Delaware Captive Insurance Association 2016 Fall Forum Investment - - PowerPoint PPT Presentation

Investment Considerations During Periods of Economic Uncertainty

David Kilborn, CFA

Chief Investment Officer Performa Limited (US), LLC (843) 297-4130 dkilborn@performausa.com

Delaware Captive Insurance Association 2016 Fall Forum

Patrick Theriault, CPA, CPCU, AIAF

Managing Director Strategic Risk Solutions (802) 861-2630 patrick.theriault@strategicrisks.com

Agenda

1) Developing a Successful Investment Program 2) Demographics and Benchmarking 3) Case Studies 4) Market Update & Outlook 5) Q&A

2

Developing a Successful Investment Program

3

How Captive Manager & Investment Manager Work Together

Captive Manager

• Captive Manager dual role: Captive Financial Controller + Regulatory Oversight
• Typically has direct contact with Captive Board and Officers: ability to make recommendations
• Positioned to share with client what captive peers are doing
• Primary contact for other service providers including investment manager
• Cash/liquidity tracking
• Aware of potential impact on operation or regulation of certain investment types – works best

when having regular communications with investment manager

Investment Manager

• Partnership approach with captive owners, captive managers and service providers
• Offer customized solutions tailored to unique needs of each captive
• Investment policy statement development and ongoing review
• Discretionary management of investment portfolios
• Portfolio design, development and execution
• Comprehensive client reporting

4

Key to Success – Plan Ahead

• Prepare investment plan at the time of captive approval
• Develop a thorough and appropriate investment strategy that is tailored to

each captive

• Recognize that your captive has different investment objectives than

mainline insurers, individuals and even your parent company’s pools of assets

• Be aware of multiple layers of fees, lower liquidity (small position sizes) and

unnecessary over diversification

• Put your money to work: holding cash over and above daily operational or

known liquidity needs has two distinct costs:

1) no income generation 2) value erosion from inflation

5

What Happens When You Don’t Have a Plan?

Breaking down $1,000 invested at 3% over 30 years

• Holding $1,000 in cash for

30 years means you start and end with $1,000 (dark blue bar):

• no income generation

i.e. no coupon payments (green bar)

• also means no

compound interest (light blue)

• However, investing $1,000

at 3% over 30 years could earn $900 in coupon payments + $543 in Interest-on-Interest for a total of $2,443 (vs $1,000 if your money sat in cash)

$1,030 $1,161 $1,347 $1,563 $1,814 $2,105 $2,443 $0 $500 $1,000 $1,500 $2,000 $2,500 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 Nominal Dollars (US$) Years

Principal Coupon Interest-on-Interest

…loss of potential income

6

1 Example assumes $1,000 is invested at a fixed rate of 3% over 30 years. 1

Source: Performa Limited (US)

Beware of the Inflation Trap…

Cost of Cash

• Holding cash might

protect nominal value (black line), but sitting in cash means losing real value (blue 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

Value of $1,000 Investment in Cash

Adjusted for Inflation (using CPI 1) $800 $825 $850 $875 $900 $925 $950 $975 $1,000 Dec-04 Nov-06 Oct-08 Sep-10 Aug-12 Jul-14 Jun-16

Dollars (US$) Years

Source: Bloomberg, Performa Limited (US) 1 US CPI (Consumer Price Index) Urban Consumers Less Food and Energy (Seasonally Adjusted)

$802

7

Building an Investment Program

Client Structure Liabilities Objectives Risk Tolerance Asset Allocation Modeling Investment Policy & Guidelines Portfolio Construction

Built for Current Stage

• f the Life

Cycle Client Variables

• Capital (i.e., current, target, surplus)
• Risk tolerance & liquidity needs
• Stage of the captive life cycle
• Ownership structure
• Claims history
• Domicile

Portfolio Variables

• Portfolio diversification
• Opinion of asset classes
• Review of strategy cost effectiveness
• Performance analysis (past and future)
• Forecasting: Market trends and interest rates

Recommendations should incorporate both…

8

Asset Allocation through a Captive’s Life Cycle

9

Demographics and Benchmarking

10

Profile of SRS Captives

11

42% 20% 7% 14% 3% 14%

Number of Captives by Size

Less than $5M Between $5M to $15M Between $15M to $25M Between $25M to $50M Between $50M to $75M Greater than $75M 12 1% 6% 10% 19% 3% 61%

Average Assets by Captive Size

Profile of SRS Captives

13

“Asset Allocation” By Captive Size

0% 1% 2% 3% 4% 5% 6% 7%

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

LESS THAN $5M $5M TO $15M $15M TO $25M $25M TO $50M $50M TO $75M GREATER THAN $75M

Average Asset Allocation by Captive Size

Fixed Income Equity Alternative Assets Money Markets Cash Average of Investment Return %

“Cash Breakdown” By Captive Size

14 0% 1% 2% 3% 4% 5% 6% 7% 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

LESS THAN $5M $5M TO $15M $15M TO $25M $25M TO $50M $50M TO $75M GREATER THAN $75M

Average Cash Breakdown by Captive Size Class

Unrestricted Cash Restricted Held in Trust Average of Investment Return %

“Asset Allocation” By Ownership Type

15

Case Studies

16

Case Study #1

Background

• Onshore single parent captive formed in 2002 providing E&O liability coverage
• Very conservative owner and management focused on preservation of capital to achieve fully

insured status

• Annual Premium roughly $1million providing excess coverage only
• Great claims experience, current investable assets = $13.3 million
• Only started investing liquid funds in late 2013, Bond Mutual Fund, currently about 23% of total

investable assets

• Handle all investment decisions internally / No outside manager

The Good

• Achieved goal of fully funded status
• Avoided crash of 2008
• Minimal investment expenses

The Potential Misses

• Investment Committee duties are secondary responsibilities = slow response
• Minimal to negative cash rate of return

17

Case Study #1

18

0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% $0 $2 $4 $6 $8 $10 $12 $14

2015 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 2003 2002

Percent Return (%) Millions ($)

Investable Assets vs. Return

Investable Assets Investment Return

$0 $50,000 $100,000 $150,000 $200,000 $250,000 $300,000 $350,000 $400,000

2015 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 2003 2002

Investment Income

• Opportunity cost compared to

2% annual return = $685,000

• Opportunity cost compared to

2.5% annual return = $1,225,000

Case Study #2

Background

• Onshore Reciprocal formed in 2004 providing Medical Malpractice coverage in 6 states
• Annual Premium roughly $13 Million / Current investable assets = $50 Million
• Investment mix as of 6/30/16
• Cash: 9% / Bonds: 82% / Equities: 3% / MPLs: 2% / Private Investments: 3%
• One primary third party manager
• Extremely active Investment Committee, weekly meetings

The Good

• Detailed investment policy with conservative industry target returns
• Regular investment policy reviews and Board reporting allowing the company to be responsive to

market fluctuations

• Expansion of investment policy has allowed for stabilization of overall returns

The Potential Misses

• Mix results with portfolio pocket money and market timing activities
• Too much input from Investment Committee members at times?
• Manager does not have oversight of all assets
• Client was not familiar with side effects of alternative investments

19

Market Update & Outlook

20

Market Update & Outlook After seven years of easing, the U.S. Federal Reserve finally increased short-term rates from 0% in December 2015…

• How do the following affect Captive Insurance portfolios going

forward? – The path of Fed policy and overall interest rates? – The state of the U.S. economy: growth, employment, inflation? – Current financial market conditions?

• How should Captive Insurers be best positioned?

21

2015 – The Year The Fed Finally Moved

22

• Beware the front-end,

safety can be a trap

• While rates drifted

higher across the curve since June...

• …front-end has been

hit hardest

• Is this time for real?

The Fed is sending signals…

0.0% 0.5% 1.0% 1.5% 2.0% 2.5% 3.0% 1M 1Y2Y3Y 5Y 7Y 10Y 30Y

Yield Maturity Source: Bloomberg, Performa Limited (US)

U.S. Treasury Curve Comparison

12/31/2015 6/30/2016 8/31/2016

Improving Economy

23

• U.S. economy continues to

lead the global recovery, supported by an improving labor market

• Less people getting fired &

new jobs created are steady at around 190k/month

• Previously, many pointed to

lack of growing wages… but look out!

• After years of little growth,

improvements are kicking in

• 3%
• 2%
• 1%

0% 1% 2% 3% 4% 5% Feb-09 Jun-09 Oct-09 Feb-10 Jun-10 Oct-10 Feb-11 Jun-11 Oct-11 Feb-12 Jun-12 Oct-12 Feb-13 Jun-13 Oct-13 Feb-14 Jun-14 Oct-14 Feb-15 Jun-15 Oct-15 Feb-16 Jun-16

sa, YoY%

Source: BLS, Performa Limited (US)

U.S. Real Average Hourly Earnings

Recession 100 200 300 400 500 100 200 300 400 500

Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Jul-13 Jan-14 Jul-14 Jan-15 Jul-15 Jan-16 Jul-16

sa, thousands sa, thousands

Source: BLS, DOL, Performa Limited (US)

Nonfarm Payrolls and Initial Jobless Claims

Change in NonFarm

Improving Economy

24

• After staging a dramatic rally, the

U.S. dollar has stalled and is looking to the Fed for its next cue (it’s a delicate balance)

• A strong dollar is great for

shoppers, but hurts American multinationals while weighing on exports

• Oil prices (black line) have seen a

bottom (for now) and that feeds into boosting headline inflation numbers

• While inflation is still below the

Fed’s 2% target, it is trending higher (blue line for headline and green line for core)

70 75 80 85 90 95 100 105

Apr-04 Nov-04 Jun-05 Jan-06 Aug-06 Mar-07 Oct-07 May-08 Dec-08 Jul-09 Feb-10 Sep-10 Apr-11 Nov-11 Jun-12 Jan-13 Aug-13 Mar-14 Oct-14 May-15 Dec-15 Jul-16

Index

Source: Bloomberg, Performa Limited (US)

The U.S. Dollar Index

Recession

• 2%
• 1%

0% 1% 2% 3% 20 40 60 80 100 120 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Jul-13 Jan-14 Jul-14 Jan-15 Jul-15 Jan-16 Jul-16

Inflation rate Oil Price

Source: BEA, Bloomberg, Performa Limited (US)

U.S. Personal Consumption Expenditure and Oil

Oil (LHS) Headline (RHS) Core (RHS) Inflation Target (RHS)

Cats and Dogs Sleeping Together….

25

• Since when do stock

prices and bond prices move in tandem?

• Isn’t there an inverse

relationship?

Risk Assets have recovered from the early year swoon, yet Treasury yields (green line) remain well below where they started the year.

50 60 70 80 90 100 110 120 Dec-15 Jan-16 Feb-16 Mar-16 Apr-16 May-16 Jun-16 Jul-16 Aug-16

S&P 500 High Yield Bond Index 10-Year Treasury Yield Commodities Index

Value or Growth Stocks for Captives?

Source: Bloomberg, BofA Merrill Lynch, Performa Limited (US)

26

S&P 500 Value index is CHEAPER - lower P/E ratio - than the S&P 500 Growth Index and has a HIGHER dividend yield

12 14 16 18 20 22 24 26

Apr-13 Jul-13 Oct-13 Jan-14 Apr-14 Jul-14 Oct-14 Feb-15 May-15 Aug-15 Nov-15 Feb-16 May-16 Aug-16

P/E Ratio

S&P 500 Growth P/E S&P 500 Value P/E

1.00% 1.40% 1.80% 2.20% 2.60% 3.00% 3.40%

Apr-13 Jul-13 Oct-13 Jan-14 Apr-14 Jul-14 Oct-14 Feb-15 May-15 Aug-15 Nov-15 Feb-16 May-16 Aug-16

Dividend Yield S&P 500 Growth Dividend Yield S&P 500 Value Dividend Yield

Vanishing Bond Market Liquidity

Positioning Fixed Income portfolios must be done prior to any stampede

27

Many factors determine market liquidity, but these changes are clear:

• Banks have to hold more capital
• Banks had to eliminate Proprietary Trading
• Corporate bond issuance has increased dramatically over the past few years

Source: Bloomberg, BofA Merrill Lynch, Performa Limited (US) $3,000 $3,500 $4,000 $4,500 $5,000 $5 $10 $15 $20 $25 $30 $35 $40 $45 $50

Apr-13 Aug-13 Dec-13 Apr-14 Aug-14 Dec-14 Apr-15 Aug-15 Dec-15 Apr-16 Aug-16 Investment Grade Corporate Market Value ($Bln) Primary Dealer Positions ($Bln)

Primary Dealer Positions - Net Outright Total Corporates ($Bln) Investment Grade Corporate Market Value ($Bln)

Key Macro Themes

• Global Monetary Policy
• November Election
• China and Commodity Prices
• Money Market Reform
• Brexit Fallout

28

Final Thoughts

29

Summary

• Rising short-term interest rates pose a significant risk to bond portfolios
• US economy is improving & continues to lead other countries
• After selling off in early 2016, risk assets rebounded in March and April, sold
• ff post-Brexit and rallied again
• Large-cap value stocks are cheaper than growth - providing more cash flow

for every dollar invested and greater cushion if markets stall or correct

Implications for Captives

• Keep interest rate risk at the lower end of the range
• Be wary of too much risk in less liquid sectors
• Favor value over growth stocks
• Active portfolio management and diversification is more important than ever

Q&A

30