The Case for Passive "ETF" Investing Grows Stronger for Captives

For captives, especially smaller captives or group captives, passive investing can help reduce frictional investment expenses in a low yield and total return environment. A recent S&P Global Market Intelligence and S&P Dow Jones Indices webinar titled "ETF Investing: Trends and Opportunities for Insurance Companies" along with a Wall Street Journal article titled "Stock Picking Is Dying Because There Are No More Stocks To Pick," strengthen the argument for passive investing. Both the presentation and the article worked to reinforce this editor's thinking that there is an overwhelming case for captives' use of passive investing.

Captive.com previously explored this topic in an April 4, 2017, article: "Is Active Investment Management Facing Extinction?" The article outlined the conundrum faced by active managers today, as follows.

[A]ctive investment management versus passive investment management, how do captive insurers choose? The argument for active managers is based on the skill of the manager to add alpha. "Alpha" is defined as the excess return above the return of the market index or benchmark. Opponents of active investment management point out that most active managers fail to best the index or produce "alpha" (i.e., beat their index) on a consistent basis. This inconsistency is further degraded by the higher fees associated with active management, where, after fees, the active manager actually underperforms the benchmark. Had the captive insurer invested in a similar index fund, it would have come out ahead.

As most investors know, the popularity of exchange-traded funds (ETFs) has continued to soar. According to Statista, at the end of 2016 there were approximately 4,770 exchange-traded funds worldwide versus less than 300 in 2003. Their popularity has been driven by lower trading costs, broader diversification, and increased tax efficiency.  And although insurance companies have been slow to adopt new ideas, the acceptance of ETFs as an investment alternative has been growing as evidenced by the S&P webinar.

The presentation opened with a survey question asking participants whether they employed ETFs in their investment portfolios. While probably not a truly representative sample of the insurance market, particularly for captives, 38.6 percent reported currently holding some type of ETF in their investment portfolios, while another 26.5 percent were exploring the possibility. Raghu Ramachandran, head of the Insurance Asset Channel at S&P Dow Jones Indices, then provided highlights from his report ETFs in Insurance General Accounts—2017. We will cover some of the highlights here, but captive insurers interested in learning more about how their competitors are using these investments should download and read the entire report.

The S&P report states, "Insurance companies continue to increase their use of ETFs. As of year-end 2016, insurance companies had, in their general account, $19 billion invested in ETFs.... In 2016, the amount invested in ETFs by insurance companies increased by 20 percent from the prior year. Moreover, ETF usage has shown a double-digit compound annual growth rate (CAGR)" of 14.1 percent over the last 3-year period, 18.1 percent over the last 5-year period, and 12.4 percent over the last 10-year period. These assets are overwhelmingly concentrated in the property and casualty (P&C) industry, which held 60.76 percent of the $19 billion, while the life insurance industry held 31.01 percent with the remaining 8.23 percent held by health insurers. One interesting observation from the report notes small insurers (which would include most captive insurers) reduced their ETF holdings in 2016. Since all of this data is drawn from the National Association of Insurance Commissioners (NAIC) Schedule D reports, S&P offers no conclusion as to why the shrinkage occurred.

Not surprisingly, the distribution of ETFs in insurers is heavily skewed toward equity funds at 74.62 percent of the total assets under management (AUM). While insurers are primarily fixed income oriented in their investment portfolios, the lower allocation to fixed income ETFs should not come as a surprise. Up until March 2017, the NAIC had treated fixed income ETFs, for accounting purposes, similar to equity investments, which required companies holding these funds to hold more capital under risk-based capital (RBC) requirements. The NAIC modified the accounting treatment to allow for "systematic value" reporting allowing a number of fixed income ETFs to have the same RBC calculation as if the company held the underlying bonds. As reported in "BlackRock Sees Insurers Pouring $300 Billion into Debt ETFs," a Bloomberg article by Sonali Basak, published on May 30, 2017, BlackRock Inc. expects $300 billion to flow into bond ETFs over the next 5 years supplanting holding individual bonds in a portfolio.

The second speaker for the S&P webinar, Robert Trumbull, managing director, State Street Global Advisors, identified five key drivers insurers should consider when deciding between holding actual bonds versus an ETF. They are as follows.

• Structural changes in the bond market where primary bond dealers have deleveraged and decreased liquidity for individual bonds, making trades more expensive to execute.
• Fixed income trading costs are significantly lower for bond ETFs versus the actual bonds with bid/ask spreads averaging 3 basis points (bps) for an investment grade (IG) bond ETF compared to 37 bps for buying individual IG bonds.
• As we noted above, the NAIC is now allowing more favorable treatment for bond ETFs.
• Using ETFs, especially for small companies (think captive insurers), allows the creation of very low cost diversified portfolios.
• ETFs present a very cost effective way to adjust insurers' portfolios' duration, asset quality, or yield.

Finally, this closing point comes from the June 23, 2017, Wall Street Journal article titled "Stock Picking Is Dying Because There Are No More Stocks To Pick," by Jason Zweig, "The evaporation of thousands of publicly traded companies may have one enduring result … most research on historical returns is based on days when the stock market had twice as many companies as it does today." While equity investments may constitute a small percentage of insurers' AUM, they are typically held to provide higher returns. If historical equity returns are overstated, this is likely to lead to additional pressure on active equity managers to reduce fees or lead to more investors deciding to take what the market gives them by investing in indexed ETFs.