Can you confidently answer these three questions about your captives investment portfolio

• Is your captive’s investment portfolio built on the proper foundation?
• Does your investment strategy leave you at risk from a regulatory exam?
• Are your captive’s investments positioned to survive a period of adverse insurance losses that coincide with a financial market correction?

In 2017, Tennessee builders began construction on more than 38,000 homes. Before a single nail was driven, each of those homes had to develop a construction plan that met the needs of the building owner and ensured the safety of its inhabitants. Natural disasters like earthquakes, tornados, floods and ice storms are all part of living in Tennessee, and homes need to have an adequate foundation to survive these unexpected events. To help mitigate this risk building, owners often rely on the specialized knowledge of architects and structural engineers to develop a plan and oversee construction.

Just as a building with a faulty foundation can be dangerous, an investment portfolio constructed with the wrong foundation can be equally unstable and dangerous. Events like market corrections or untimely cash withdrawals can destabilize an investment portfolio, the same as an earthquake can destroy a home. And just like structural engineers possess a unique knowledge required to develop the critical component of your building, a professional in captive insurance investing possesses distinct skills to help develop the foundation of your captive’s investment portfolio.

What is an investment foundation?

An investment foundation is the underlying principle that governs which investments are appropriate for your cash and investment holdings. The most common and well-known investment foundation is called asset allocation. This foundation is based on assembling non-correlated assets (assets whose values move independent from each other). Where this is a great investment foundation for individuals saving for retirement, it is generally inappropriate for a captive insurance company.  

Asset allocation fails CICs as well as other insurance companies because it focuses on cobbling investments together based on their relationship to each other without regard for the insurance company’s liabilities, risks and unknown cash flow timing. Many captive owners and their investment advisors inherently recognize the limitations of asset allocation for CICs but don’t have the tools or expertise to develop an appropriate investment foundation. As a result, captive owners often choose to remain “conservative,” ultimately leaving earnings on the table. Other owners may invest funds similarly to their own personal asset allocation, but this may create liquidity issues in the event of adverse claims and may expose their captive to regulatory and/or IRS criticism.

CICs face unique challenges not experienced by other investors. As a regulated entity with uncertain cash flow timing, a captive’s investment portfolio foundation should be built around their specific liabilities. This foundation is called Liability Driven Investing (LDI) and is the most common investment foundation for commercial insurance companies. This foundation recognizes the potential for unexpected claims and aligns an asset strategy accordingly. Developing this foundation requires an asset/liability analysis.

Asset / Liability Analysis

An asset/liability analysis is based on the same actuarial inputs that drive your premiums, reserve requirement, etc., and provides a blueprint for the development of an investment strategy. This blueprint provides three distinct benefits for CICs.

First, this blueprint helps your captive mitigate risks. By calculating your captive’s potential cash flows, an investment strategy can be developed to help match and mitigate certain risks. Second, this analysis gives greater insight as to how your captive may perform. As the basis for both your assets and your liabilities, this analysis permits a stress test of your captive’s asset/liability strategy simulating a period of adverse claims that may correspond to a financial or market crisis. Finally, an asset/liability analysis provides regulators clear documentation for the basis of your investment and asset strategy.

Having a blueprint for your captive’s investment strategy starts with choosing an investment advisor who knows and understands the needs and regulatory environment of your captive. If you are unsure of the answer the three original questions, then it may be time to have your foundation evaluated.

You wouldn’t invest your hard-earned money to build a home and rely on luck to ensure that the foundation is adequate. Don’t rely on luck for your captive’s investment foundation either.