Designing Investment Policy Statements

Policy and Practice

Andrew Baron, CFAHead of Group Fixed Income, Butterfield Asset Management

Wes CarterDirector, Laurier Indemnity Limited

IntroductionDesigning an Investment Policy Statement is the most important initial step in the investment process for a Captive

The structure of this policy is often given perfunctory attention as something best left to either Investment Managers or in the case of larger Captives, the parent’s Corporate Treasury

This presentation will cover:

1. Why the document is important

2. What should be included in a good Investment Policy

3. Pitfalls and why Investment Managers fail to live up to expectations

4. Real-world examples of how to navigate your Board or Investment Committee through the process

Why is an IPS Important?

1. Well-defined and well-written long-term objectives ensure a Committee or Board understands the nature of potential risk and its relationship with return, liquidity or capital preservation goals

2. The IPS establishes roles and responsibilities in decision-making

3. Setting asset allocation guidelines, both across and within asset classes removes a degree of emotion and behavioral issues that can lead the Captive away from its long-term objective

Why is an IPS Important?

S&P 500

T-Bills

Global Bonds

Why is an IPS Important?

How to Start – Regulatory Requirements

1. Regulatory Guidance in Cayman Islands

• All Insurance companies are required to have an investment strategy and an IPS that details:

• Asset allocation and any limitations on geography, markets, sectors, counterparties or currencies

• The “overall approach” to the selection of securities• “Details, where applicable, of any restrictions on

assets”• The scope for investment flexibility in active

management

• BE AWARE – You are currently limited to 20% Equities Exposure!

• The Regulatory Guidance is minimal! – only 185 words cover the entire Investment Strategy section of the CIMA Guidelines

• Asset allocation and any limitations on geography, markets, sectors, counterparties or currencies

• Does not specify that any limits on any of those items are either necessary or appropriate

• The “overall approach” to the selection of securities• Does not say “The Dartboard” is an invalid strategy

• “Details, where applicable, of any restrictions on assets”

• Does not specify any suggested restrictions

How to Start – Regulatory Requirements

Every Investment Policy Statement should have these building blocks:

1. Purpose Statement/Introduction/Overview

2. Portfolio Goals and Objectives

3. Definition of Duties

4. Investment Strategy and Asset Allocation

5. Liquidity and Collateral Considerations

6. Monitoring and Review Procedures

7. Investment Limitations

The Basics

1. Purpose Statement/Introduction/Overview

The purpose statement should include a broad overview of the material and the reasons for creating the document.

Example:

ABC Captive Limited is a Limited Liability Company incorporated under the laws of the Cayman Islands and regulated by the Cayman Islands Monetary Authority. This document outlines and determines the investment policies, goals and limitations of ABC Captive Ltd and clearly establishes the roles and responsibilities of each relevant party in the investment process.

2. Portfolio Goals and Objectives

Goal Setting gives all responsible parties a clear idea of what is expected in terms of investment returns and risk tolerance

This section should include both a statement on:

• A return Objective• A specific risk tolerance

Return Objective

• Should state specifically what the primary objective is for investing:• Principal Preservation• Liquidity• Growth• A numerical target, based on actuarial data• A target at or above inflation

Risk Tolerance

• Must recognize the existence of market risks in the investment portfolio

• Should also make clear what the priorities are in terms of:

• Volatility (can range between “don’t care” and “Low”• Liquidity• Asset Quality• Diversification

Within this section, some mention can be given to the following other items:

• Any specified and regular liquidity needs• The Time Horizon of the investment portfolio (nearly always “long)• The existence of taxes, whether things like withholding tax should be

avoided, the Captive files as 953d, no Canadian Source Income, etc• Other unique circumstances (green, ethical, etc)

Example

The objectives under this Mandate are to maximize the rate of return on invested assets (Total Return Objective) subject to constraints described herein.

• To grow capital in order to improve the Company's competitive position and allow for expansion of operations. Stability and growth of investment income is viewed as critical to assuring a high probability of success.

• To ensure sufficient cash flow and liquidity to support the Company's operations. The Investment Committee recognizes the need for flexibility to manage assets to improve investment returns; however, it also sees benefits from lowering the risk of forced asset sales in the event of suddenly adverse market conditions.

• Subject to achieving the first two objectives, pursue favorable risk-adjusted, total returns in order to enhance the Company's competitive position.

This Mandate will be managed using an active management focus, so liquidity and trade execution are important considerations.

3. Definition of Duties

At a minimum, each of the relevant parties that has some responsibility for the IPS should be identified

• The Board of the Captive• Has ultimate Fiduciary responsibility for the Captive company• If there are employees of the Captive Manager on the Board

of the company, they should know and recognize that they have a fiduciary responsibility in this regard.

• Should state whether monitoring the compliance to the IPS is the responsibility of an Investment Committee or the Board

• Investment Committee• Common in Captive governance, but not required• Usually responsible for recommending investment strategies,

service providers, brokers, custodians, etc to the full Board

• Investment Managers• Investment Consultants• Custodian• Actuarial provider – may have an effect on Investment Policy

4. Investment Strategy and Asset Allocation

Ideally, an Investment Committee will have done some research into what they believe is achievable in the portfolio and how to reach their goals

There are a few different ways to articulate this “Investment Philosophy”

Although it can be incorporated into the section that details what the investment strategy and asset allocation will be, thought should be given to whether a separate statement/paragraph could be useful

This is an idea that is incorporated LEAST in Captive IPS (and indeed in other types of institutional clients)

The Importance of Investment Philosophy

Items that can be covered include:

• Whether costs are important

• Whether inflation is a concern

• Whether any contrarian views are desired

• The purpose of inclusion of Alternative asset classes

• Whether Active Management is desired or if there is a belief that an active manager can add value

• Whether any tactical shifts in asset allocation are going to be employed and who is responsible for those decisions

• Whether equities should have any inherent size bias (small, medium, large-cap

• Whether equities should any kind of style tilt (Value, dividends, etc)

The Importance of Investment Philosophy

• “Equities” and “Bonds” is not an asset allocation

• Specifically set the type of assets that are allowable, unless you want a “go anywhere” global manager

• Set a strategic allocation that makes sense in the context of the objectives of the Captive – attempt to incorporate a forward Capital Markets assumption

• Be Realistic

• Set allowable ranges for the strategic or tactical allocation – this avoids the possibility of getting over-emotional and potentially acting without an Investment Committee vote

Step 1 - Define Allowable Asset Classes

Example

Step 2 - Define Allowable Allocations

Asset Class Minimum % Target % Maximum %

Global Equity 10% 15% 20%

Commodities 5% 8% 11%

Total Risk Assets 15% 23% 31%

High Yield Debt 5% 8% 11%

EM Debt 5% 8% 11%

Global Investment Grade Fixed Income 42% 50% 58%

US TIPS 7% 11% 15%

Cash/Short Duration 0% 0% 16%

Total debt Instruments 69% 77% 95%

Define expectations clearly and use appropriate benchmarks

Pitfalls include:• Asking a manager who shows a track record in S&P 500 stocks to

manage a global portfolio• Choosing benchmarks that are popular, but don’t reflect the

composition of the portfolio or the investment philosophy

Example

Captive YYZ gives a mandate to Super-Alpha Advisors to manage a balanced portfolio. The Chairman’s Brother in-Law is an investment manager who says everyone nowadays uses the MSCI World Index as a benchmark, so the MSCI World Index is used in the IPS. No one in the Committee discusses the fact that the MSCI World Index is the total world equity market, including Emerging Markets. In fact, Super-Alpha Advisors is a specialist asset manager that has beaten the S&P 500 over the last 7 years using a high dividend, value strategy.

Step 3 - Define Proper Benchmarks

5. Liquidity and Collateral Considerations

Captive Companies often have specific collateral needs based on an LOC or Collateral Trust Program

Be sure that you IPS directly addresses the collateral needs and limitations and take care to avoid conflicts between the IPS and externally controlled restrictions that may severely limit the ability to take incremental risk and earn a rate of return that is acceptable

6. Monitoring and Review Procedures

• The IPS should not be static, the document itself should be formally reviewed on an annual basis – it is meant to be a document that is portable in the instance that Committee members change or service providers change and should be updated in light of market developments in some instances

• Set a timeframe for formal review of the document and include all relevant parties, including your investment manager

• Review procedures is one area that CIMA does have guidance on. Sections 6 and 7 of the Statement of Guidance provide good guideposts for review procedures

Review

• The periodic reviews procedures should also state how professional managers hired on behalf of the portfolio will be judged and what procedures can be implemented in the event a manager needs to be replaced

• Detail Index measurements and time frames• Repeat any specific numerical goals• State whether peer groups matter and over what

time frame• Clearly state the time-frame• Specify a reporting frequency requirement

Review

7. Investment Limitations

Investment Limitations

• Many Captives spend a great deal of time on this section, which says little about the investment goals of the company

• Limitations should be reasonable in the context of the goals and care should be taken not to create either an incentive structure that encourages risk taking, nor one that is over-conservative for the circumstances

• In general, this section tends to be heavily used for defining specific limitations on credit quality, concentration and interest rate risk

Investment Limitations

A Word on Credit Ratings Agencies

• Reliance on Credit ratings agencies, or NRSRO’s as they are termed, should be limited to whatever degree possible within collateral requirements

• Post-2008, many assumed that the credibility of the agencies (like S&P and Moody’s) was completely broken and agreed that there had to be a better way to quantify credit risk – little has been done

• The agencies are slow to recognize problems when there is deterioration and equally slow to improve their opinions – the markets do this for them through price

• Be absolutely certain that if you have to include a threshold for ratings, that it is applied consistently in the IPS, the benchmark you use is appropriate and that the Investment Manager and the Committee agree on the scope for outperformance

• If your manager uses credit products, understand what they plan to use and understand how they manage credit risk and analyze securities – this is the best way to protect yourself – it cannot be outsourced to a rating agency

Investment Limitations• If possible, state specifically what instruments are

allowable, rather than a long list of what is not allowable (except a prohibition on derivative instruments, which should be stated)

Example – Permitted Fixed Income Securities

• Government and Government Agency Securities, excluding mortgage derivative securities whose underlying collateral is in the form of mortgages or mortgage backed securities.

• Supranational agencies and international development banks.• Sovereign Country debt, issued in US dollars• State and Municipal debt• Corporate Bonds, including convertible bonds and bonds with

warrants• Mortgage Backed Securities, who’s underlying collateral is in the form

of U.S. Agency mortgages• Pooled short-term Money Market funds• Exchange-Traded Funds listed on recognized global stock exchanges

Investment Limitations

Example – Restrictions and Limitations

• For diversification purposes, the maximum investment in any single issue is 5% and funds invested in any one issuer shall not exceed 5% of total invested assets

• No purchases are permitted for individual fixed income assets with Standard & Poor's (or Moody’s equivalent) rating of below BBB-. To the extent the credit rating of a previously purchased fixed income asset falls below BBB-, it is not required that the asset be sold; however, the Company is to be immediately notified. In addition, updates on the financial condition of the credit are to be given to the Company, in writing, on a regular basis.

CASE STUDIES

Case Study - CFA Institute IPSOne might expect an industry body tasked with promoting best practice in the Investment Management industry to have a decent IPS document and they do

Purpose

The purpose of the portfolio is clearly laid out, with special mention made of the process by which the company models their targeted reserve levels – very similar to how a Captive, through internal forecasting and modeling, or with the use of an outside consultant, can measure the liability structure of the Captive and predict insured losses.

Investment Objectives

The three return goals, in order of importance are clearly laid out, with emphasis given to properly balancing the needs – included is a mention of preserving the purchasing power of the portfolio

Captives rarely recognize the importance or even the existence of inflation in the return objectives

Case Study - CFA Institute IPSInvestment Objectives, Continued

The existence of market risk is recognized and a commitment to a specific portion of the capital markets is made (determination of how this is measured can be left to later in the document):

• Moderate Volatility• Highly liquid• High quality

Asset Allocation

Very clearly lays out the investment philosophy within the asset allocation section of the document:• Committed to Global investing for both return and diversification purposes• Committed to equities investing for long-term capital growth• Committed to the higher quality portion of fixed income investments for

volatility purposes• Committed to using inflation-protected securities

Case Study - CFA Institute IPSAsset Allocation, Continued

• Committed to diversification of asset classes by adding specific examples (REITs, EM Debt, Commodities)

• Committed to some degree of dynamic or tactical asset allocation• Committed to specific currency exposure

Investment Management Strategy

Here, the IPS makes clear its views on investment vehicles and the potential to produce excess return through dynamic asset allocation• Specifically mentions the existence, usefulness and economy of passive

mutual funds

Case Study - CFA Institute IPS

Asset Class Minimum % Target % Maximum %

Global Equity 36% 41% 46%

Commodities 5% 8% 11%

Global REITs 5% 8% 11%

EM Debt 5% 8% 11%

Opportunity Fund 0% 0% 5%

Total Risk Assets 60% 65% 70%

Global Fixed Income 18% 23% 28%

US TIPS 9% 12% 15%

Cash/Short Duration 0% 0% 10%

Total Safe Assets 30% 35% 40%

Case Study - CFA Institute IPSEvaluation and Monitoring of Investment Managers

The selection of managers, including passive strategies is laid out in detail• “At a basic level, any active manager hired should exhibit skill”• Qualitative factors are clearly laid out• Fee levels are important• Past Performance should be evaluated on a risk-adjusted basis

(important philosophical point)• Manager incentives considered (organizational structure)• Specific attributes are included

What this IPS does not say:

• It does not say that the manager needs to be a global giant• It does not say that the manager needs to beat the index every year• It does not set benchmarks arbitrarily and ask managers to compare

themselves against unattainable benchmarks• Lastly, it does not have any credit ratings restrictions

Case Study – Captive XYZIPS is from an actual client of Butterfield Asset Management

• Biggest problem - Existence of contradictory restrictions within the IPS The index construction is allowed to contain issuers with an “A”

rating by one of the agencies, but the portfolio is restricted to “Aa3/AA-” or better – the manager cannot replicate the index, even if he desired to do so

Index has a plethora of Canadian issuers and the IPS bars the portfolio from Canadian issuers

• All securities and issuers must be within a narrowly defined Index, making the investable universe is too small

• Allocation is overly conservative and does not recognize the existence of inflation The loss history of the Captive is close to zero in 6 years of

management, yet the portfolio is 25% cash

• Lastly, these points come up at least annually and they ignore the advice of people they pay to give them advice