Disciplined Investment (Risk Management/Alton Cogert)

Strategic Asset Alliance

Developing a successful, disciplined investment process for a captive means going beneath the surface to understand how each step in the process works together to produce solid results and then sticking to it.

Disciplined investment strategy focused on meeting the captive's key goals and objectives is the key to success. Every captive should view its investment process as a series of activities focused on meeting and exceeding key performance indicators (KPI) -- typically investment income, net income, return on surplus or other measures -- and tie these to the process whenever possible.

To understand how to link these KPIs, you first have to understand the investment process, which can be viewed as seven separate, but interrelated parts.

These are:

investment policy
strategic asset allocation
investment benchmarking
peer group analysis
investment management evaluation and responsibility
portfolio monitoring
performance measurement

The investment process of an insurer-whether a captive or a commercial company-is more complicated than simply picking an investment manager and asking them to beat a benchmark. For many smaller captives, the uncertainty inherent in this complexity is hedged by taking virtually no credit risk at all. Such captives have historically placed their portfolios in the full faith and credit of the U.S. government by holding Treasury bills, notes and bonds. And, indeed, these "safest" of fixed income securities have provided solid returns as a growing flight from uncertainty has coincided with the global credit crunch.

Along with safety, however, these captives have lost out on superior investment income found in other investment-grade bonds-the very investments that can provide captives with revenue to pay claims and fund operational requirements.

Other captives, realizing that, over time, nearly all of an investment-grade bond's return comes from its yield, have invested in non-Agency and Treasury securities like corporate bonds, and mortgage- and assetbacked securities (including, in some cases, sub-prime bonds). The fluctuations in the financial markets, however, have not only caused many of these portfolios to underperform versus their "safer" counterparts, but also led to credit-related losses.

So, which strategy will prove superior for the future? Perhaps George Washington put it best when he said: "Discipline is the soul of an army. It makes small numbers formidable; procures success to the weak and esteem to all." Developing a successful, disciplined investment process for a captive means going beneath the surface to understand how each step in the process works together to produce solid results-and then, sticking to it.

A disciplined investment strategy focused on meeting the captive's key goals and objectives is the key to success. Every captive should view its investment process as a series of activities focused on meeting and exceeding key performance indicators (KPIs)-typically investment income, net income, return on surplus or other measures-and tie these to the process whenever possible.

To understand how to link these KPIs, you first have to understand the investment process, which can be viewed as seven separate, but interrelated parts:

Investment policy
Strategic asset allocation
Investment benchmarking
Peer group analysis
Investment management evaluation and responsibility
Portfolio monitoring
Performance measurement

Investment Policy

Too many investment policies are so "plain vanilla" that one wonders how effective they really are. The captive should have a policy that ensures that the investment process is relevant in today's capital markets and that it is specifically related to the unique requirements of the captive. Importantly, the policy should protect the captive from investment managers taking actions that have been a problem for other insurers.

An ideal policy should have all of these components:

* Background: Who is responsible for what? What are the roles and responsibilities of all key people and committees involved in the process, including the board of directors.

* Investment return and management objectives: What is more important-return or yield-and why?

* Asset allocation and risk management guidelines: This section is what most people think of when discussing policies. What are the limitations and parameters within which the manager should manage the portfolio?

* Investment performance and reporting: What types of reporting will be required and from whom? How will performance be judged and against what benchmarks?

* Investment policy and guidelines evaluation: How often will the policy and related guidelines be reviewed and by whom?

Strategic Asset Allocation

Choosing the long-term strategic asset allocation is probably the most important investment decision for a captive investment portfolio, as asset allocation determines more than 90% of investment performance. Development of the allocation can be done using various tools, including dynamic financial analysis (DFA), which takes both sides of the balance sheet into account and looks at the probability of meeting key performance indicators. If a captive requires a rating from A.M. Best, for example, DFA can be utilized to determine how different asset allocations improve or reduce the probability of exceeding a minimum BCAR (risk capital) level-a necessary, but not sufficient, factor in achieving or maintaining a given A.M. Best rating.

DFA can also help develop a long-term strategic asset allocation that provides guidance on fixed income versus equity mix, fixed income duration targets, credit risk targets and different kinds of equities

Investment Benchmarking

Investment benchmarking allows the captive to set a risk-adjusted benchmark that the investment manager must exceed. What most captives may not fully realize is that benchmarking is, essentially, behavioral psychology in action.

Very few managers ever want to hold portfolios that are materially different from the benchmark because it will increase the likelihood of significant under-performance-the leading cause of manager termination. Thus, most managers' mold their behavior to the chosen benchmark.

Additionally, the benchmark should be directly related to the preferred strategic asset allocation. Because of this, most captive clients do not use generic benchmarks, such as the Lehman Aggregate for core fixed income portfolios. Instead, they tend to use customized benchmarks that are basically re-weighings of the generic index. These re-weighings, with characteristics tied to the strategic asset allocation, allow the captive to focus on a relevant goal instead of a generic index that has no relation to the actual objectives of the captive.

Peer Group Analysis

Peer group analysis is perhaps the most difficult investment process task for a captive to perform. Because many captives are not required to file annual statement information with the National Association of Insurance Commissioners, there are few, if any, good sources of public information on captives.

Despite this, an analysis can be made between captives and commercial companies having similar lines of business and may serve as a starting point for further discussion. Start by looking at what your peers seem to have as an investment strategy and whether or not it might work for you.

Investment Management Evaluation and Responsibility

It is important for a captive to properly evaluate the current manager and, when the time comes, carefully outline and execute a plan for a manager search.

Manager evaluation is normally tied to the degree of value added by the manager at various stages of the investment process, the quality of communications between- the manager and the captive, and monitoring and understanding the effect of changes that may occur within die investment management firm.

Should a search be desired, it should begin with a specific timeline, knowledge of the current state of the market for insurance investment management services and an understanding of the relevant fees charged for such services. In many instances, captives are charged quite a bit more than what is typically charged to other insurers, mainly because the standard fee schedule for core fixed income managers is typically related to pension and other clients and many captives are unaware of a historical difference. A greater focus on the bottom line by the insurer than by pension clients has meant that investment manager fees for insurers are materially lower. Usually, immediate cost savings can be achieved in this area.

Portfolio Monitoring

Portfolio monitoring refers to basic monitoring of reports like a credit watch list-something that will become even more important if the U.S. economy stagnates and the proliferation of high-yield bonds and leveraged loans issued over the past few years is a harbinger of increasing default rates.

Portfolio monitoring should go beyond the traditional credit watch list, however, and can include:

Monitoring compliance with the investment policy
Review of analytic and risk management reports
Review of the routine versus material event notification process
Stress-testing the portfolio against credit-related issues
Portfolio turnover analysis

Performance Measurement

Performance should be viewed on a risk-adjusted basis. There are many ways to define risk, so a careful understanding of different risk measures is important to determine whether value is being added by the manager after consideration of risk taken.

A captive focused on investment income should compare how the portfolio is generating yield and income versus budgeted assumptions. Performance measurement comparisons should be done after manager fees and taxes (where applicable) and combined across all accounts to determine not only how a given manager is doing but how the overall investment portfolio is doing.

Finally, many managers are able to provide performance attribution that can offer reasons for under- or over-performance. For fixed income portfolios, this means determining how much of performance was due to the manager's decisions about duration, the position of the yield curve on the portfolio, and whether the manager was invested in sectors that performed well.

Alton Cogert, CFA, CPA, is president and CEO of Strategic Asset Alliance, an investment consulting firm that exclusively serves the insurance industry. He has more than twenty years of financial institution experience, including over ten years in senior financial management.