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.”

5

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?

6

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

12

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

22

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

24

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

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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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