Alternative Asset Class Exposures: Gaining Objectives-Based Efficiency for Insurers

Transcription

1 Alternative Asset Class Exposures: Gaining Objectives-Based Efficiency for Insurers August 21, 2014 Singular Focus. Empowering Client Success.

2 Introduction Miles Capital Overview Founded in 1982, managed insurance assets since 1988 Manage $4.2 Billion in AUM Asset Management: Broad in house active management capabilities including equities, fixed income, cash management, and allocations to alternative assets Customized Solutions: Specialize in comprehensive bespoke asset allocation solutions for insurers Insurance Expertise: Average tenure for insurance relationships is longer than 13 years, and nearly 75% of AUM for insurance client relationships Client Breadth: Property & Casualty, Life, Healthcare, and Captive Insurers Speaker Biography Alex Ducharme, CFA Portfolio Manager Equity & Alternative Market Solutions Alex Ducharme, CFA, is a member of the Miles Capital Equity team and leads management of the AMS solution. Prior to joining Miles Capital, Alex served as VP, Research Analyst at Westwood Holdings Group in Dallas, and a Portfolio Manager at Temujin Fund Management in New York. Alex previously served as Vice President of Mergers & Acquisitions at Citigroup in New York and as an investment banker at Salomon Smith Barney in New York. He earned his B.A. in Economics from Davidson College and has earned his CFA designation. P 2

3 Executive Summary TRENDS Industry Trends in Asset Allocation Why Alternatives? How Much to Allocate? INSIGHTS Objectives Based Asset Allocation Framework What Asset Classes and Why? Key Considerations Before You Allocate P 3

4 Trends in Asset Allocation: Risk Assets Allocations to risk assets are rising, preservation assets decreasing Strong returns in public equities Low interest rate environment Dwindling reserve redundancies pressure profitability Inflationary concerns P&C Life Figure 1. Typical P&C Risk Asset Allocation 2008 vs Figure 2. Typical Life Risk Asset Allocation 2008 vs % 6% 25% 5% 20% 4% 15% 3% 10% 2% 5% 1% 0% Source: Miles Capital, SNL, NAIC Reports as of YE 2008 and YE Average of P&C allocations of companies from $100mm to $2billion. 0% P 4 All data based on composites and peer groups from U.S. statutory filings. Risk Assets = Below Investment Grade, Real Estate, Equity, Other (B/A), excluding Derivatives

5 Trends in Asset Allocation: Alternatives Figure 1. P&C Risk Asset Carry Value Over Time $30.0 $25.0 $20.0 $15.0 $10.0 $5.0 $0.0 Allocations to Risk Assets Increasing Other Alternatives Real Estate Hedge funds Private Equity Figure 2. Life Risk Asset Carry Value Over Time $80.0 $70.0 $60.0 $50.0 $40.0 $30.0 $20.0 $10.0 $0.0 Other Alternatives Real Estate Hedge Funds Private Equity Trend Likely to Continue The percentage of alternative insurance mandates has been steadily growing for years. Nearly half of all insurers intend to increase their exposure to alternatives in the next 12 months. Lemann, Mariana. Alternative Outsourced Insurance Mandates Skyrocket. Fundfire March 24, 2014 Insurance company assets invested with Top 25 managers increased from $219.8bn in 2012 to $244.2bn in The trend is expected to continue. Towers Watson, Global Alternatives Survey 2014 Global alternative investments doubled in AUM between 2005 and 2011, despite the drop during the crisis. This represents a CAGR of 14% over the period. And growth is set to continue. Institutional investors expect to increase their allocations to alternatives over the next three to five years. McKinsey & Company, The Mainstreaming of Alternative Investments Source: SNL, NAIC Reports as of YE P 5 All data based on composites and peer groups from U.S. statutory filings. Risk Assets = Below Investment Grade, Real Estate, Equity, Other (B/A), excluding Derivatives

6 Why Alternatives? Alternative assets, when leveraged strategically, can help enhance portfolio performance through delivering stronger risk adjusted returns. Volatility Reduction Portfolio Efficiency Lower Losses in Stress Periods Inflation Protection Return Enhancing P 6 Past performance is not a guarantee of future results.

7 Why Alternatives? What insurers are saying [This] last year, we outlined three levers that we were pulling on to get to 10% ROE for And I think in order of contribution, I probably saw the business optimization initiatives first, and then followed by the share buybacks and then investments in alternative assets. So all three are doing what we expected of them and it's in 2014 as we'll really start seeing our contribution come through. John Worth, CFO, Aspen Insurance Holdings Limited (2/7/14) [We] do have an increasingly diverse portfolio of alternative investments. And those investments have performed well over time and should serve us well in a rising interest rate environment The alternative asset funds have performed quite well since inception of that asset mandate in our portfolio outperforming the S&P and certainly exhibiting much lower volatility than the S&P. So, it's an asset class that in an allocation that we feel is appropriate given the interest rate environment. And it's also been a good excess return investment for us over time. Michael McGuire, CFO, Endurance Specialty Holdings (9/5/12) [What] we have been doing is diversifying our portfolio [and] allocating a smaller, modest portion of our portfolio to equity strategies and alternative strategies that although, I'll say, "are considered risk assets", I think offer a much superior riskadjusted return. So, on the margin you'll see that change. You've seen that over the last year and you'll see that continue into this year as new money is invested less in fixed income and more in some of the alternative classes that offer better return potential and I think better upside potential [Anytime] we make any investment, we're looking at the overall company and we're looking for things that aren't necessarily all correlated. So, we may be looking for a space that isn't as correlated to the equity market or things like that. So, I think we're focused on areas in the marketplace that don't necessarily add as much to risk as you might expect from an investment like that. Randall Freitag, CFO, Lincoln National (3/21/13) P 7 Past performance is not a guarantee of future results.

8 Why Alternatives: Growth in Capital Appreciation Figure 1. Return History Selected Asset Classes , Starting Value of 100 2,500 2,000 Private Equity Capture illiquidity premium 1,500 1, Private Equity Equities Fixed Income Hedge Funds Capture alpha potential from skilled managers 1, Hedge Funds Equities Fixed Income Source: Hedge Fund Research Index (HFRI), Bloomberg, Cambridge Associates Indices marked to market monthly P 8 Returns are shown gross of fees and does not include the deduction of management fees and other expenses that may be incurred in managing an investment account. Past performance is not a guarantee of future results.

9 Why Alternatives: Risk Mitigation Diversification Alternative investments have low correlations to traditional classes Near zero correlation with fixed income, largest asset class for insurers Volatility & Risk Reduction Reduced portfolio volatility & drawdowns Low correlations Lower volatility Lower drawdowns (e.g. Hedge Funds, Figure 2) Efficiency (Return per Unit of Risk) As measured by Sharpe Ratio S&P 500: 0.37 Hedge Funds (HFRI): 0.80 Private Equity (Cambridge): 0.91 Figure 1. Asset Class Correlations Over 20 Years Fixed Income 1.00 Low US Equities Low Mod Hedge Funds Mod High Private Equity Commodities Real Estate Fixed US Hedge Private Commo Real Income Equities Funds Equity dities Estate Figure 2. Hedge Funds vs. Equity Market Drawdowns Source: HFRI, Bloomberg, Miles Capital Figure 3. Historical Efficiency Analysis: Period Jan 1996 Dec 2013 Source: HFRI, Bloomberg, Cambridge Associates Source: Bloomberg, Zephyr StyleAdvisor % 10% 20% 30% 40% 50% 60% 16% 12% 8% 4% 0% : Hedge Funds: +10% US Equities: (48%) 15.6% 13.9% Private Equity (Cambridge) US Equities 8.9% 8.7% 7.1% Hedge Funds (HFRI) Hedge Funds 15.6% S&P 500 Index : Hedge Funds: (20%) US Equities: (52%) Return Std Deviation 5.8% 3.5% Barclays Aggregate P 9 Past performance is not a guarantee of future results. HFRI = Hedge Funds Research Index Cambridge = Cambridge Private Equity Index

10 Why Alternatives: Inflation Protection Inflation Protection Figure 1. Long Term Asset Class Correlations to Consumer Price Index Current inflation trends stable BUT future timing of inflation unknown and may be less gradual than is desired Commodities Private Real Estate Fixed income worst asset class for inflationary periods TIPS 0.18 Commodity and real estate asset classes can defray inflation risk Higher correlations to CPI than TIPS (0.18) Inflation-Linked Source: Bloomberg, Zephyr StyleAdvisor, CommonFund 0.18 P 10 Past performance is not a guarantee of future results.

11 Executive Summary TRENDS Industry Trends in Asset Allocation Why Alternatives? How Much to Allocate? INSIGHTS Objectives Based Asset Allocation Framework What Asset Classes and Why? Key Considerations Before You Allocate P 11

12 How Much to Allocate P&C Life Figure 1. P&C Allocations to Schedule BA Assets, YE 2013 Figure 2. Life Allocations to Schedule BA Assets, YE 2013 Top P&C insurers: 3 6% allocations Top Life insurers: 2 4% allocations P 12 All data based on composites and peer groups from U.S. statutory filings.

13 How Much to Allocate: Business Considerations Matter Issue Separate Investment Policy for capital & surplus Capital budget: target RBC Business line volatility Sensitivity to income volatility Volatility of liquidity needs Considerations The purpose of the reserves or productsupporting assets is very different Pre existing risk exposures to equities/alts Know your tolerance Certain asset classes may compound business risks How much can you afford to allocate away from yield generating assets? Over or under allocated to liquidity? Interest rate & inflation risk stress testing Hedge for these risks may be required State code Individual LP, LLC limited to X% of surplus Total LP, LLC exposure limited to X% of Surplus Excess allocations occasionally permitted as Other Investments, limited to X% of admitted assets P 13

14 Objectives-Based Asset Allocation: Product Versus Solution Focus One-off product solutions can result in the stacking of risk, relative to an integrated, holistic approach that ensures incremental risk complements, rather than exacerbates business risk. Product Focus Portfolio Focus Public & Private Equity Hedge Funds Core Fixed Income Satellite Fixed Income (HY, CML) Commodities & Real Estate P 14

15 Objectives-Based Asset Allocation: The Framework Most insurers already understand the traditional choices. Expanded asset classes can enhance results. Objectives Approach Expanded Asset Classes Deflation Protection, Yield (Preservation of Capital) Growth (Appreciation of Capital) Risk Mitigation (Volatility of Capital) Inflation Protection (Purchasing power of capital) Traditional Enhanced Traditional Core Fixed High Yield, CML Global Bonds Public Equity Emg Market Equity Venture Capital Buyout Distressed Debt Market Neutral Hedged Equity Arbitrage Strategy Event Driven Currency, EM Debt TIPS, ILS Private Real Estate Commodities Infrastructure Objectives-based asset allocation can complement your business goals. P 15

16 Objectives-Based Asset Class Selection Broad Spectrum of Strategies & Impacts Universe of non traditional investments expanded Risk factors, return characteristics vary widely Structured Asset Class Selection Evaluate the key characteristics of asset classes Assess & select the asset classes that align with portfolio objectives Figure 1. Expanded Asset Class List, Categorized Figure 2. Align Benefits with Portfolio Needs Public Equity Emerging Market Equity Private Equity: Venture Capital, Buyout, Distressed Debt Growth: Private Equity Return enhancement bps target over public markets Diversified risk characteristics Lower volatility than public equities Currency, Managed Futures EM Debt Hedge Funds: Market Neutral, Hedged Equity, Arbitrage Strategy, Event Driven TIPs / Inflation Linked Private Real Estate Commodities: Natural Resources, Infrastructure Risk Mitigation: Hedge Funds Inflation Protection: Commodities & Real Estate Volatility dampener Diversified, enhanced efficiency Growth and income, varies by strategy and manager skill Inflation protection, correlated with CPI Uncorrelated returns to other classes Potential for growth, varies by strategy The universe is broad and the characteristics vary significantly. Organize the opportunity set. P 16

17 Consideration: Alternative Vehicles Liquidity Lack of Liquidity Concerns Investors Private vehicles carry illiquidity But public and liquid vehicles have drawbacks Inability to customize allocations Historical underperformance High tracking error and correlations Mark to market volatility Figure 1. Sample Formal Liquidity Plan Liquidity Tier First Tier Second Third Definition Borrowing, Lines of Credit, Securities sold for cash settlement Securities sold T+3 settlement without significant transaction costs Securities that could require up to one quarter to sell at market price Allocation Range 5 10% 50 60% 15 25% Fourth Securities with low liquidity 5 20% Source: Miles Capital, CapVisor Associates Potential Solutions for Liquidity Illiquidity can enhance portfolio premium exists Plethora of daily liquid alternatives now exist Formal Liquidity Plan leverages appropriate allocation to illiquidity Figure 2. Performance of Primarily Liquid vs. Primarily Illiquid Portfolios over 10 Years Ending December % 75% 50% 25% 0% 6.4% Higher Liquidity Liquid Moderately Liquid Illiquid 10 Year Annualized Performance 6.7% 7.0% 7.6% Lower Liquidity Source: 2014 NACUBO-Commonfund Study. Based on 835 institutions. 8.3% 9% 8% 7% 6% 5% 4% May be over-allocated to liquidity, which comes at a cost to growth. P 17 Past performance is not a guarantee of future results. Based on total returns, indicates percentile rankings. NOTE: Liquid = approximately 1 day to liquidate, Moderately-liquid = Monthly or quarterly liquidity and Illiquid = assets with liquidity characteristics that are greater than quarterly or are considered long term (unable to prematurely liquidate without significant cost).

18 Consideration: Manager Selection Requires Robust Diligence Manager Dispersion is Extremely High Manager Selection is Critical Annual Returns Figure 1. Historical Hedge Fund Performance, Manager Quartiles 200% 150% 100% 50% 0% 50% 100% Source: HFRI Top quartile Second quartile Third quartile Bottom quartile Figure 2. Return Dispersion: Distribution of 5 Year Annual ROR Determine Portfolio Need Sourcing / Screening Preliminary Review Suitability / Portfolio Fit Due Diligence Document Review Manager / Fund Approval Due Diligence Evaluation: Organizational Characteristics Structure, Suitability, Fees Strategy Philosophy & Process Consistency Risk & Performance Persistency Analysis Governance & Oversight Infrastructure & Operational Manager Allocation / Implementation Source: HFRI, CommonFund Carefully screen and select managers to help ensure you are compensated for your risk level. P 18 Past performance is not a guarantee of future results. Based on total returns, indicates percentile rankings.

19 Consideration: Top-Tier Manager Access is Difficult Top Tier Manager Access is Difficult Top tier managers Long term performance and persistence Lower volatility and smaller drawdowns Dynamic exposures Access is difficult and barriers to entry are high for top quartile managers Closed to new investors or Limited Partners Distributed through proprietary channels Large initial or minimum investment required Solutions for Access Screen and select emerging managers with lower barriers Fund of Funds: Diversified exposures across skilled managers, strategies, geographies, and vintage years Partner with others to aggregate investments P 19 Past performance is not a guarantee of future results. Based on total returns, indicates percentile rankings.

20 Consideration: RBC Implications P&C Standard capital charge on Schedule BA alternatives of 20%, reduced by covariance adjustment in RBC formula Incremental change depends largely on pre existing equity R2 RBC relative to total RBC, the size of the allocation to alternatives, and magnitude & distribution of RBC components Based on industry averages: For a 5% allocation to alternatives we estimate an effective capital charge of approximately 10% although a range of outcomes is possible Life Standard capital charge on Schedule BA alternatives of 30% (19.5% after tax) is reduced by covariance adjustment in RBC formula Incremental capital requirement depends largely on sum of pre existing common stock asset risk (C1cs) and market risk (C3c) relative to total RBC as well as the size of the allocation to alternatives Based on industry average data, for a 5% allocation to alternatives we estimate an effective capital charge of approximately 9% although a range of outcomes is possible P 20 Source: Miles Capital, NAIC Assumes no concentration factor adjustment, no RBC offset from assets sold to fund allocation, industry-average RBC ratios, investment leverage, and initial covariance adjustment

21 Consideration: Accounting Accounting Issue Legal Structure Often structured as LPs or LLCs Guidance Pass through tax treatment, liability of limited partners and minority owners is capped at cost basis Accounting Method Depends on level of ownership. Less than 20 percent: trading or available for sale securities, marking the asset to market value More than 20 percent but less than majority control: Equity Method, historical cost adjusted up or down for the pro rata portion of the LP or LLC s income, dividends, and other financial impacts Tax Considerations Tax reporting and considerations for tax exempt investors. Many LPs and LLCs have a fiscal year end of December 31st and report tax information to investors via Schedule K 1, typically later in the spring Tracking Investment Flows Fund winding up procedures Reconcile Capital commitments, return of investment principal, and distributions of capital with administrator May include claw back provisions of carried interest/performance fees paid to the general partner/management company P 21 This list is not meant to be comprehensive and is intended to stimulate dialogue between the investor and their accounting and tax advisors before investment in private equity, hedge funds, and other alternative investment funds.

22 The Framework Alternatives are growing in the insurance industry & for good reasons Allocations should occur strategically within the context of an objectives based asset allocation framework Implementation is not straight forward and should be approached thoughtfully P 22

23 Disclosures NOT FOR PUBLIC DISTRIBUTION. The information provided herein is furnished by Miles Capital, Inc. solely for informational purposes and is confidential. It may not be reproduced or distributed to anyone else without prior consent. This Presentation is not a solicitation of an offer to buy or sell any security or other financial instruments or to participate in any trading strategy. All expressions of opinion and predictions in this report are subject to change without notice. This report is not intended to be, nor should it be relied upon in any way as a forecast or guarantee of future events regarding a particular investment or the markets in general. The strategies described in the presentation may not be suitable for all investors. There is no assurance that any of the objectives described will be achieved. This information contained herein does not take into account the particular investment objectives or financial circumstances of any specific person or entity who may receive it. You should consult your tax or legal advisor before making an investment, and investors are advised to thoroughly and carefully review financial, legal, and tax consequences of all investments to determine suitability. Investments in Alternative Markets Solutions may be illiquid and present significant risks. Past performance is not a guarantee of future results. There can be no guarantee that any investment strategy discussed in this Presentation will achieve its investment objectives. As with all strategies, there is a risk of loss of all or a portion of the amount invested. P 23