investments for captives: approach to asset allocation ... · 1) asset allocation for captives 2)...

16th Annual Executive Educational Conference

Investments for Captives: Approach to Asset Allocation &

Market Outlook Wednesday, September 23

9:00am-10:00am

Presenters

David Kilborn, CFA Chief Investment Officer

Performa Limited (US), LLC

Mike Stellato Senior Consultant

The Concord Advisory Group

David Pittman Chief Financial Officer and Chief Operating Officer

Bennett International Group, LLC


Agenda

1) Asset Allocation for Captives

2) Captive Owner Perspective

3) Market Outlook

4) Q&A


Asset Allocation for Captives


Winning the Investment Game

A sound and repeatable process is the key to increasing the odds of portfolio success in any market environment

Sound Governance

Investment Strategy

Strategic asset allocation that matches the liabilities of the asset pool and the financial position of the

organization

Portfolio Execution

Well-defined vendor selection process

‘Best-in-class’ pricing

Decision-making framework for the

organization

Portfolio oversight

These basic elements form the crucial foundation of an investment program for Captives

4


Governance Process

• Establish framework for decision making and accountability

• Set a risk budget based on financial tolerance

• Document intentions via formal Investment Policy Statement (“IPS”).

• Oversight and monitoring of portfolio results versus IPS and long-term goals.

• Focus on relevant and productive forward-looking matters

Investment Policy Statement

Development / Revision

Asset Allocation

Manager Due Diligence / Oversight

Performance Reporting

Cost Analysis

5


Governance – Effective Decision Making Structure

• Board Responsibilities

– Establish reporting structure and protocol for investment operations

– Establish Investment Committee

– Review and approve/reject Investment Committee recommendations

• Investment Committee Responsibilities

– Recommend investment objectives, policies, and guidelines

– Develop asset allocation and risk parameters for the portfolio

– Vendors selection and performance evaluation

• Staff Responsibilities

– Daily oversight of investment operations

– Ongoing reporting to Board and Investment Committee

6


Investment Program Roles & Responsibilities

Investment Consultant Investment Manager Captive Owner

Governance

IPS1 Development & Revision

Portfolio Monitoring & Oversight

Cost Analysis

Audit & Regulatory Filing Support

Comprehensive Reporting

Board / Committee Education

Investment Policy Input for Specific Asset Classes or IPS Development (if no consultant)

Portfolio Reporting

Audit & Regulatory Filing Support

Board / Committee Reporting & Meetings

Regulatory Compliance & Oversight

Daily Accounting

Quarterly & Annual Regulatory Filings

IPS1 Approval

Monthly Portfolio Review

Quarterly Committee Oversight

Strategy

Asset Allocation Modeling & Strategy

Total Portfolio Risk Management

Portfolio Customization

Asset Class Expertise

Underlying Portfolio Risk Management

Advise on Projected Cash Flows & Liabilities

Asset Allocation Approval

Establish Risk Tolerance Thresholds

Execution

Investment Manager Searches & Recommendations

Rebalancing Recommendations

Document Preparation & Staff Support

Discretionary Management of

Underlying Portfolios

Final Manager Selection Decisions

Portfolio Rebalancing Approval

Transaction Signoff

7 1 Investment Policy Statement


Strategy: Asset Allocation

Return Enhancement

Core Capital

Liquidity

Allocation Building Blocks

Liquidity bucket for expected short-term cash flows. Periodically utilized as a tactical investment in periods of stress.

Income producing and low volatility strategies that support underwriting reserves. Provides diversification and safety to the majority of insurance assets.

Total return strategies that seek to grow surplus assets. Equity-like levels of volatility.

• Develop appropriate investment strategies which align with the operating needs of the organization.

• Recognize the importance of risk management.

• Focus on long-term strategy, while remaining aware of short-term market dynamics.

• Establish liquidity for demands of the organization

• Utilize combination of assets that attempts to minimize risk and maximizes return

8


Strategy: Insurance Portfolio Evolution

Formation Stage Growth Stage Maturity Stage

Investable Assets

Limited Reserves Reserve Accumulation / Modest Surplus Stable Reserves / Rising Surplus

Risk Tolerance None Low Moderate

Investment Profile

Capital Preservation Growth & Income Total Return

Investment Goal

Minimize Risk of Loss Income Generation Income & Capital Gains

Investment Options

Cash & Equivalents Short-Term Bonds

Investment Grade Bonds Global Bonds

High Yield Bonds Convertible Securities

High Quality Global Equities

Emerging Markets Equities Commodities Real Estate

Alternative Strategies

Typical Investment

Management Structure

Bank / Single Manager

Single or Multi-Manager / Consulting Services

Multi-Manager / Consulting Services

9


Strategy: Asset / Liability Matching

Key Observations:

Total Assets: Consist of Reserves supporting company liabilities and Surplus assets

Liquidity: cash supports daily operations

Core Capital Reserves: Investment grade bonds invested across the yield curve

Surplus Assets: Invested for a total return across a diversified opportunity set of risk assets

10

Cash

Core Fixed Income

High Yield

Convertibles Real Return

Global Equity

Liquidity

Core Capital

Return Enhancement

$0

$2,000

$4,000

$6,000

$8,000

$10,000

$12,000

$14,000

$16,000

$18,000

$20,000

$22,000

$24,000

$26,000

Assets Surplus/Reserves Asset AllocatonRationale

InvestmentPortfolio

$'s

Th

ou

san

ds

Sample Insurance Company Balance Sheet Assets Reserves Surplus


Execution: Cost vs. Performance

11

Items to consider:

• Measurement against peers (percentile ranking)

• Performance: Lower percentile better (higher returns)

• Fees: Higher percentile better (lower fees)

• Goal is to assemble the most efficient mix:

-Performance: Above median (1st to 50th)

- Fees: Below median (51st to 100th)


Captive Owner Perspective

12



Background

• Core business is transportation and logistics - not managing investments!

• Celebrating 42 years in business

• Privately Held, located in McDonough, GA

• CEO and President = Mrs. Marcia Taylor

• Annual Revenues = $340 million

• Started 1st Captive in 2004 (domiciled in South Carolina)

• Started 2nd Captive in 2011 (domiciled outside of S.C for diversity)

• Current combined asset base of $17 million

13



Investment Program Overview

• First and foremost, leave investing up to the Experts!

• Developed an Investment Policy Statement (IPS)

– A good Investment advisor will assist you with this

• Interviewed several Investment Advisors

– Track record, experience, proximity and “chemistry” matters

• Selected multiple advisors for diversification

– Each follows the same IPS

• Established a reasonable long-term annual return expectation

• Required monthly reporting and quarterly meetings (in-person or conference call)

– Investment Advisors know that we will be monitoring performance

• We invest for the long-term

– Bull and Bear markets are reality – Occasionally we alter Asset Allocation, but we avoid knee jerk reactions to daily swings 14



Evolution of Asset Allocation

15

Cash Fixed Income Equities

2008 – 2009 10% 65% 25%

2009 – 2010 5% 80% 15%

2010 – 2011 -- 75%, 70%, 65% 25%, 30%, 35%

2011 – 2012 -- 55% 45%

2012 – 2013 -- 65% 35%

Since 2013 -- 60% 40%


Market Outlook

16


2015 Macroeconomic Landscape

• U.S.A. — The U.S. economy

continues to lead the world as the Fed is inching closer to a 2015 rate hike.

• Eurozone — Sluggish growth and threat of looming deflation resulted in ECB QE and negative interest rates.

• U.K. — Improving fundamentals has the B.O.E. looking to raise rates, but still lagging the Fed.

• Japan — Abenomics is in full gear as Prime Minster Shinzo Abe looks to revive the Japanese economy.

• China & India — Looser monetary policy should be supportive of growth going forward.

17


Divergent Central Bank Policies Resulting in Strong U.S. Dollar

• The U.S. Dollar Index is a broad

measure of the strength of the U.S. dollar vs other major world currencies.

• As the Fed moves closer to raising short-term interest rates, the U.S. dollar has appreciated dramatically.

• While a stronger dollar is good for the U.S. consumer (increased purchasing power), it weighs on inflation and hurts U.S. exports as they become relatively more expensive.

• The dollar rally has taken a pause as market expectations for a Fed interest rate hike have been pushed back.

18


Feelin’ Alright

• The University of Michigan

Consumer Sentiment Index tracks attitudes and expectations of U.S. consumers.

• We care because consumers who report feeling more optimistic are more likely to increase discretionary spending.

• Falling gas prices, an improving labor market, and buoyant equity prices have supported consumer confidence measures in 2015.

• The pain of the financial crisis is ingrained in consumer psychology, but a nice tailwind from significantly lower gas prices should help comfort consumers.

19


Small Businesses - Doing Their Part

• The NFIB small business survey

reports on topics ranging from current activity to expectations 3-6 months ahead.

• We care because a positive trend in this series indicates that small businesses are more upbeat about the economy and their own prospects.

• Optimism declined during the first quarter, but has stabilized around 95 in recent months. A trend back towards 100 would be consistent with solid economic expansion.

• Going forward we will interpret small business optimism as a positive signal for job creation and broader economic activity.

20


Job Growth is Solid & Claims are Down

• Nonfarm Payrolls tracks

the net change in the number of employees on business payrolls. Initial Jobless Claims measures the number of new unemployment claims filed.

• We care because initial claims trending around 300k is consistent with solid job creation and economic expansion.

• Today, initial claims are tracking well below 300k offering further evidence that the labor market remains in good health, with job creation rebounding after experiencing a slowdown in March.

21


Fed Conundrum #1: Unemployment: How Much Lower Can It Go?

• The Unemployment Rate and

job creation are closely watched data series by market participants and policymakers alike.

• The unemployment rate reached a fresh cycle low of 5.1% in August, a level not seen since early 2008.

• Despite the precipitous decline in unemployment, we have yet to see significant wage growth.

• Interestingly, Walmart recently decided to implement higher wages, potentially pressuring other multinationals to follow suit, a positive signal for wage growth looking forward

22


The Fed Keeps Moving its Employment Target: Where Have All the Workers Gone? Explaining Slack

• The Labor Force Participation

Rate (LFPR) is the percentage of people 15 years or older who are either employed or looking for work.

• Many cite the recent decline in the LFPR as evidence of the slack that exists in today’s labor market – using it to explain the lack of wage growth witnessed during the current recovery.

• While the cyclical argument certainly has some validity, we note that demographics are changing, and thus playing a role too. The social, economic, and demographic forces that sent the LFPR higher in the 1970’s have shifted.

23


Fed Conundrum #2: Inflation Below 2% Target Lower Oil Prices Having an Impact on Headline Inflation

• The Consumer Price Index (CPI)

tracks prices paid for a broad basket of consumer goods and services.

• We care because modern day monetary policy is closely tied to inflation rates, with many central banks adopting inflation targets.

• Recently, headline CPI measures have fallen as a result of sharply lower oil prices.

• While core measures (which strip out volatile components like food and energy) have held up, the lack of price pressures has allowed central bankers to keep interest rates lower for longer.

24


Core Inflation: Take Out Food & Energy - Still Below 2% The Fed Remains “Reasonably Confident” Inflation Will Rise

• Personal Consumption

Expenditure (PCE) is the Fed’s preferred measure of inflation.

• Headline PCE has moved well below the Fed’s inflation target, dragged down by sharply lower oil prices.

• Meanwhile core PCE, which strips out volatile components like food and energy, has held up well.

• The Fed continues to characterize the effects of lower oil prices and a stronger U.S. dollar on inflation measures as transitory, and remains “reasonably confident” that inflation will move back toward 2%, a prerequisite for raising rates.

25


Wage Growth will be the Next Catalyst: Is it Around the Corner

• U.S. real average hourly earnings

track the year-over-year growth rate of money paid for work or service, adjusting for inflation.

• While rising wages don’t necessarily cause inflation, we are starting to see mounting wages pressures in the U.S. economy - a good signal that broader price pressures are building.

• Income boosts will filter through the economy and provide the backdrop and confidence for the Fed to raise short-term interest rates, not to mention support U.S. consumption.

26


Yield Curve: A Tail of Two Ends…

Interest rates are headed higher in the long run, but as 2014 and 2015 show, it’s more than just the headlines, it’s about the curve…

27 Source: Bloomberg, Performa Limited U.S.


Inflation…

Cost of Cash

• Holding cash might protect nominal value (black line), but sitting in cash means losing real value (green line)

• Over time, inflation erodes purchasing power

• Example – Holding $1,000 in cash since 2005 would result in a value of roughly $800 in 2015, adjusted for inflation

$800

$825

$850

$875

$900

$925

$950

$975

$1,000

Dec-04Dec-05Dec-06Dec-07Dec-08Dec-09Dec-10Dec-11Dec-12Dec-13Dec-14

Do

lla

rs (

US

$)

Years

Value of $1,000 from 2005-2015 Adjusted for Inflation (using CPI 1)

Source: Bloomberg, Performa Limited U.S.

… danger lurking below the surface of every portfolio

1 Consumer Price Index

28


Inflation…

Source: Bloomberg, Performa Limited U.S.

1 Consumer Price Index

29

$950

$1,000

$1,050

$1,100

$1,150

$1,200

$1,250

Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14

Do

llars

(U

S$)

Years

Cost of Cash

• Captives should take steps to defend their capital against inflation

• Ex: A $1,000 investment in a high quality, investment grade bond strategy (as represented by Barclays Intermediate Govt/Credit Index) would have grown to $1,208, adjusted for inflation

Value of $1,000 Investment in Barclays Capital Intermediate Gov/Credit Index

Adjusted for Inflation (using CPI 1)


US Stocks...

Source: Bloomberg, eVestment

• While S&P 500 has done well in recent years…

YTD (8/31/2015) -2.88% 1 Year 0.48% 3 Years 14.31% 5 Years 15.87%

…returns have been led by a small cohort (i.e., 5 stocks combined represent more than 80% of the total return YTD).

• With such a concentrated group of stocks generating most of the performance, stocks that have not participated may offer compelling opportunities for appreciation

… not what they seem

1 1 Year as of August 31, 2015

10.8%

11.0%

12.9%

22.5%

24.1%

0% 5% 10% 15% 20% 25% 30%

Facebook

Home Depot

Visa

Apple

Amazon

Percent of Total Index Return

S&P 500 Index Top 5 Performance Contributors of the Index 1

30


Q&A

31

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