Portfolio Management Strategies for Insurance Pools

Transcription

1 Portfolio Management Strategies for Insurance Pools NLC RISC Trustees Conference Presented By: Kenneth Schiebel, CFA, Managing Director Mark Yasenchak, CFA, Director May 11, 2018 PFM Asset Management LLC 213 Market Street Harrisburg, PA pfm.com PFM 1

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 2

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 PFM 3

4 Investment Management for Insurance Pools PFM 4

5 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 5

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 6

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 7

8 An Investment Framework Surplus (Net Position) Claim Reserves Current Claims & Admin. Costs PFM 8

9 Segmenting the Portfolio Liabilities Investment Strategy Current Claims & Administrative Costs Claim Reserves (Non-current liabilities) Surplus (Net Position) Cash portfolio Highly liquid Short term investments Laddered maturities Very high credit quality Liability hedging portfolio Assets matched to expected claim payments Based on actuarial assumptions Intermediate-term investments Medium to high credit quality Growth portfolio Goal: long term surplus growth Longer-term & broader investments Less need for liquidity Potential for (moderately) greater risk PFM 9

10 Developing a Strategic Asset Allocation Sample Pool Asset Allocation Liability Profile Cash Flows Multi Asset Class Portfolio Cash / Liquidity Portfolio Strategic Asset Allocation Global Investment Universe Capital Market Assumptions Risk/Return Analysis Member Pool Goals and Preferences Traditional Fixed-Income PFM 10

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 11

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 the liability stream as the benchmark Product-based Situation-based Investment performance focused on 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 success meeting liabilities and growing surplus PFM 12

13 Impact of Interest Rate Changes Effects both assets and liabilities PFM 13

14 Maturity (Duration) Effects the Degree of Price Volatility There is no free lunch: Greater rewards require greater risk 2-Year Bond 10-Year Bond 30-Year Bond Price Current Yield Yield PFM 14

15 Matching Assets to Liabilities Typical Liability Pay-Out Pattern Perfect Cash Flow Match $5.0 $5.0 $4.0 $4 $3.5 $4.0 $4 $3.5 Liabilities Assets $ Millions $3.0 $2.0 $2.5 $2.5 $2 $1.5 $ Millions $3.0 $2.0 $2.5 $2.5 $2 $1.5 $1.0 $1 $0.5 $1.0 $1 $0.5 $ $ PFM 15

16 Impact of Liability Mismatch $5 Perfect Cash Flow Match $8 Mismatched Portfolio Millions of Dollars $4 $3 $2 $1 Assets Liabilities Millions of Dollars $7 $6 $5 $4 $3 $2 $1 Assets Liabilities $ $ Total Assets $ million Total Assets $ million Total Liabilities $ million Total Liabilities $ million Duration of Assets 3.22 years Duration of Assets 2.04 years Duration of Liabilities 3.22 years Duration of Liabilities 3.22 years Equal Duration of Assets and Liabilities Shorter Duration of Assets than Liabilities PFM 16

17 Impact of Liability Mismatch Perfect Cash Flow Match Mismatch Portfolio Before Before Total Assets $ million Total Assets $ million Total Liabilities $ million Total Liabilities $ million Assume a 100 basis point (1%) decrease in interest rates After After Total Assets $ million Total Assets $ million Total Liabilities $ million Total Liabilities $ million Impact on Surplus = $0 Impact on Surplus = $(207,000) Liabilities Remain Funded Liabilities Become Un-funded PFM 17

18 Role of a Trustee PFM 18

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 Acquire Requisite Knowledge Learn regulations, fiduciary duties and related background information Understand the Business Develop understanding of the business, operations, pricing, and business risks Develop an Investment Policy Create a formal investment policy statement (IPS) that includes investment objectives, philosophy, asset allocation targets, and risk metrics Ongoing Oversight Meet periodically with investment manager Review investment holdings, transactions, asset allocation, and policy compliance Review performance relative to a benchmark Understand source of over or under performance Formal Review Cycle Annually review pool financials and actuarial assumptions Review investment objectives Review investment policy and guidelines PFM 19

20 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 20

21 The Importance of Diversification Source: JP Morgan Guide to the Markets as of 12/31/2017. PFM 21

22 2018 Capital Market Assumptions Expected Return Expected Risk Expected Return Expected Risk US Equity 6.5% 17% 7.7% 16% International Developed Equity Emerging Markets Equity 6.6% 18% 7.7% 17% 6.6% 24% 7.7% 20% Core Bonds 1.9% 4% 5.5% 5% Intermediate Investment Grade Emerging Markets Debt Intermediate: Next 5 Years Long Term Projections 2.3% 6% 6.3% 7% 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% 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 22

23 2018 Capital Market Assumptions (cont.) Correlations 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 Estate Commodities Hedge Funds Private Equity Cash US Equity 1 International Developed Equity Emerging Markets Equity Core Bonds Intermediate Investment Grade Corp Emerging Markets Debt High Yield Bank Loans REITs Private Equity Real Estate Commodities Hedge Funds Private Equity Cash 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 23

24 Asset Allocation Summary Short Term Fixed Income 20/80 Model 30/70 Model 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 24

25 Return Projections Based on Intermediate-Term Capital Market Assumptions Return at the 95 th percentile Return at the 75 th percentile Return at the 50 th percentile Return at the 25 th percentile Return at the 5 th percentile Short-Term Fixed Income PFM 25

26 Return Projections Based on Intermediate-Term Capital Market Assumptions 25 1 Year 5 Year 10 Year 20 Annualized Return (%) Short Term Fixed Income 20/80 Model 30/70 Model 40/60 Model Short Term Fixed Income 20/80 Model 30/70 Model 40/60 Model Short Term Fixed Income 95th th th th th /80 Model 30/70 Model 40/60 Model PFM 26

27 Return Projections Based on Long-Term Capital Market Assumptions Year 20 Year 30 Year Annualized Return (%) Short Term Fixed Income 20/80 Model 30/70 Model 40/60 Model Short Term Fixed Income 20/80 Model 30/70 Model 40/60 Model Short Term Fixed Income 95th th th th th /80 Model 30/70 Model 40/60 Model PFM 27

28 Investment Risks & Opportunities PFM 28

29 The Nature of Risk Traditional Portfolio Investment risks: Interest rate risk* Credit/default risk* Reinvestment risk Prepayment/call risk Insurance Pool Business risks: Cash available to pay claims Pricing adequacy Surplus sufficiency Operating ratios Liquidity risk* Inflation risk* Exchange rate risk * Key risks to insurance portfolios. PFM 29

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 Liquidity Risk Loss of purchasing power over time as a result of inflation Inability to sell portfolio holdings at a competitive price 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 Reasonably strong liquidity in investment grade markets Increased capital cost has resulted in reduced dealer inventory Liquidity falls when markets are stressed PFM 30

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 Equities Alternatives TIPS/Inflation-hedge Foreign Sovereign/Supras Commercial MBS High Yield Domestic Large Cap Domestic Small/Mid Cap Domestic Value/Growth Commodities Real Estate Hedge Funds Private Placements Convertibles Non-U.S. Dollar investment grade Emerging Markets Debt International Large Cap International Small/Mid Cap Emerging Markets Private Equity Venture Capital Tangible Assets PFM 31

32 Increasing Diversification with Multi-Asset Class Management Important Principles Asset allocation ranges Risk measures Diversification Return profiles PFM 32

33 5-Year Treasury Yield History (March 1965 March 2018) 18% 16% 14% 12% 10% 8% 6% 4% 2% 10-year average: 1.67% 0% Source: Bloomberg as of 03/31/2018. PFM 33

34 Equity Market Risk Source: J.P. Morgan PFM 34

35 Recent Asset Class Returns Equities U.S. Developed ex U.S. Emerging Markets 21.9% 25.7% 37.5% Domestic Fixed Income Cash Short Bonds Core Bonds High Yield Corporates 0.8% 0.7% 3.6% 7.5% 2017 Alternatives Commodities Real Estate Hedge Funds 1.7% 9.3% 8.5% Prior 5 Years -10% -5% 0% 5% 10% 15% 20% 25% 30% 35% 40% Prior 5-year returns are based on and are annualized. PFM 35

36 A Comparison of Investment Strategies: Historic Growth $45,000,000 $40,000,000 $35,000,000 60% 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% $39,438,429 $36,273,039 $33,201,188 $30,000,000 $25,000,000 $31,586,942 $20,000,000 $15,000,000 $10,000,000 Data Source: Investment Metrics. Calculation based on monthly periodicity. PFM 36

37 Historic 10 Year Rolling Returns 10% 9% 8% 60% Fixed Income / 40% Equity Strategy 70% Fixed Income / 30% Equity Stragegy 80% Fixed Income / 20% Equity Strategy BofA Merrill Lynch 1-5 Yr Treasury Index 7% 6% 5% 4% 3% 2% 1% 0% Dec-12 Dec-13 Dec-14 Dec-15 Dec-16 Dec-17 Source: Investment Metrics as of 12/31/2017. Calculation based on monthly periodicity. PFM 37

38 Pulling it All Together PFM 38

39 The Nature of the Investable Assets Newer Pool Mature Pool Reserves Reserves Surplus Administrative Costs Surplus Administrative Costs PFM 39

40 Sample Segmented Portfolios Municipal Bonds Money Market Securities Money Market Funds MBS/ABS Treasuries TIPS/ Inflation- Hedge Money Market Securities (T-Bills, CP, CD, BA) Investment-Grade Corporate Bonds Agencies Equity Int l Equity Domestic Fixed Administrative Costs Reserves Surplus PFM 40

41 Increasing Diversification with a Multi-Asset Class Approach Investment Risk & Return Analysis Understanding cash flow, other liquidity factors, investment horizon and return objectives. Spend the time necessary to thoroughly understand both the business and investment objectives. Customized Asset Allocation Translation of risk and return considerations into an investment strategy that covers the investable universe of debt and equity securities across the globe. Based upon risk and return discussions, determine the best mix of assets that may meet your objectives. Investment Selection Review and selection of investments, funds and/or managers. Carefully review investment options, or hire a professional partner to manage the investment process. PFM 41

42 Implementation Strategic Asset Allocation U.S. Equity International Equity Fixed Income Other Asset Class Structure Large Mid/Small Developed Emerging Gov t/corp High Yield Alternatives Investment Strategy Value Added 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 Dynamic Asset Allocation Make slight, opportunistic adjustments to exploit undervalued asset classes, limit risk, and optimize manager allocation Rebalancing Thoughtful, disciplined process based on buying low and selling high not a calendar PFM 42

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 43

44 Questions? PFM 44

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. PFM 45