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An investment manager can improve captive finances.

In a rapidly changing environment the task of administering an offshore captive's investment portfolio presents both L- challenges and opportunities. An investment manager can relieve the burden of meeting these demands and enable the risk manager to identify, understand and pursue the opportunities available. The range of products and services offered by most investment managers is complex and, to a large extent, has been developed in response to the business demands of offshore companies.

The role of an investment manager is to provide a risk manager with access to a wealth of information regarding his or her insurance company's assets and investment policy and interpret this information to present it in a meaningful form. To meet this challenge successfully, an investment manager must have first-hand knowledge of the underlying investment framework in the offshore insurance industry, keep abreast of innovations, trends and developments and have the knowledge and resources to provide in-depth advice to clients as opportunities arise.

Like many business functions, the complex task of controlling or managing a pool of insurance assets is comprised of three stages: planning, implementation and review. At each stage of the process, an experienced investment manager will have available the resources to identify, analyze and make recommendations on each of the major issues involved.

Planning

The nature and complexity of the investment strategy will depend to some degree on the range of eligible investment instruments available to the fund. Many offshore captives are restricted, often by regulatory, legislative or fiscal factors, to Eurodollar securities. Others have more broadly based investment horizons embracing U.S. taxable and tax-exempt fixed-income or holdings in equities or real estate.

The planning process may involve a comprehensive analysis of the risk return trade-offs of multiple asset classes or may consist of a simple set of maturity guidelines for a single currency fixed-income portfolio. In each case, the goal is to control the portfolio risk to provide an acceptable balance between required return over the long-term and short-term capital loss. In simple terms, risk can be thought of as the possibility of failing to achieve a required rate of return over a given time period.

Since most captive insurance portfolios are invested in fixed-income securities, the average maturity decision is usually the key element of the investment strategy. This decision represents a strategic objective and is quite distinct from a limited short-term tactical change in maturity applied by the investment manager to exploit anticipated interest rate movements. The strategic position should be determined according to the company's liabilities and risk tolerance, and should be conveyed to the risk manager as a suitable index benchmark.

Some captive insurance companies are invested exclusively in cash deposits. Cash instruments are highly liquid and provide no threat of capital loss and a known return to redemption. Not surprisingly, they are often considered the ideal low risk investment. However, this perception is misleading. Consider, for example, a set of insurance liabilities which have an average payout horizon of five years. Assume that these liabilities are estimable and are fully cov - "The task of controlling

a pool of insurance assets

comprises three stages" ered by cash deposits. If interest rates were to fall, the discounted value of the payouts would increase. At the same time, the future expected return on the cash portfolio would fall causing a mismatch between the assets and the liabilities.

The theoretical solution to this problem is to build a portfolio of fixed-income instruments with a stream of coupon payments and redemptions which are broadly in balance with future payouts. Variations in the present value of the liabilities arising from changes in interest rates will be matched by fluctuations in the market value of the portfolio. In reality, the exercise is rarely that simple. Often the payout pattern is difficult to quantify. For example, many types of excess liability insurance cover potentially large losses which are relatively unlikely to occur. The reporting cycle may also militate against holding long-term securities which could threaten book surplus if short-term losses must be realized following market weakness.

By considering a company's nature of business, the best estimate of its liability profile and its reporting structure, an investment manager can assist you to design a maturity framework which represents the best compromise between these factors. This process will include an analysis of the risk return trade-offs of securities with different maturities. For example, a significant benefit has historically been achieved for each unit of risk by extending maturities to approximately four years. Beyond this, and as far as 10 years, some benefit has been identified, but the effect is reduced. For portfolios with maturities in excess of 10 years, there has been very little to reward the investor for accepting the added market risk of longer bonds. A company's investment policy must be designed to exploit the opportunities available without incurring unrewarded risk.

In addition to dollar denominated bond portfolios, many offshore companies have now broadened their investment policy to include other types of bonds, equities and real estate. Here, the strategy issues become more complex, requiring a detailed understanding of the asset classes available and the role that each can play as part of a broadly diversified portfolio. Access to a database of security returns is essential together with the skill to manipulate and interpret the historic data and make meaningful projections about the future. An asset allocation model, combining statistical techniques with investment theory, can explore the effects of combining assets and help quantify risk. These tools are available to an investment manager who can also contrast existing or proposed strategies with current market practice.

Irrespective of a company's size or the underlying pattern of insurance risk, the planning process, involving careful determination of a disciplined, coherent strategy, is crucial. It is possible at this stage that the use of an investment manager is most beneficial. By identifying clearly and simply the range of strategic options available, and indicating the risks involved in each, he can help you select the policy which best meets your business needs.

Implementation

The implementation process involves applying the theoretical solutions derived at the planning stage to the real world. In some cases, a long-term strategic asset allocation target can be readily achieved. More often, however, there are practical short-term limitations, usually relating to fiscal or regulatory constraints. Security buy or sell programs may be hampered by the existence of unrealized gains or losses in the portfolio, which, if liquidated, might have an unwelcome effect on financial statements. While legal opinion may be needed on tax issues, few investment managers have a detailed knowledge of the complexities of tax legislation. However, market experience will enable the investment manager to offer the risk manager a helping hand as the various options are weighed.

Whether the risk manager is using an outside investment manager or in-house resources, the investment policy will need to be reworked into a set of portfolio guidelines identifying eligible security classes, detailing maturity restrictions and giving credit and issue size constraints. An investment

manager is able to give advice in the drafting process and help achieve a mandate which avoids tying the risk manager's hands, but instead protects the portfolio from undue market risk. He or she is also able to provide unbiased advice on the market index bench marks which most closely mirror the desired structure of a portfolio.

The fact that an investment manager serves a range of clients keeps him in touch with the leading market players, and competitive forces will ensure that he is kept up-to-date with the latest products and is introduced to key individuals. The investment manager, in turn, should be supported by a skilled, well-resourced research team able to collect, analyze and contrast information and present it to the risk manager in a consistent, comprehensive and readable form. The research process should strive to provide insights into each organization and look behind the polished image presented by the professional marketer.

Review

Once the implementation stage is complete and the initial strategy is in place, a regular review is essential. This process should reveal whether the aims of the strategy have been fulfilled and whether the strategy is still appropriate given changing market conditions and business needs. It should also determine what, if any, remedial steps need to be taken. If changes need to be made, the review process leads back to the strategy stage.

Very often, the initial strategy is relatively averse to risk, particularly if a company is in the early stages of growth. However, as assets grow and the surplus position improves, there may be scope for taking more risk, either by extending the maturity guidelines or diversifying into other asset classes. Similar strategic changes may also be stimulated by changes in fiscal policy, such as the U.S. Tax Reform Act of 1986, or as a result of new initiatives and ideas arising from changes in a company's personnel. In each case, there will be a need to revisit the strategy and consider further options.

Whether money management takes place externally or in-house, the performance of each portfolio should be carefully monitored. Investment returns should be measured on a consistent basis and compared against a suitable market proxy and other investment managers of similar portfolios. The range of maturity guidelines and portfolio discretion varies enormously. Consequently, it is necessary to subdivide the sample of offshore portfolio returns by explicit maturity constraints.

An investment manager will take responsibility for collecting portfolio information and calculating returns according to an accepted set of standards. He or she should also present the results in a concise, readable format and provide interpretive advice and comments. If the results are unsatisfactory, the investment manager can identify the reasons and help the risk manager decide if funds should be reallocated. The risk manager must bear in mind that performance results are highly time dependent and can be misleading.

An investment manager's strategy should be given reasonable time to ride out short-term interest rate trends. On the other hand, the time may come when a termination decision will have to be made. This decision should be based on qualitative factors, such as changes in business structure or personnel turnover, as well as the more obvious quantitative measures. The role of an investment manager should be to act as a risk manager's eyes and ears during his ongoing contact with the management community and provide the risk manager with information and opinions on any changes that take place.

To formulate and apply an effective investment policy in a demanding business environment is a challenge in itself. However, this policy will only remain effective if it is constantly monitored and adjusted as necessary. This critical task is administratively onerous, particularly if it begins to encroach on the time and resources needed to run the core of everyday business. In addition to providing the risk manager with support and direction in designing a suitable strategy, an investment manager is able to take on much of the ongoing burden and provide informed opinion to the risk manager. In the end, the investment manager should enable the risk manager to make investment decisions that provide continuity as a company's business needs change.
COPYRIGHT 1990 Risk Management Society Publishing, Inc.
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1990 Gale, Cengage Learning. All rights reserved.

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Title Annotation:insurance companies
Author:Stannard, John C.
Publication:Risk Management
Date:Feb 1, 1990
Words:1863
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