Financial Primer: Investments, Audits, and Insurance ...€¦ · ‒Examples: Document core values,...

Financial Primer: Investments, Audits, and Insurance Accounting for Directors Sarah McConnell Principal Johnson Lambert LLP Falls Church, Va. As a principal at Johnson Lambert, Sarah McConnell manages all aspects of performing financial statement audits. Her responsibilities include overseeing and advising associates, preparing financial statements, and performing substantive and analytical tests of account balances and tests of controls. Her experience also includes significant Securities and Exchange Commission Rule 404 compliance testing and consultation services regarding internal control and business operations. Sarah co-manages operations, including marketing, strategic planning, engagement analysis, and personnel oversight, in Johnson Lambert’s Virginia office. She also coordinates recruiting services for the Virginia office, which includes the internship program, office visits, and firm-wide new-hire orientations. Sarah develops and teaches firm-wide training on technical topics, accounting updates, and soft-skills training. Michael Stellato Lead Consultant The Concord Advisory Group, Ltd. Princeton, N.J. As a lead consultant at the Concord Advisory Group, Ltd., Michael Stellato is responsible for providing strategic advice to institutional investors regarding all facets of portfolio operations, including investment policy, asset allocation, investment manager due diligence, performance reporting, and cost analysis. He joined Concord in 2006 and has more than 15 years of experience in the financial services industry. During that time, Michael has worked extensively with mutual insurers and captive insurers domiciled domestically and abroad. Prior to joining Concord, Michael was employed at Prudential, working with retirement investment products. He started his career at Merrill Lynch, working in investment management. Michael holds an MBA in finance from Fairleigh Dickinson University and a Bachelor of Science in business from Mount Saint Mary’s College.

Session Description: Part of the responsibilities of board members is to understand accounting and investments. This session will help directors get a better grasp of governance, strategy, and execution – the three components of a well-structured investment program. Challenges such as regulatory constraints, investment strategy-financial position alignment, and risk management will also be discussed. Directors will leave this session knowing the basics of investments as well as the right questions to ask in order to keep their organizations on the right financial track. Learning Objectives • Describe privately held insurance company board governance best practices; • Identify the common risks within the core operating cycles of an insurance company; • Understand the roles and responsibilities of the board, management, and service providers

in the investment process; • Learn tips that can be used to maximize the value of the interactions among the board,

management, and external service providers; • Understand current governance challenges in overseeing an insurance investment portfolio;

and • Identify the key components of a sound and repeatable institutional investment process.

Top Three Session Ideas

Tools or tips you learned from this session and can apply back at the office.

1. ______________________________________________________________________

2. _______________________________________________________________________

3. _______________________________________________________________________

Financial Primer: Investments, Audits, and Insurance Accounting for Directors

Presented by: Sarah McConnell, CPA and Michael Stellato

Auditing and Accounting Governance for Directors

Sarah McConnell, CPA

September 22, 2014

2014 NAMIC Connect Differently - McConnell & Stellato Page 1 of 25

Learning Objectives

· At the end of the session participants will be able to:

• Describe privately-held insurance company board governance best practices;

• Identify the common risks within the core operating cycles of an insurance company; and

• Utilize tips to maximize the value of the interactions between the board, management and external service providers.

Audit Committee Requirements and Responsibilities


Board and Audit Committee Requirements

· Determine/understand organization’s mission and purpose

· Monitor key executives/management

· Ensure effective organizational planning

· Determine, monitor and strengthen the organization’s programs and services

· Maintain accountability to stakeholders

· Provide proper financial oversight

· Recruit & orient new Board members and assess performance

· Ensure legal & ethical integrity

· Appointment, compensation and oversight of the auditor

NAIC Model Audit Rule

· Annual Financial Reporting Model Regulation (“Model Audit Rule” or “MAR”)


Model Audit Rule - Governance

· Requires insurance company to have an audit committee (or equivalent body)

• Solely responsible for appointment, compensation and oversight of the company’s auditor

• $300 - $500 million in premium requires 50% of audit committee to be independent

• >$500 million in premium requires 75% of audit committee to be independent

Model Audit Rule – Internal Control

· >$500 million in premium – required to file management’s assessment of internal control over financial reporting.


ERM in Insurance

• ERM has become a part of compliance and certification practices including:– ORSA – Originated with Solvency II

– A.M. Best – BCAR Rating

– S&P Insurer’s Rating

Own Risk and Solvency Assessment Requirements

· Adopted by NAIC: September, 2012

· Expected implementation: January, 2015

· Component of insurer’s ERM framework

· ORSA Applicability

• Annual Premium is greater than $500 million

• Member of insurance group annual premium greater than $1 billion

· ORSA Requirements:

• Conduct ORSA annually

• Document the process and results of assessment

• Provide high-level ORSA Summary Report


ORSA Action Items for Small Insurers

· At a minimum, be prepared to discuss your risk management program and results with regulators.

· Be prepared to discuss financial and operational risks of related parties/TPAs and any potential events that could indirectly affect regulated entities.

· Knowledge is power. Be familiar with the IAIS ICP 16 and the NAIC ORSA Guidance Manual.

· Begin documenting early and make frequent updates to improve existing documentation.

· Embrace ERM for the right reasons.

· Start now!

Engagement with the Auditors


Design of Audit Approach

Planning

Risk Assessment

Control Testing

Substantive Testing

Required Communications and Reporting

Audit Plans

· Ongoing process throughout the audit to gather information to properly design the audit

• Internal and external sources

• Prior year audit results

• Inquiries, analytics, interim testing

• Understanding of internal controls

· Communication to the AC:

• Critical and significant audit areas

• Overview of audit procedures and timing/staffing

• Name of the partner with final responsibility


Required Communications

· Making the most of a full agenda

• Accounting policies

• Estimates

• Audit differences and significant deficiencies in internal control

• Items of significant discussion

‒ Accounting

‒ Disclosures

• Consultations with other accountants

• Independence

Five Suggested Questions to Ask your Auditors

Where does our company differ from other companies you see?

• If you were the CFO, what would be keeping you up at nights?

• What are you planning to do differently next time in your audit?

• If we were to improve one area of internal control, where should we focus our efforts?

• What should we have asked you that we did not ask and how can we improve our effectiveness as an audit committee?


Governance Over Key Insurance Cycles

Underwriting Risks

· Ultimate costs may not be known for several years

· Pricing for the risk taken in an insurance policy –underwriting guidelines/discipline

• New trends in claims for existing products

• New markets without historical company experience

• Non-renewal decisions or change in risk/pricing assumptions

· Hard vs. Soft market cycles

• Are we competing on price to win or keep business?

‒ Renewal rates

‒ Rate increases/decreases


Underwriting Governance

Production vs. plan• Budget oversight including ratio monitoring

• Reinsurance capacity and stability

Producer and management incentives• “Top line” growth vs. profitability triggers

New products or geography = new risks?

• Who is our resident expert?

Investment Cycle

· Ideally risk would primarily reside within the claims side of the balance sheet

· Duration matching

· Equity investments


Investment Governance Items

· Asset allocation vs. targets

· Portfolio yields vs. targets

· Overview of market conditions & outlook

· Compliance monitoring

Claims Cycle

· Estimates for the ultimate costs of insured events that have occurred

· Reporting and settlement timeliness

• Long-tail

• Short-tail

· Frequency and severity trends

· Claims department/handling trends


Claims Governance

· Understanding of company and industry changes

· Actuarial reserving methodologies and levels of disaggregation

· Retrospective review of prior estimates

· Fraud prevention/detection

· Periodic review of actuary’s qualifications

Common Service Providers

· Underwriting Cycle

• MGA = Managing General Agent

• MGU = Managing General Underwriter

· Investment Cycle

• Investment manager(s)

• Investment custodian

· Loss Cycle

• TPA = Third Party Administrator

• Actuary

· External auditor

· External legal counsel


Board Role in Monitoring Service Providers

· Management’s satisfaction with each service provider’s performance

· Changes in service provider operations, ownership, staffing, etc.

· Service provider update as to the size and scope of their services to similar organizations

· Monitor expenses

• Actual vs. expected fees

• Renewal vs. historical fees

• Understand how compensation structure works

• Goal is not “cheapest” but “cost-effective”

The Future of Governance


Corporate Governance Model Law

START NOW!

· The proposed and soon-to-be adopted Corporate Governance Model Law will require companies to document controls over Corporate Governance and file an annual report to the domestic regulator.


Suggested Company Actions:

· Begin documenting controls related to bringing on new officers and directors, as well as controls related to ownership changes.

· Document Competency Standards

• How is an individual’s competency verified?

‒ Examples: Document verification of degrees and other credentials; document employment history verification.

• Document Integrity Standards

• How is an individual’s integrity verified?

‒ Examples: Document background checks and personal reference checks (or procedures performed in lieu of).



Suggested Company Actions:

· Document Controls over Remuneration:

‒ Examples: Document how compensation practices are managed, aligned with company goals and monitored. How are risks mitigated?

· Document Oversight of Operations:

‒ Examples: Director and Officer job descriptions, organizational chart.

• Document all Board-level actions and thoughts:

‒ Examples: Document core values, code of ethics, review of strategy and business plan, performance goals, oversight of management, committee charters, policy setting.

Questions & Answers

Contact Information:

Sarah McConnellPrincipal

[email protected]

www.johnsonlambert.com30


Insurance Investment Management:

Best Practices for Institutional Investing

32The Concord Advisory Group, Ltd. Experience. Leadership. The Right Solution.

Winner’s Game: Outcome is determined by the correct actions of the winner

Loser’s Game:Outcome is determined by the mistakes made by the loser

The Winner’s Game vs. The Loser’s Game



Structural Disadvantages

Influx of intelligent competitors with access to information Increase in number of portfolio / market transactions Low interest rates High costs (fees) relative to expected returns

Increased complexity

Plethora of new securities Regulatory constraints Appropriate capital allocation strategies to fund liabilities Reserves (Liquidity / Core Capital) vs. Surplus (Risk Capital)

Contributing Factors to the “Loser’s Game”:

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Fees and Asset Management Industry Evolution

The Concord Advisory Group, Ltd. Experience. Leadership. The Right Solution.

Singular objective to ‘beat the market’ has generally become more expensive and less probable

Actively-managed equity managers have consistently underperformed their benchmarks

Fixed income managers have had more success – partially due to inefficient benchmarks

Difficulty in active manager selection – performance impact

*Source: S&P Dow Jones Indices, CRSP


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Fees and Asset Management Industry Evolution


Fixed income management fees have remained static while interest rates have declined

As a percentage of expected returns, fees are significantly higher than anytime in recent history

*Note: Data prior to 8/31/2000 is Yield to Worst

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Investment Industry is Increasingly Complex


1980’s CD’s

Bonds

Stocks

Real Estate

US Stocks

US Bonds

Non-US Stocks

Emerging Market Stocks

Real Estate – Private

Real Estate – REIT

Global Bonds

High Yield

Global Stocks

Money Market

Growing number of potential strategies to consider; Many associated with higher fees More choices make capital allocation decisions increasingly difficult

Managed Futures

Hedge Funds

Private Equity

Commodities

TIPS

Tactical Strategies

Emerging Market Bonds

Bank Loans

Convertible Bonds

Currencies

2014



Investment success is predicated on being a “strong-handed” investor, whereas many investors are “weak-handed”

High fees are the enemy of good performance

Process drives performance

Winning the Investment Game

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Winning the Investment Game

A sound and repeatable process is the key toincreasing the odds of portfolio success in any market environment


Sound

Governance

These basic elements form the crucial foundation of an investment program

Investment

Strategy

Strategic asset allocation that matches the liabilities of the asset pool and the financial position of the

organization

Portfolio

Execution

Well-defined vendor selection process

‘Best-in-class’ pricing

Decision-making framework for the

organization

Portfolio oversight


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Governance = Leadership


Less than optimal governance procedures create a drag on investment performance.

In today’s low return / high risk environment the need to re-examine your decision making process is

paramount.

Directors must ask themselves:

Questions Solutions

Who’s making your decisions? Define the organization’s decision-making hierarchy

How are decisions being made? Create a process-driven investment program

How are decisions being implemented? Develop portfolio operations best-practices

How are results evaluated? Implement on-going monitoring procedures

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Governance Process

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Investment Policy Statement

Development / Revision

Asset Allocation

Manager Due Diligence / Oversight

Performance Reporting

Cost Analysis

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Establish framework for decision making and accountability

Set a risk budget based on financial tolerance

Document intentions via formal Investment Policy Statement (“IPS”).

Oversight and monitoring of portfolio results versus IPS and long-term goals.

Focus on relevant and productive forward-looking matters


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Board Responsibilities

Establish reporting structure and protocol for investment operations

Establish Investment Committee

Review and approve/reject Investment Committee recommendations

Investment Committee Responsibilities

Recommend investment objectives, policies, and guidelines

Develop asset allocation and risk parameters for the portfolio

Vendors selection and performance evaluation

Staff Responsibilities

Daily oversight of investment operations

Ongoing reporting to Board and Investment Committee.

Governance – Effective Decision Making Structure

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Investment Program Roles & Responsibilities

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Investment Consultant Investment Manager Insurance Company

Governance

Investment Policy Statement Development & Revision

Portfolio Monitoring & Oversight

Cost Analysis

Audit & Regulatory Filing Support

Board / Committee Reporting & Meetings

Board / Committee Education

Investment Policy Input for Specific Asset Classes or IPS Development (if no consultant)

Portfolio Reporting

Audit & Regulatory Filing Support

Board / Committee Reporting & Meetings

Regulatory Compliance & Oversight

Daily Accounting

Quarterly & Annual Regulatory Filings

Investment Policy Statement Approval

Monthly Portfolio Review

Quarterly Committee Oversight

Strategy Asset Allocation Modeling & Strategy

Total Portfolio Risk Management

Portfolio Customization

Asset Class Expertise

Underlying Portfolio Risk Management

Advise on Projected Cash Flows & Liabilities

Asset Allocation Approval

Establish Risk Tolerance Thresholds

Execution

Investment Manager Searches & Recommendations

Portfolio Rebalancing Recommendations

Document Preparation & Staff Support

Discretionary Management of Underlying Portfolios

Final Manager Selection Decisions

Portfolio Rebalancing Approval

Transaction Signoff

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Strategy: Process-Driven Investment Management


Develop an investment strategy that matches with the underlying liabilities of asset pool

Investment strategy rationale is based on:

Liability structure Balance sheet Capital market conditions

A dynamic review process based on changing circumstances is imbedded in the Governance process.

44 44100-11-928-6750614

Strategy: Asset Allocation

Return Enhancement

Core Capital

Liquidity

Allocation Building Blocks

Liquidity bucket for expected short-termcash flows. Periodically utilized as a tacticalinvestment in periods of stress.

Income producing and low volatilitystrategies that support underwritingreserves. Provides diversification andsafety to the majority of insurance assets.

Total return strategies that seek to growsurplus assets. Equity-like levels ofvolatility.

• Develop appropriate investment strategies which align with the operating needs of the organization.

• Recognize the importance of risk management.

• Focus on long-term strategy, while remaining aware of short-term market dynamics.

• Establish liquidity for demands of the organization

• Utilize combination of assets that attempts to minimize risk and maximizes return


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Strategy: Insurance Portfolio Evolution

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Formation Stage Growth Stage Maturity Stage

Investable Assets Limited ReservesReserve Accumulation /

Modest SurplusStable Reserves /

Rising Surplus

Risk Tolerance None Low Moderate

Investment Profile Capital Preservation Growth & Income Total Return

Investment Goal Minimize Risk of Loss Income Generation Income & Capital Gains

Investment OptionsCash & EquivalentsShort-Term Bonds

Investment Grade BondsGlobal Bonds

High Yield BondsConvertible Securities

High Quality Global Equities

Emerging Markets EquitiesCommoditiesReal Estate

Alternative Strategies

Typical Investment Management

Structure

Bank / Single Manager

Single or Multi-Manager / Consulting Services

Multi-Manager / Consulting Services

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Execution: Efficient & Cost-Conscious Implementation


Investment costs are now running at approximately 20% of expected

returns (YTM) versus approximately 5% fifteen years ago.

The investment management community as a whole is providing

less excess return.

The least risky way to increase expected return is to decrease cost.


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Comprehensive Cost Analysis


Monitoring investment operating expenses frequently, and versus peers, is a best practice

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Execution: Cost vs. Performance


Items to consider:

Measurement against peers (percentile ranking)

Performance: Lower percentile better (higher returns)

Fees: Higher percentile better (lower fees)

Goal is to assemble the most efficient mix:

Performance: Above median (1st to 50th)

Fees: Below median (51st to 100th)



Timing Skill

• Evolution away from the ‘traditional’ ranking system

• Removal of emotion from investment decision-making process

• Hire and fire on a proactive and timely basis

Conviction

Active Manager Selection Process Based on Three Factors

• Persistent evidence of successful investment process

• Understandable risk, return, and portfolio characteristics

• Differentiated source of return that is repeatable into the future

• Classification of underlying investment processes and their characteristics

• Defining how the processes will perform in various market environments

• Allocate capital to managers on a time-sensitive basis

Unhindered Access to Institutional Investment Universe

Platforms, or ‘constrained’

universes, bias towards large, asset gathering managers

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Questions & Answers

Q & A



Financial Primer: Investments, Audits, and Insurance ...€¦ · ‒Examples: Document core values,...

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