Articles - Where do you go for low-risk investment returns?


Most insurers invest in cash deposits of some form or other, either to provide short term liquidity or to provide a degree of stability of the investment returns the fund is able to achieve. Historically, firms have done this by depositing cash with banks or building societies. The deposits are generally guaranteed not to fall in value and earn interest at prevailing rates.

 By Christopher Critchlow, Director, OAC

 However, with the persistent low interest environment the interest rates attaching to these accounts, even accounts subject to 3 for 6 months notice, are minimal at best. So how else can firms try to improve value without sacrificing the underlying security that bank deposits have traditionally provided?

 One option might be to invest in cash type funds – typically a collective investment scheme (“CIS”). The characteristics of these types of investment might at first look very similar to cash deposits but in fact there are a number of differences to be aware of:

 Whilst cash deposits generally contain a guarantee from the bank or building society that the capital sum will not fall in value, this is generally not the case with cash type funds where the value of the investment can fall as well as rise.

 The rate of return offered on a deposit account is after the effect of charges. The returns offered by cash-type funds are generally before the effect of charges. So to enable a like for like comparison, the fund’s charges should be allowed for when comparing headline returns that may be quoted.

 For Solvency II purposes, the capital requirements of cash deposits are subject to a separate counterparty default risk module whereby the capital requirements are driven primarily by the perceived creditworthiness of the counterparty and the spread of such investments across different counterparties.

 For cash type funds, however, the capital requirements are driven by the nature of the assets underlying the cash fund. This will clearly vary from fund to fund but they can generate lower capital requirements than cash deposits because:

 The underlying investments will normally be in high quality and short-term government backed or other high quality (AAA or AA rated) securities, bonds, certificates of deposit, commercial paper, debentures or floating rate notes. Banks can be high quality but many may be of a lower investment grade and therefore require more capital.

 The spread of investments will often be very much greater than any insurance company could achieve so ensuring a very well-diversified portfolio.

 Having said all that it is likely that insurers will focus on their immediate concern which is: “which investment will give me the greatest return for the lowest level of risk?” Although the returns on cash deposits are not very exciting it is still possible to secure returns of 0.5% - 1.0% a year, and sometimes even a little more. However, this often requires investment in a relatively small number of counterparties and this does increase the capital requirements (and hence the perceived risk) of such an approach.

 The nature of the investments underlying cash funds is such that, in the current economic climate, it is very hard to secure a return over 0.5% a year, albeit that this is likely to generate lower capital requirements than the deposit approach.

 Conclusion

 So, where do you go for low-risk investment returns? I wish I could offer a more inspiring conclusion, but the upshot of the environment we now live in and likely to be faced with over at least the next year or so is:

 There is not much difference between investing in cash deposits with banks or building societies and investing in cash funds.

 It is very hard indeed to secure a rate of return, at minimal investment risk, of much more than 0.5% - 1.0% a year.

 Therefore, whilst firms would like to earn more, and feel as though they should be earning more, it is hard to see how that is possible without increasing the risk profile of your investment funds and even then there is no certainty that the returns will be any better! So, for example, extra returns might be possible on non-standard bonds e.g. callable/perpetual bonds but any extra returns may well be offset by the capital you need to set aside to cover the extra risk. And of course the approach must be consistent with your risk appetite and ORSA process, but that is for another discussion.

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