash to hold?
Maintaining adequate cash reserves enables captive insurers to adapt their asset allocation more nimbly by providing liquidity to quickly seize investment opportunities, or rebalance the portfolio without the need to sell other assets at an inopportune time.
Cash reserves act as a financial buffer against market volatility and unexpected claims, allowing insurers to manage risks more effectively.
The prudent level of cash to hold varies depending on the insurer’s operational needs, investment strategy, and the overall market conditions.
Typically, a range of five to 10 per cent of the total portfolio is considered a balanced approach, offering flexibility while minimising the drag on overall portfolio performance that can result from holding too much in low-yielding cash. This level should be regularly reviewed and adjusted based on the insurer’s liquidity requirements, anticipated cash flows and changes in the economic environment to ensure that the portfolio remains aligned with the insurer’s strategic objectives and risk tolerance.
How should captive insurers think about allocating to credit in a rising rate environment? When does credit become more attractive?
In a rising rate environment, captive insurers must exercise discernment when allocating to credit, including corporate bonds and asset-backed securities (ABS).
As rates climb, the immediate impact can depress the prices of existing fixed-income securities. However, this environment also presents opportunities for insurers to capture higher yields, particularly as new issuances come to market with more attractive rates.
Our insights suggest that the ongoing cycle of rate hikes is likely at its peak, signalling the potential need for a strategic adjustment in the near future. When considering allocations to credit, insurers should prioritise credit quality and duration.
High-quality, short to intermediate-duration bonds can offer a more favourable risk-return profile, mitigating interest rate risk while providing income. Diversification across sectors and credit qualities is also crucial to managing potential default risks.
Credit becomes more attractive as the spread between corporate bonds and risk-free rates — such as treasury yields — widens, indicating higher compensation for taking on credit risk.
Insurers and their investment managers should closely monitor these spreads, along with economic indicators and corporate health metrics, to identify opportune moments for increasing their credit exposure.
It is essential to balance the pursuit of higher yields against the portfolio’s overall risk tolerance and liquidity needs, ensuring that the insurer stays prepared to meet its obligations and capitalise on the evolving investment landscape.
For equity investments, how can a focus on dividend-paying stocks help mitigate volatility? What dividend yield strategies make sense in this environment?
This is a prudent strategy for captive insurers aiming to mitigate volatility in their equity investments. Often established and financially stable, dividend-paying companies can provide a steady income stream, contributing to the portfolio’s overall returns even in fluctuating markets. This income can help cushion the impact of price volatility and support the insurer’s liquidity needs.
In the current environment, a strategy emphasising stocks with a history of consistent and rising dividends makes sense. Such companies are likely to have resilient business models and strong cash flows: particularly valuable attributes in uncertain economic times. However, it’s critical to balance yield with quality; chasing high dividend yields without considering the sustainability of those dividends or the underlying company’s financial health can introduce undue risk. A focus on dividend yield, combined with dividend growth, can offer a balanced approach, providing income, potential for appreciation and a hedge against inflation. This aligns well with the long-term objectives of captive insurers.
What are some timing considerations around when to make asset allocation changes? How can captive insurers avoid buying or selling at the wrong time?These considerations hinge on disciplined analysis rather than market timing, which is notoriously challenging. Captive insurers should base decisions on comprehensive market research, economic indicators and alignment with their strategic investment objectives and risk appetite. Key considerations include interest rate trajectories, inflation expectations and regulatory or sector-specific developments that could impact portfolio performance.
To avoid the pitfalls of buying or selling at inopportune times, insurers should employ a systematic approach to rebalancing, adhering to predetermined thresholds that trigger portfolio adjustments. This method reduces the temptation to react impulsively to market volatility and ensures actions are aligned with long-term strategies. Additionally, incorporating a dollar-cost averaging strategy for entering or exiting positions can further mitigate timing risk. By making incremental adjustments over time rather than all at once, captive insurers can smooth out the effects of market fluctuations, enhancing the likelihood of achieving favourable outcomes over the long-term.
What risk management strategies should accompany asset reallocation decisions? How can captive insurers manage portfolio risk effectively?
Accompanying asset reallocation decisions, risk management strategies are paramount for captive insurers to manage portfolio risk effectively. Diversification remains the cornerstone of risk management — spreading investments across various asset classes, sectors and geographies to mitigate systemic and specific risks. Additionally, employing duration management in fixed-income investments helps manage interest rate risk, especially pertinent in volatile rate environments.
Stress testing and scenario analysis also play critical roles, enabling insurers to evaluate portfolio resilience under various economic conditions and adjust their strategies proactively.
Effective risk management further involves continuous monitoring of the risk-return profile to ensure alignment with the insurer’s risk appetite and investment objectives. By adhering to these strategies within a disciplined investment framework, captive insurers can navigate market uncertainties, maintaining portfolio stability and ensuring long-term financial health.
