Investment Solutions for Captive Insurance Entities
Larry Fernandes, Wells Fargo Asset Management, EVP, Managing Director
Cindy Belcher, Cooperative of American Physicians Insurance Company, Inc., COO
Gary Schlossberg, Wells Fargo Asset Management, Chief Economist
1
Evolving Strategic Investment Policies
Larry FernandesExecutive Vice President/Managing Director
Wells Fargo Asset Management/Wells Capital Management
2
Life, P&C, and Health Industry Yields 2008-2012
Source: SNL Financial3
5.24 5.1 4.92 4.85 4.83
2.772.5
2.22 2.342.03
3.73 3.83 3.683.43
3.65
0
1
2
3
4
5
6
2010 2011 2012 2013 2014
Life Industry Health Industry P&C Industry
2010 2011 2012 2013 2014Government Bonds 9.5% 9.6% 9.1% 8.3% 7.9%Municipal Bonds 26.7% 24.7% 23.7% 22.1% 21.1%Mortgage Backed Securities 10.5% 11.2% 10.1% 9.5% 9.4%Corporate Bonds 19.4% 21.7% 22.5% 22.6% 23.2%Equity (Common and Preferred) 17.3% 17.9% 19.3% 22.3% 22.6%Real Estate Loans 1.1% 1.1% 1.1% 1.2% 1.3%Contract Loans and Premium Notes 0.0% 0.0% 0.0% 0.0% 0.0%Other Investment Holdings 9.1% 8.3% 8.3% 8.4% 8.7%Cash & Short Term 6.4% 5.3% 5.8% 5.6% 5.8%Total 100.0% 100.0% 100.0% 100.0% 100.0%
0%
20%
40%
60%
80%
100%
2010 2011 2012 2013 2014
Cash & Short Term
Other Investment Holdings
Contract Loans and PremiumNotesReal Estate Loans
Equity (Common and Preferred)
Corporate Bonds
Mortgage Backed Securities
Municipal Bonds
Property & Casualty Industry
Source: SNL Financial4
2014 saw a continued downward move in Government Bonds. This continues a trend that has been occurring over the last 5+ years. Municipals are utilized extensively in the P&C industry due to the positive benefit from taxation and overall yield advantage. Allocations in Corporate Bonds, Equity and Other Investment Holdings (Alternatives) were the beneficiaries of the downward shift in Governments. Cash allocations in the Industry tend to run a little higher then in Life and Health as the liabilities in the sector tend to be shorter tail.
Investing Captive Insurance Assets
Captive Owner“My investment portfolio is another profit center. I do not need an investment manager that understands the markets but not our needs.”
Portfolio Manager“I expect a captive insurance company that hires me understands that I cannot possibly do the job without communication. The investment manager must completely understand the goals, objectives and constraints of the insurance entity.”
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Building The Investment Plan
What is the risk-tail on the insurance coverage(s) included – short tail or long tail? Should the liability duration be matched with the asset duration?
What is your risk tolerance (volatility)? What should be the asset allocation? Should it be managed on an after-tax basis? What is the company’s business objective?
How much of the funds in the captive are minimum capital required, loss reserve and unearned premium, and excess reserves?
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Building The Investment Plan
Insurance Capitalization Minimum capital required Loss reserves and unearned premium Excess reserves
Do Captive Insurance Companies in Hawaii Invest in Equities? Hawaii captives can invest in equities There are limits for RRGs No more than 5% of assets in single name There are no restrictions for Pure captives other than
the Commissioners prohibition or limitation mentioned prior 7
Do Domestic Captives Invest In Equities? YES! Stocks offer growth opportunity to offset inflation U.S. Domiciled Captives Filing Statutory P&C Statement: Percent of Assets in
Equities
Source: A.M. Best Special Report – U.S. Captive Insurance, 6/30/15
20.0%
13.4% 13.2%
8.7%
10.9% 11.0% 10.6%
12.6% 13.1% 12.5%
0%
5%
10%
15%
20%
25%
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
8
Asset Classes & Investment StylesRisk/Return Style Listings
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Performance Measurement
The case for and against Total Return (long term; economic value) Yield (short term; investment income)
Return metric Total Return (risk adjusted) v Yield (risk
adjusted) Net of Fees Combined across all investment classes and
managers
Performance Attribution10
Choosing an Asset Manager or Mutual Fund(s)
Experience with investing captive or traditional insurance assets – a valued and responsive partner with captive owners and the captive manager
Quality of people within the organization
Time-proven investment policy and process
Competitive and consistent investment performance versus benchmarks and peers
Timely and accurate reporting specific to captive insurance companies and their captive managers
Additional service such as standby LCs, insurance trusts…
Cost 11
Annually, Evaluate Your:
Investment policy
Unique company changes and cash flows
Monitor portfolio performance
Investment manager or funds
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A Case Study in the Evolutionof a
Strategic Investment Policy
Cindy BelcherChief Operating Officer
Cooperative of American PhysiciansInsurance Company, Inc.
(CAPIC)
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The Early Years – CAPIC
October 17, 2002 - Initially licensed as a Class 1 Pure Captive in Hawaii
Objectives:
Supplemental layer of reinsurance for parent
Protection from vagaries of reinsurance marketplace post 9/11
Aggregate stop loss for parent
Smoothing of future pricing fluctuations
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The Early Years – CAPIC
Initial Capital Contribution from parent:
$1,001,000
2003 Balance sheet was levered:
Reserves of $7,375,000; Surplus of $2,256,000
Annual contributions from parent:
$300,000 per year for four years
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The Early Years – CAPIC
Lacked:
Sophistication
Tools
Underwriting
Risk Management
Investments
Experienced:
High Underwriting Risk
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The Early Years – CAPIC
Simple Investment Guidelines – 2 page document
Permitted investments as defined by Hawaii Insurance code
Most investments high quality, short duration
U.S. Treasury Securities
U.S. Govt. Agency Bonds & Securities
Corporates
Characterized by many positions in small lots
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CAPIC MATURES Additional products/coverages added to the captive
Product selection
Limited severity/predictable and low frequency
Improved Risk Management tools, including
Actuarial modeling pricing tool for pricing
Disciplined investment guideline process established
Considers both underwriting and investment volatility, and incorporates risk appetite
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CAPIC TODAY $13,799,000 reserves
$25,049,000 surplus
Reduced underwriting risk
Enhanced investment analytics
Investments longer in duration and wider in variety
Mortgage backed securities
Corporates
Municipals
U.S. Treasuries19
CAPIC TODAY Prior to 2015, Investment manager used VAR (Value
at Risk) methodology – identifies risk to capital of a given strategy at a given confidence level (99%)
2015, Strategic Investment Policy adopted by BOD and approved by the Insurance Commissioner
2015, focus shifted to utilizing T-VAR (Tail Value at Risk) - identifies risk to capital if results breach capital risk threshold at a given confidence level (99%)
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THE U.S. ECONOMIC AND FINANCIAL MARKET OUTLOOK THROUGH 2016:
Investing In The Post-”Meltdown” Economy
A Presentation To The Hawaii Captive Insurance Council
Kauai, HawaiiOctober 30, 2015
21
-3.0
-1.7
-0.4
0.9
2.2
3.5
Dec-12 Apr-13 Aug-13 Dec-13 Apr-14 Aug-14 Dec-14 Apr-15 Aug-15
IS SLOWING WAGE -SENSITIVE SERVICES INFLATION JOINING TRADE-SENSITIVE "GOODS" "DEFLATION" IN PULLING THE OVERALL RATE LOWER?
Annualized Three -Month Percent Change
Source: U.S. Department Of Labor
"Services" CPI , Excluding Energy
(Right Scale)
"Goods" CPI, Excluding Food &
Energy(Left Scale)
8/15
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0.5
1.5
2.5
3.5
4.5
5.5
6.5
7.5
8.5
9.5
Jan-57 Sep-65 May-74 Jan-83 Sep-91 May-00 Jan-09 Sep-17
STILL SOME ROOM TO RUN IN INFLATION'S LONG DECLINE? Rolling Ten -Year Average Annual Percent Change
Source: U.S. Department Of Labor
Average 1957 -2014=3.7%
"Goods" CPI, Excluding Food &
Energy
August '15=2.0%
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-1.5%
-0.5%
0.5%
1.5%
2.5%
3.5%
Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14 Dec-15 Dec-16
PROFIT MARGINS, EARNINGS GROWTH THREATENED BY WEAK "PRICING POWER, " PRESSURE ON UNIT LABOR COSTS
Average Annual Percent Changes, Rolling Three-Year Periods; Non-Financial Corporations
Selling Prices
Unit Labor Costs
Source: U.S. Commerce Dep't.
'15Q2Recession
Period
Margin Pressure
Margin Expansion
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IS OVER THIRTY YEARS OF THE BOND MARKET'S "GOLDEN AGE" ENDING?Rolling Ten-Year, Average Annual Returns Long-Term Government Bonds; In Percent
-1%
2%
5%
8%
11%
14%
17%
Dec-52 Dec-60 Dec-68 Dec-76 Dec-84 Dec-92 Dec-00 Dec-08 Dec-16
Sources: Barclay's Capital
9/15
Average Annual Returns, 1952 -
82=3.5%
Average Annual Returns, 1982 -
2014=9.7%
25
0
2
4
6
8
10
12
14
16
4
8
12
16
20
24
28
Jan-79 Jan-83 Jan-87 Jan-91 Jan-95 Jan-99 Jan-03 Jan-07 Jan-11 Jan-15
Sources: Standard & Poors, Inc., IBES, Federal Reserve Board
S&P 500 Forward Price -Earnings Multiple
(Left Scale)
10/5/15
Multiple Of Projected Earnings Percent
10-Year Treasury Yield
(Right Scale)
STOCK-MARKET VALUATIONS--AND RETURNS--RISE AND FALL WITH INFLATION AND INTEREST RATES
26
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A RETURN TO A MORE NORMAL, RESILIENT ECONOMIC GROWTH CYCLE?
”Big-Ticket” Housing, Autos On The Leading Edge Of Economic Growth
A Long-Awaited Lending Recovery Has Arrived
Job Growth, Household Formations Back To A More Satisfactory Pace
A “NEW NORMAL” FOR THE U.S. ECONOMY?
An Aging, Slower-Growing Workforce
Lingering Fall-Out From The 2008-09 Financial “Meltdown”
Policy Uncertainties In The U.S., Structural Adjustment Abroad
Weak “Pricing Power” In A Highly Competitive Economy
--Bracing For Further Dollar Increases Pressuring U.S. Competitiveness
A Jobs Mismatch Between Skilled And Less Skilled Workers
Potentially Volatile, “Asset-Driven” Economic Cycles28
-4%
0%
4%
8%
12%
16%
20%
24%
28%
Dec-10 Sep-11 Jun-12 Mar-13 Dec-13 Sep-14 Jun-15
7/15
Job Openings
Hiring
Source: U.S. Bureau of Labor Statistics
Change In Open, But Unfilled
Positions
IS A LABOR MISMATCH LEAVING THE JOB MARKET "TIGHTER" THAN IT APPEARS?Year-Ago Percent Change; Three-Month Moving Average Data
29
30
BRACING FOR AN UNUSUAL INTEREST-RATE CYCLE IN 2016
A Cautious “Sea Change” In Monetary Policy
A Still-”Friendly” Backdrop For Long-Term Rates--Moderate Growth, A Slow Transition From “Disinflation” --Still-Subdued Inflation Expectations--Foreign “Flight-” And Yield-Driven Demand For U.S. Debt
A “Bumpy” Ride Higher?--Artificially Low Yield Premiums, Untested Policy Tools And An Unwinding Of Financial-Market Distortions
-0.4
0.1
0.6
1.1
1.6
2.1
2.6
3.1
3.6
0 5 10 15 20 25 30 35 40Years To Maturity
Fed Funds Futures Rates
Source: Bloomberg Financial News, Inc.
10/17 Futures Curve
10/16 Futures Curve
Yield Curve On 10/2/15
October 2017
October 2016
FUTURES "PRICED" FOR A MODEST "BEAR-MARKET FLATTENING" OF THE TREASURY YIELD CURVE
The Treasury Yield Curve, Selected Periods, In Percent, Based On Futures Rates As Of October 2, 2015
31
The Good News…
--No Housing “Bubble”
--Less Leveraged, Better Capitalized Banks
--More Manageable Household Debt Burdens
…And The Bad
--”Shadow Banking” Fills The Traditional-Banking Vacuum
--”Illiquidity” Risk Amid Ample “Liquidity”
--Weakening Underwriting Standards
--Increased Portfolio Leveraging
--Inflated Asset Values
A REPLAY OF LAST DECADE’S “BOOM-BUST” CYCLE?
32
-1.5
-1.0
-0.5
0.0
0.5
1.0
1.5
2.0
2.5
Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14 Dec-15
Rolling 10 -Year Moving Average
Oct. 1, '15= +0.58%
Source: Bloomberg Financial News, Inc.
* As measured by the stated yield on a ten-year "TIPS."
Sept. '15 =1.01%
"LEAN" INFLATION PREMIUMS: AN ANCHOR OR A COILED SPRING FOR FUTURE INTEREST RATE CHANGES?
The Yield On A Ten-Year Treasury Inflation-Protected Security (Or "TIPS"), In Percent
33
Weak “Pricing Power,” Cost-Cutting Pressure Takes Its Toll
An Asset-Driven Economic Cycle
Pressure Points From A Strong Dollar
Policy Gridlock In The Run-Up To The 2016 Elections
RISKS IN THE ECONOMIC AND INTEREST-RATE OUTLOOK
34
Commodity-Price “Deflation”
More Burdensome Cost Of Dollar-Debt Payments Abroad
Higher Overseas Interest Rates To Contain “Flight” Capital
”Translation” Losses On Foreign Income Of U.S. Multinationals, Foreign Investors
A Loss Of U.S. International Competitiveness
“Bad Deflation,” Via Weakening Business “Pricing Power”
WEIGHING A STRENGTHENING DOLLAR’S THREAT TO THE GLOBAL AND U.S. ECONOMIES
35
“Duration” Strategy--How Big A Threat From Interest-Rate Risk?
Sector Allocation--Will Ample “Liquidity,” Growth Suppress Credit Risk?
Security Selection--Opportunities In A “Transitioning” Market
“Yield Curve” Strategy--Positioning For Changing Short Vs. Longer-Term Rates
“ENGINES” OF FIXED-INCOME PERFORMANCE
36
Supports
--A “Passive” Earnings Recovery In 2016
--Low Yields Sustaining A “Liquidity”-Driven Rally?
--Still-Healthy Merger And Acquisition Activity?
Hurdles
--Slowing Buy-Back And Dividend Growth
--Above Average Valuations
--Weak “Pricing Power” Threatening A Cost-Driven Rally
--A Delayed “Kick” From Operating Leverage
U.S. STOCK MARKET SUPPORTS AND HURDLES
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