Portfolio Management Strategies for Insurance Pools...Portfolio Management Strategies for Insurance...

© PFM 1

Portfolio Management Strategies for Insurance PoolsNLC – RISC Trustees Conference

PFM AssetManagement LLC

213 Market StreetHarrisburg, PA 17101

717.232.2723pfm.com

Kenneth Schiebel, CFA, Managing Director

Mark Yasenchak, CFA, Director

Presented By:

May 11, 2018

© PFM 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.

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Topics to be Covered

1. Investment Management for Insurance Pools

2. Role of a Trustee

3. Investment Risks & Opportunities

4. Pulling it All Together

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Investment Management for Insurance Pools

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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 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 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 8

An Investment Framework

Claim Reserves

Surplus(Net Position)

Current Claims

& Admin. Costs

© PFM 9

Segmenting the Portfolio

Liabilities Investment Strategy

Current Claims & Administrative

Costs

“Cash portfolio”• Highly liquid• Short term investments• Laddered maturities• Very high credit quality

Claim Reserves(Non-current

liabilities)

“Liability hedging portfolio”• Assets matched to expected claim payments• Based on actuarial assumptions• Intermediate-term investments• Medium to high credit quality

Surplus (Net Position)

“Growth portfolio”• Goal: long term surplus growth• Longer-term & broader investments• Less need for liquidity• Potential for (moderately) greater risk

© PFM 10

Developing a Strategic Asset Allocation

Cash / Liquidity

Traditional Fixed-Income

Multi Asset Class Portfolio

Sample PoolAsset Allocation

Portfolio StrategicAsset Allocation

Member Pool Goals and Preferences

Liability ProfileCash Flows

Global Investment UniverseCapital Market Assumptions

Risk/Return Analysis

© PFM 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 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 theliability stream as the benchmark

Product-based Situation-based

Investment performance focusedon 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 successmeeting liabilities and growing surplus

© PFM 13

Impact of Interest Rate Changes

Effects both assets and liabilities

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Pric

e

Yield

2-Year Bond10-Year Bond30-Year Bond

Maturity (Duration) Effects the Degree of Price Volatility

There is no free lunch: Greater rewards require greater risk

Current Yield

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Matching Assets to Liabilities

Typical Liability Pay-Out Pattern Perfect Cash Flow Match

$2.5

$4

$3.5

$2.5

$2

$1.5

$1

$0.5

$0.0

$1.0

$2.0

$3.0

$4.0

$5.0

2011 2012 2013 2014 2015 2016 2017 2018

$ M

illio

ns $2.5

$4

$3.5

$2.5

$2

$1.5

$1

$0.5

$0.0

$1.0

$2.0

$3.0

$4.0

$5.0

2011 2012 2013 2014 2015 2016 2017 2018

$ M

illio

ns

Liabilities

Assets

© PFM 16

Impact of Liability Mismatch

$0

$1

$2

$3

$4

$5

2012 2013 2014 2015 2016 2017 2018 2019

Mill

ions

of D

olla

rs

Assets

Liabilities

$0

$1

$2

$3

$4

$5

$6

$7

$8

2012 2013 2014 2015 2016 2017 2018 2019

Mill

ions

of D

olla

rs

Assets

Liabilities

Perfect Cash Flow Match Mismatched Portfolio

Total Assets $17.500 million

Total Liabilities $17.500 million

Duration of Assets 3.22 years

Duration of Liabilities 3.22 years



Duration of Assets 2.04 years

Duration of Liabilities 3.22 years

Equal Duration of Assets and Liabilities Shorter Duration of Assets than Liabilities

© PFM 17

Impact of Liability Mismatch

Assume a 100 basis point (1%) decrease in interest rates





Before

After

Impact on Surplus = $0

Liabilities Remain Funded

Perfect Cash Flow Match





Before

After

Impact on Surplus = $(207,000)

Liabilities Become Un-funded

Mismatch Portfolio

© PFM 18

Role of a Trustee

© PFM 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

Annually review pool financials

and actuarial assumptions

Review investment objectives

Review investment policy and guidelines

Formal Review Cycle

Meet periodically with

investment manager

Review investment

holdings, transactions,

asset allocation, and policy

complianceReview

performance relative to a benchmarkUnderstand

source of over or under

performance

Ongoing Oversight

Create a formal investment

policy statement (IPS) that

includes investment objectives,

philosophy, asset allocation targets, and risk

metrics

Develop an Investment

PolicyDevelop

understanding of the business,

operations, pricing, and

business risks

Understand the Business

Learn regulations,

fiduciary duties and related background information

Acquire Requisite Knowledge

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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 21

The Importance of Diversification

Source: JP Morgan Guide to the Markets as of 12/31/2017.

© PFM 22

2018 Capital Market Assumptions

Expected Return Expected Risk Expected Return Expected Risk

US Equity 6.5% 17% 7.7% 16%

International Developed Equity 6.6% 18% 7.7% 17%

Emerging Markets Equity 6.6% 24% 7.7% 20%

Core Bonds 1.9% 4% 5.5% 5%

Intermediate Investment Grade 2.3% 6% 6.3% 7%

Emerging Markets Debt 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%

Intermediate: Next 5 Years Long Term Projections

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.

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2018 Capital Market Assumptions (cont.)

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

EstateCommodities Hedge

FundsPrivate Equity Cash

US Equity 1

International Developed Equity 0.8 1

Emerging Markets Equity 0.7 0.7 1

Core Bonds 0.3 0.2 0.2 1

Intermediate Investment Grade Corp 0.3 0.2 0.2 0.9 1

Emerging Markets Debt 0.5 0.5 0.5 0.4 0.4 1

High Yield 0.7 0.5 0.5 0.4 0.4 0.4 1

Bank Loans 0.4 0.3 0.3 0.3 0.3 0.7 0.7 1

REITs 0.5 0.4 0.4 0.3 0.3 0.3 0.4 0.4 1

Private Equity Real Estate 0.4 0.3 0.3 0.3 0.3 0.2 0.4 0.2 0.8 1

Commodities 0.1 0.1 0.2 0.2 0.2 0.3 0.2 0.2 0.1 0.1 1

Hedge Funds 0.6 0.5 0.5 0.4 0.4 0.3 0.4 0.4 0.4 0.3 0.2 1

Private Equity 0.7 0.6 0.6 0.3 0.3 0.3 0.5 0.2 0.4 0.4 0.1 0.5 1

Cash 0.1 0.1 0.1 0.2 0.2 0.1 0.1 0.2 0.1 0.1 0.1 0.1 0.1 1

Correlations

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 24

Asset Allocation SummaryShort Term

Fixed Income 20/80Model

30/70Model

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 25

Return at the 5th percentile





Return ProjectionsBased on Intermediate-Term Capital Market Assumptions

Short-Term Fixed Income

© PFM 26

Return ProjectionsBased on Intermediate-Term Capital Market Assumptions

-10

-5

0

5

10

15

20

25

ShortTermFixed

Income

20/80Model

30/70Model

40/60Model

ShortTermFixed

Income

20/80Model

30/70Model

40/60Model

ShortTermFixed

Income

20/80Model

30/70Model

40/60Model

95th 6.14 14.73 17.55 19.87 3.88 8.41 9.77 11.14 3.26 6.98 8.02 9.0575th 3.68 7.92 8.91 10.00 2.73 5.45 6.17 6.94 2.52 4.97 5.63 6.3550th 1.96 3.40 3.90 4.45 2.00 3.56 3.94 4.34 2.00 3.64 4.12 4.5325th 0.43 -0.54 -0.66 -1.00 1.23 1.73 1.78 1.82 1.49 2.25 2.50 2.705th -2.13 -5.72 -6.90 -8.08 0.19 -1.15 -1.55 -1.90 0.75 0.31 0.23 0.04

Annu

aliz

ed R

etur

n (%

)

1 Year 5 Year 10 Year

© PFM 27

Return ProjectionsBased on Long-Term Capital Market Assumptions

0

2

4

6

8

10

12

14

Short TermFixed

Income

20/80Model

30/70Model

40/60Model

Short TermFixed

Income

20/80Model

30/70Model

40/60Model

Short TermFixed

Income

20/80Model

30/70Model

40/60Model

95th 6.00 9.98 10.69 11.48 5.51 9.07 9.61 10.12 5.33 8.69 9.20 9.6975th 5.01 8.03 8.50 8.88 4.86 7.59 7.92 8.29 4.81 7.48 7.77 8.1050th 4.43 6.61 6.84 7.02 4.40 6.66 6.92 7.13 4.41 6.63 6.88 7.1025th 3.79 5.34 5.36 5.33 3.97 5.71 5.79 5.86 4.05 5.86 6.01 6.085th 2.90 3.32 3.16 2.96 3.34 4.29 4.27 4.13 3.52 4.76 4.77 4.71

Annu

aliz

ed R

etur

n (%

)

10 Year 20 Year 30 Year

© PFM 28

Investment Risks & Opportunities

© PFM 29

The Nature of Risk

Traditional Portfolio

Investment risks:

• Interest rate risk*

• Credit/default risk*

• Reinvestment risk

• Prepayment/call risk

• Liquidity risk*

• Inflation risk*

• Exchange rate risk

Insurance Pool

Business risks:

• Cash available to pay claims

• Pricing adequacy

• Surplus sufficiency

• Operating ratios

* Key risks to insurance portfolios.

© PFM 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 Loss of purchasing power over time as a result of inflation

• 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

Liquidity Risk Inability to sell portfolio holdings at a competitive price

• Reasonably strong liquidity in investment grade markets• Increased capital cost has resulted in reduced dealer

inventory• Liquidity falls when markets are stressed

© PFM 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

• TIPS/Inflation-hedge• Foreign Sovereign/Supras• Commercial MBS• High Yield

• Private Placements• Convertibles• Non-U.S. Dollar investment grade• Emerging Markets Debt

Equities• Domestic Large Cap• Domestic Small/Mid Cap• Domestic Value/Growth

• International Large Cap• International Small/Mid Cap• Emerging Markets

Alternatives• Commodities• Real Estate• Hedge Funds

• Private Equity• Venture Capital• Tangible Assets

© PFM 32

Important Principles

• Asset allocation ranges

• Risk measures

• Diversification

• Return profiles

Increasing Diversification with Multi-Asset Class Management

© PFM 33

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

1965

1967

1969

1971

1973

1975

1977

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

2009

2011

2013

2015

2017

5-Year Treasury Yield History (March 1965 – March 2018)

10-year average: 1.67%

Source: Bloomberg as of 03/31/2018.

© PFM 35

8.5%9.3%

1.7%

7.5%3.6%

0.7%0.8%

37.5%25.7%

21.9%

-10% -5% 0% 5% 10% 15% 20% 25% 30% 35% 40%

2017

Prior 5 Years

Equities

Domestic Fixed Income

Alternatives

U.S. Developed ex U.S. Emerging Markets

CommoditiesReal EstateHedge Funds

CashShort BondsCore BondsHigh Yield Corporates

Prior 5-year returns are based on 2012-2017 and are annualized.

Recent Asset Class Returns

© PFM 36

A Comparison of Investment Strategies: Historic Growth

Data Source: Investment Metrics. Calculation based on monthly periodicity.

$39,438,429

$36,273,039

$33,201,188

$31,586,942

$10,000,000

$15,000,000

$20,000,000

$25,000,000

$30,000,000

$35,000,000

$40,000,000

$45,000,00060% 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%

© PFM 37

Historic 10 Year Rolling Returns

Source: Investment Metrics as of 12/31/2017. Calculation based on monthly periodicity.

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

Dec-12 Dec-13 Dec-14 Dec-15 Dec-16 Dec-17

60% Fixed Income / 40% Equity Strategy70% Fixed Income / 30% Equity Stragegy80% Fixed Income / 20% Equity StrategyBofA Merrill Lynch 1-5 Yr Treasury Index

© PFM 39

The Nature of the Investable Assets

Newer Pool

SurplusAdministrative

Costs

Reserves

Surplus

Administrative Costs

Reserves

Mature Pool

© PFM 40

Sample Segmented Portfolios

Administrative Costs

Reserves Surplus

TIPS/Inflation-

Hedge

Equity

Int’lEquity

DomesticFixedMoney Market Securities

(T-Bills, CP, CD, BA)

MoneyMarketFunds

Municipal Bonds

MBS/ABS

Investment-GradeCorporate

Bonds

Money Market Securities

Treasuries

Agencies

© PFM 41

Spend the time necessary tothoroughly understand both the business and investment objectives.

Based upon risk and return discussions, determine the bestmix of assets that may meetyour objectives.

Carefully review investment options, or hire a professional partner to manage the investment process.

Investment Risk & Return Analysis• Understanding cash flow, other liquidity

factors, investment horizon and returnobjectives.

Customized Asset Allocation• Translation of risk and return

considerations into an investment strategy that covers the investable universe of debt and equity securitiesacross the globe.

Investment Selection• Review and selection of investments,

funds and/or managers.

Increasing Diversification with a Multi-Asset Class Approach

© PFM 42

Implementation

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

DynamicAsset Allocation

• Make slight, opportunistic adjustments to exploit undervalued asset classes, limit risk, and optimize manager allocation

Strategic Asset Allocation

Asset Class Structure

U.S. Equity International Equity Fixed Income

Large Mid/Small Developed Emerging Gov’t/Corp High Yield

Other

Alternatives

Investment Strategy Value Added

Rebalancing • Thoughtful, disciplined process based on “buying low and selling high”—not a calendar

© PFM 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 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.

Portfolio Management Strategies for Insurance Pools...Portfolio Management Strategies for Insurance...

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