Portfolio Management Strategies for Insurance Pools...Portfolio Management Strategies for Insurance...
Transcript of Portfolio Management Strategies for Insurance Pools...Portfolio Management Strategies for Insurance...
© PFM 1
Portfolio Management Strategies for Insurance PoolsNLC – RISC Trustees Conference
PFM AssetManagement LLC
213 Market StreetHarrisburg, PA 17101
717.232.2723pfm.com
Kenneth Schiebel, CFA, Managing Director
Mark Yasenchak, CFA, Director
Presented By:
May 11, 2018
© PFM 2
Investment Management Strategies for Insurance Pools
This session will provide an introduction to the investments and strategies used in managing
assets of insurance pools, along with considerations for selecting an investment management
strategy that meets the needs of your insurance pool. An overview of today’s changing financial
markets and their application to portfolios, as well as additional considerations for Trustees in
fulfilling their fiduciary role will also be discussed.
© PFM 3
Topics to be Covered
1. Investment Management for Insurance Pools
2. Role of a Trustee
3. Investment Risks & Opportunities
4. Pulling it All Together
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Investment Management for Insurance Pools
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The Nature of Insurance Liabilities
Unique nature of insurance liabilities:
• Both the timing and amount of cash flows are uncertain
Understanding liabilities is key to determining an appropriate investment strategy:
• Lines of business (short tail vs. long tail)
• Actuarial assumptions
• Confidence levels
• Cyclical nature of claims
• Low probability/high impact events
© PFM 6
Factors Impacting Investment Strategy
Business Profile
• Members/participants
• Lines of business
• Size/history
• Risk retention
• Liabilities
• Surplus
• Accounting methods
• Ratings (if any)
Investment Policy
• State laws
• Investment objectives
• Risk tolerance
• Permitted Investments
• Asset allocation targets
• Performance benchmark(s)
Portfolio Construction• Objectives
• Safety
• Liquidity
• Income vs. Growth
• Discount rate
• Asset allocation
• Cash, bonds, stocks
• Market conditions
• Bond yields
• Stock market multiples
• Relative value
• Risk management
• Diversification
• Taxes (if any)
© PFM 7
Considerations Unique to Insurance Pools
Matching assets to liabilities• Actuarial reports & assumptions
• Ensure sufficient liquidity to pay claims
• Invest reserve funds to match expected claim payments
• Surplus management
Business considerations• Competitive marketplace
• Actuarial discount rate
• Pricing
• Cash flow/liquidity management
• Budgeting of investment earnings
• Statutory reporting
• Dividend policies
© PFM 8
An Investment Framework
Claim Reserves
Surplus(Net Position)
Current Claims
& Admin. Costs
© PFM 9
Segmenting the Portfolio
Liabilities Investment Strategy
Current Claims & Administrative
Costs
“Cash portfolio”• Highly liquid• Short term investments• Laddered maturities• Very high credit quality
Claim Reserves(Non-current
liabilities)
“Liability hedging portfolio”• Assets matched to expected claim payments• Based on actuarial assumptions• Intermediate-term investments• Medium to high credit quality
Surplus (Net Position)
“Growth portfolio”• Goal: long term surplus growth• Longer-term & broader investments• Less need for liquidity• Potential for (moderately) greater risk
© PFM 10
Developing a Strategic Asset Allocation
Cash / Liquidity
Traditional Fixed-Income
Multi Asset Class Portfolio
Sample PoolAsset Allocation
Portfolio StrategicAsset Allocation
Member Pool Goals and Preferences
Liability ProfileCash Flows
Global Investment UniverseCapital Market Assumptions
Risk/Return Analysis
© PFM 11
Liability Driven Investment Approach
Benchmark / Mandate Driven:
Investment universe is defined by the mandate
Benchmark = return bogey
Success is measured by comparison to the benchmark
Manager must deviate and take risks to beat the benchmark
Liability Driven:
Focus on meeting liabilities
Performance measured relative to liabilities
Investment manager objectives linked to business objectives
Increases likelihood that the business will achieve its objectives
© PFM 12
“Liability-Driven Investing”
Traditional Approach Liability-Driven Investing (LDI)
Asset-only focus Asset-Liability focus
Objective to beat a benchmark Treat the risk and return characteristics of theliability stream as the benchmark
Product-based Situation-based
Investment performance focusedon total returns
Investment performance measured in terms of impact on enterprise value
Beating a benchmark does not assure assets can meet liabilities
Increases likelihood of business successmeeting liabilities and growing surplus
© PFM 13
Impact of Interest Rate Changes
Effects both assets and liabilities
© PFM 14
Pric
e
Yield
2-Year Bond10-Year Bond30-Year Bond
Maturity (Duration) Effects the Degree of Price Volatility
There is no free lunch: Greater rewards require greater risk
Current Yield
© PFM 15
Matching Assets to Liabilities
Typical Liability Pay-Out Pattern Perfect Cash Flow Match
$2.5
$4
$3.5
$2.5
$2
$1.5
$1
$0.5
$0.0
$1.0
$2.0
$3.0
$4.0
$5.0
2011 2012 2013 2014 2015 2016 2017 2018
$ M
illio
ns $2.5
$4
$3.5
$2.5
$2
$1.5
$1
$0.5
$0.0
$1.0
$2.0
$3.0
$4.0
$5.0
2011 2012 2013 2014 2015 2016 2017 2018
$ M
illio
ns
Liabilities
Assets
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Impact of Liability Mismatch
$0
$1
$2
$3
$4
$5
2012 2013 2014 2015 2016 2017 2018 2019
Mill
ions
of D
olla
rs
Assets
Liabilities
$0
$1
$2
$3
$4
$5
$6
$7
$8
2012 2013 2014 2015 2016 2017 2018 2019
Mill
ions
of D
olla
rs
Assets
Liabilities
Perfect Cash Flow Match Mismatched Portfolio
Total Assets $17.500 million
Total Liabilities $17.500 million
Duration of Assets 3.22 years
Duration of Liabilities 3.22 years
Total Assets $17.500 million
Total Liabilities $17.500 million
Duration of Assets 2.04 years
Duration of Liabilities 3.22 years
Equal Duration of Assets and Liabilities Shorter Duration of Assets than Liabilities
© PFM 17
Impact of Liability Mismatch
Assume a 100 basis point (1%) decrease in interest rates
Total Assets $17.500 million
Total Liabilities $17.500 million
Total Assets $18.064 million
Total Liabilities $18.064 million
Before
After
Impact on Surplus = $0
Liabilities Remain Funded
Perfect Cash Flow Match
Total Assets $17.500 million
Total Liabilities $17.500 million
Total Assets $17.857 million
Total Liabilities $18.064 million
Before
After
Impact on Surplus = $(207,000)
Liabilities Become Un-funded
Mismatch Portfolio
© PFM 18
Role of a Trustee
© PFM 19
Roles & Responsibilities on an Investment Committee
Establishing and participating on an investment committee is a sound risk-management strategy
Trustees have a fiduciary responsibility to the organization
Establishing written policies and guidelines are a fundamental responsibility
Trustees/committee members have ongoing oversight responsibilities
Annually review pool financials
and actuarial assumptions
Review investment objectives
Review investment policy and guidelines
Formal Review Cycle
Meet periodically with
investment manager
Review investment
holdings, transactions,
asset allocation, and policy
complianceReview
performance relative to a benchmarkUnderstand
source of over or under
performance
Ongoing Oversight
Create a formal investment
policy statement (IPS) that
includes investment objectives,
philosophy, asset allocation targets, and risk
metrics
Develop an Investment
PolicyDevelop
understanding of the business,
operations, pricing, and
business risks
Understand the Business
Learn regulations,
fiduciary duties and related background information
Acquire Requisite Knowledge
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Key Components of a Sound Investment Policy Purpose and Scope: Outlines the general purpose of the Investment Policy. Identifies the nature of the funds to be
managed.
Investment Authority: Documents significant parties involved and their respective roles (Board, Investment Advisor, Investment Committee, Custodian, etc.), as well as fiduciary requirements of all parties.
Statement of Objectives: Identifies the primary objectives, business sensitivities, performance expectations, risk tolerance and liquidity needs.
Investment Guidelines: Establishes the permitted investment types, maximum exposures (max maturity, beta, per sector, industry, issuer limits), investment time horizon, diversification parameters, rebalancing philosophy, risk tolerances, and any SRI or ESG parameters. Also describes prohibited investments and strategies.
Investment Managers: Documents the process and criteria for selecting investment managers.
Asset Allocation Targets: Establishes acceptable ranges and targets for major asset classes (e.g. equities, fixed income, cash, alternatives), and sub-class ranges within each major asset class.
Safekeeping of Assets: Documents the manner in which assets are held in custody.
Control Procedures: Documents major procedures for protection of assets, trade execution, movement of cash or securities, separation of duties, need for audit or reconciliation.
Reporting: Required period reports, including holdings, transactions, fees, and performance.
© PFM 21
The Importance of Diversification
Source: JP Morgan Guide to the Markets as of 12/31/2017.
© PFM 22
2018 Capital Market Assumptions
Expected Return Expected Risk Expected Return Expected Risk
US Equity 6.5% 17% 7.7% 16%
International Developed Equity 6.6% 18% 7.7% 17%
Emerging Markets Equity 6.6% 24% 7.7% 20%
Core Bonds 1.9% 4% 5.5% 5%
Intermediate Investment Grade 2.3% 6% 6.3% 7%
Emerging Markets Debt 4.2% 10% 7.3% 10%
High Yield 4.3% 10% 6.8% 10%
Bank Loans 4.0% 6% 5.2% 6%
REITs 5.6% 12% 6.5% 12%
Private Equity Real Estate 6.9% 15% 7.8% 15%
Commodities 4.2% 16% 5.3% 16%
Hedge Funds 5.7% 15% 7.3% 15%
Private Equity 8.0% 25% 9.5% 25%
Cash 2.2% 1% 3.3% 1%
Intermediate: Next 5 Years Long Term Projections
For the intermediate term (up to 5 years), our capital market assumptions derive from our assessment of current economic conditions, including corporate profits, balance sheets, etc., and current valuations for various asset classes. Our long-term assumptions are derived using an economic building block approach that projects economic and corporate profit growth and takes into consideration the fundamental factors driving long-term real economic growth, our expectation for inflation, productivity and labor force growth.
© PFM 23
2018 Capital Market Assumptions (cont.)
US Equity
International Developed
Equity
Emerging Markets Equity
Core Bonds
Intermediate Investment Grade Corp
Emerging Markets
Debt
High Yield
Bank Loans REITs
Private Equity Real
EstateCommodities Hedge
FundsPrivate Equity Cash
US Equity 1
International Developed Equity 0.8 1
Emerging Markets Equity 0.7 0.7 1
Core Bonds 0.3 0.2 0.2 1
Intermediate Investment Grade Corp 0.3 0.2 0.2 0.9 1
Emerging Markets Debt 0.5 0.5 0.5 0.4 0.4 1
High Yield 0.7 0.5 0.5 0.4 0.4 0.4 1
Bank Loans 0.4 0.3 0.3 0.3 0.3 0.7 0.7 1
REITs 0.5 0.4 0.4 0.3 0.3 0.3 0.4 0.4 1
Private Equity Real Estate 0.4 0.3 0.3 0.3 0.3 0.2 0.4 0.2 0.8 1
Commodities 0.1 0.1 0.2 0.2 0.2 0.3 0.2 0.2 0.1 0.1 1
Hedge Funds 0.6 0.5 0.5 0.4 0.4 0.3 0.4 0.4 0.4 0.3 0.2 1
Private Equity 0.7 0.6 0.6 0.3 0.3 0.3 0.5 0.2 0.4 0.4 0.1 0.5 1
Cash 0.1 0.1 0.1 0.2 0.2 0.1 0.1 0.2 0.1 0.1 0.1 0.1 0.1 1
Correlations
Please refer to PFM’s 2018 Capital Market Assumptions for a complete description of the methodology used to develop these assumptions and important disclosures.
© PFM 24
Asset Allocation SummaryShort Term
Fixed Income 20/80Model
30/70Model
40/60 Model
Equity 0.0% 20.0% 30.0% 40.0%Domestic Equity 0.0% 13.0% 20.0% 26.0%International Developed Equity 0.0% 5.0% 7.0% 10.0%Emerging Markets Equity 0.0% 2.0% 3.0% 4.0%Fixed Income 100.0% 80.0% 70.0% 60.0%Core Fixed Income 0.0% 40.0% 35.0% 30.0%Investment Grade Corporate 0.0% 20.0% 17.5% 15.0%Emerging Markets Debt 0.0% 10.0% 8.8% 7.5%High Yield 0.0% 10.0% 8.8% 7.5%Short Term Fixed 100.0% 0.0% 0.0% 0.0%
Projections based on Intermediate-Term Assumptions (5 Years)Expected Return 2.0% 3.6% 3.9% 4.3%Standard Deviation 2.5% 6.3% 7.4% 8.6%Projections based on Long-Term Assumptions (30 Years)Expected Return 4.4% 6.6% 6.9% 7.1%Standard Deviation 3.0% 6.5% 7.4% 8.4%
© PFM 25
Return at the 5th percentile
Return at the 95th percentile
Return at the 50th percentile
Return at the 25th percentile
Return at the 75th percentile
Return ProjectionsBased on Intermediate-Term Capital Market Assumptions
Short-Term Fixed Income
© PFM 26
Return ProjectionsBased on Intermediate-Term Capital Market Assumptions
-10
-5
0
5
10
15
20
25
ShortTermFixed
Income
20/80Model
30/70Model
40/60Model
ShortTermFixed
Income
20/80Model
30/70Model
40/60Model
ShortTermFixed
Income
20/80Model
30/70Model
40/60Model
95th 6.14 14.73 17.55 19.87 3.88 8.41 9.77 11.14 3.26 6.98 8.02 9.0575th 3.68 7.92 8.91 10.00 2.73 5.45 6.17 6.94 2.52 4.97 5.63 6.3550th 1.96 3.40 3.90 4.45 2.00 3.56 3.94 4.34 2.00 3.64 4.12 4.5325th 0.43 -0.54 -0.66 -1.00 1.23 1.73 1.78 1.82 1.49 2.25 2.50 2.705th -2.13 -5.72 -6.90 -8.08 0.19 -1.15 -1.55 -1.90 0.75 0.31 0.23 0.04
Annu
aliz
ed R
etur
n (%
)
1 Year 5 Year 10 Year
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Return ProjectionsBased on Long-Term Capital Market Assumptions
0
2
4
6
8
10
12
14
Short TermFixed
Income
20/80Model
30/70Model
40/60Model
Short TermFixed
Income
20/80Model
30/70Model
40/60Model
Short TermFixed
Income
20/80Model
30/70Model
40/60Model
95th 6.00 9.98 10.69 11.48 5.51 9.07 9.61 10.12 5.33 8.69 9.20 9.6975th 5.01 8.03 8.50 8.88 4.86 7.59 7.92 8.29 4.81 7.48 7.77 8.1050th 4.43 6.61 6.84 7.02 4.40 6.66 6.92 7.13 4.41 6.63 6.88 7.1025th 3.79 5.34 5.36 5.33 3.97 5.71 5.79 5.86 4.05 5.86 6.01 6.085th 2.90 3.32 3.16 2.96 3.34 4.29 4.27 4.13 3.52 4.76 4.77 4.71
Annu
aliz
ed R
etur
n (%
)
10 Year 20 Year 30 Year
© PFM 28
Investment Risks & Opportunities
© PFM 29
The Nature of Risk
Traditional Portfolio
Investment risks:
• Interest rate risk*
• Credit/default risk*
• Reinvestment risk
• Prepayment/call risk
• Liquidity risk*
• Inflation risk*
• Exchange rate risk
Insurance Pool
Business risks:
• Cash available to pay claims
• Pricing adequacy
• Surplus sufficiency
• Operating ratios
* Key risks to insurance portfolios.
© PFM 30
Primary Investment Risks in Fixed Income
Type of Risk Definition Current Outlook
Interest Rate Risk Change in market values due to changes in interest rates
• Positive economic trends• Federal Reserve expected to continue to raise short-term
rates• Expected increased U.S. Treasury borrowing
Credit Risk Risk of default or decline in security value due to credit deterioration
• Healthy credit fundamentals with solid corporate earnings• Narrow yield spreads, but recent spread widening• Recession risk is low, but slowly increasing
Inflation Risk Loss of purchasing power over time as a result of inflation
• Inflation has been low, inching up recently• Core personal consumption expenditures (PCE) price index,
the Fed’s preferred measure of inflation, at 1.6% YOY, below the Fed’s 2% target
• Commodity prices (CRB) up 11.5% over past year
Liquidity Risk Inability to sell portfolio holdings at a competitive price
• Reasonably strong liquidity in investment grade markets• Increased capital cost has resulted in reduced dealer
inventory• Liquidity falls when markets are stressed
© PFM 31
Universe of Investment Sectors
Cash • Money Market Securities (MMF, Repo, T-Bills, CP, CD, BA)
“Conventional”Fixed-Income
• U.S. Treasury / Agency Bonds• U.S. Corporate Bonds• Mortgage Backed Securities (MBS)• Asset Backed Securities (ABS)• Municipal Securities (Taxable and Tax-exempt)
Broader Fixed-Income
• TIPS/Inflation-hedge• Foreign Sovereign/Supras• Commercial MBS• High Yield
• Private Placements• Convertibles• Non-U.S. Dollar investment grade• Emerging Markets Debt
Equities• Domestic Large Cap• Domestic Small/Mid Cap• Domestic Value/Growth
• International Large Cap• International Small/Mid Cap• Emerging Markets
Alternatives• Commodities• Real Estate• Hedge Funds
• Private Equity• Venture Capital• Tangible Assets
© PFM 32
Important Principles
• Asset allocation ranges
• Risk measures
• Diversification
• Return profiles
Increasing Diversification with Multi-Asset Class Management
© PFM 33
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
1965
1967
1969
1971
1973
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
2011
2013
2015
2017
5-Year Treasury Yield History (March 1965 – March 2018)
10-year average: 1.67%
Source: Bloomberg as of 03/31/2018.
© PFM 34
Equity Market Risk
Source: J.P. Morgan
© PFM 35
8.5%9.3%
1.7%
7.5%3.6%
0.7%0.8%
37.5%25.7%
21.9%
-10% -5% 0% 5% 10% 15% 20% 25% 30% 35% 40%
2017
Prior 5 Years
Equities
Domestic Fixed Income
Alternatives
U.S. Developed ex U.S. Emerging Markets
CommoditiesReal EstateHedge Funds
CashShort BondsCore BondsHigh Yield Corporates
Prior 5-year returns are based on 2012-2017 and are annualized.
Recent Asset Class Returns
© PFM 36
A Comparison of Investment Strategies: Historic Growth
Data Source: Investment Metrics. Calculation based on monthly periodicity.
$39,438,429
$36,273,039
$33,201,188
$31,586,942
$10,000,000
$15,000,000
$20,000,000
$25,000,000
$30,000,000
$35,000,000
$40,000,000
$45,000,00060% Fixed Income / 40% Equity Strategy - Annualized Return = 6.66%70% Fixed Income / 30% Equity Stragegy - Annualized Return = 6.06%80% Fixed Income / 20% Equity Strategy - Annualized Return = 5.44%BofA Merrill Lynch 1-5 Yr Treasury Index - Annualized Return = 2.46%
© PFM 37
Historic 10 Year Rolling Returns
Source: Investment Metrics as of 12/31/2017. Calculation based on monthly periodicity.
0%
1%
2%
3%
4%
5%
6%
7%
8%
9%
10%
Dec-12 Dec-13 Dec-14 Dec-15 Dec-16 Dec-17
60% Fixed Income / 40% Equity Strategy70% Fixed Income / 30% Equity Stragegy80% Fixed Income / 20% Equity StrategyBofA Merrill Lynch 1-5 Yr Treasury Index
© PFM 38
Pulling it All Together
© PFM 39
The Nature of the Investable Assets
Newer Pool
SurplusAdministrative
Costs
Reserves
Surplus
Administrative Costs
Reserves
Mature Pool
© PFM 40
Sample Segmented Portfolios
Administrative Costs
Reserves Surplus
TIPS/Inflation-
Hedge
Equity
Int’lEquity
DomesticFixedMoney Market Securities
(T-Bills, CP, CD, BA)
MoneyMarketFunds
Municipal Bonds
MBS/ABS
Investment-GradeCorporate
Bonds
Money Market Securities
Treasuries
Agencies
© PFM 41
Spend the time necessary tothoroughly understand both the business and investment objectives.
Based upon risk and return discussions, determine the bestmix of assets that may meetyour objectives.
Carefully review investment options, or hire a professional partner to manage the investment process.
Investment Risk & Return Analysis• Understanding cash flow, other liquidity
factors, investment horizon and returnobjectives.
Customized Asset Allocation• Translation of risk and return
considerations into an investment strategy that covers the investable universe of debt and equity securitiesacross the globe.
Investment Selection• Review and selection of investments,
funds and/or managers.
Increasing Diversification with a Multi-Asset Class Approach
© PFM 42
Implementation
Passive/Active • Invest in low-cost passive index funds unless a catalyst exists to use active management
Traditional/Alternatives • Allocation to alternatives is dependent on risk tolerance and liquidity needs
DynamicAsset Allocation
• Make slight, opportunistic adjustments to exploit undervalued asset classes, limit risk, and optimize manager allocation
Strategic Asset Allocation
Asset Class Structure
U.S. Equity International Equity Fixed Income
Large Mid/Small Developed Emerging Gov’t/Corp High Yield
Other
Alternatives
Investment Strategy Value Added
Rebalancing • Thoughtful, disciplined process based on “buying low and selling high”—not a calendar
© PFM 43
Putting It All Together
Conclusion
Liability-driven investing aligns with business needs
Benchmark management alone is one-dimensional
Portfolio structure and strategy are key
What We’ve Learned
The unique characteristics of insurance assets
Asset-liability matching principles
Constructing an investment policy that articulates objectives
The importance of diversification
The role of risk management
Asset allocation is the most important decision
© PFM 44
Questions?
© PFM 45
Disclaimer
This material is based on information obtained from sources generally believed to be reliable and available to the public,
however PFM Asset Management LLC cannot guarantee its accuracy, completeness or suitability. This material is for
general information purposes only and is not intended to provide specific advice or a specific recommendation. All
statements as to what will or may happen under certain circumstances are based on assumptions, some but not all of
which are noted in the presentation. Assumptions may or may not be proven correct as actual events occur, and results
may depend on events outside of your or our control. Changes in assumptions may have a material effect on results.
Past performance does not necessarily reflect and is not a guaranty of future results. The information contained in this
presentation is not an offer to purchase or sell any securities.