WAMIC, District 7 & 8 Conference March 30, 2017 Investment Hot Topics

Investment Hot Topics Insurance companies must accumulate a significant portfolio of invested assets in order to fulfill their current and future policyholder obligations. To ensure that these assets will be available to pay obligations as they come due, insurers must constantly consider the appropriate level of risk vs. return in their portfolios. While it is true that state insurance laws regulate an insurer’s investments and prescribe the types of investments permitted (generally by type and issue), the laws also allow for a fair amount of board/management discretion. This flexibility can lead to unintended (or even disastrous) consequences if the portfolio becomes overly concentrated in highly complex and/or illiquid investments.

The Investment Policy To ensure the appropriate level of risk vs. return, it is crucial for insurers to develop an investment strategy that clearly articulates the company’s investment goals and objectives. This strategy should be documented in a Board approved Investment Policy, which will serve as the foundation of the company’s investment program. Although the Investment Policy should be tailored to the needs of the Company, the following components are generally recommended:

Investment Policy: Recommended Components Investment Objectives: The Policy should clearly articulate the primary investment objectives (e.g. – long-term capital growth, desired return, risk tolerance) and any constraints (e.g. – liquidity, time horizon, regulatory/legal restrictions, taxes, etc.). Performance Evaluation: The Policy should articulate the metrics that will be used to evaluate the portfolio’s performance by asset class. Asset Allocation: The Policy should specify allowable asset classes (e.g. Cash/Short Term, U.S. Government Bonds, Investment Grade Corporate Bonds, U.S. Equities, etc.), and the allowable range (% of the total portfolio) for each class.

Investment Policy: Recommended Components Permitted/Prohibited Investments, Limitations: The Policy should clearly articulate permitted/prohibited classes (and types) of investments, and any limitations on permitted investments. IMPORTANT: It is recommended that the Policy incorporate a summary of the Wisconsin Investment Limitations (per Chapter 620 of the Wisconsin Statutes and s. Ins 6.20, Wis. Admin. Code) by appendix or reference.

Investment Policy: Recommended Components Investment Processes/Controls: The Policy should discuss the following processes, and controls over those processes: Investment Policy Review: The Board should review the Investment Policy at least annually, and should consider updating the policy to reflect any changes in risk tolerance, regulations, capital market expectations, etc. Trading: The Policy should articulate how trading activity will be monitored, and how any irregularities/unresolved issues should be addressed. Portfolio Rebalancing: On a periodic basis, management should review the portfolio market values to determine whether asset class allocations are within the specified limits. The Policy should articulate how any exceptions should be addressed.

Investment Policy: Recommended Components Investment Processes/Controls (Cont.): The Policy should discuss the following processes, and controls over those processes: Performance Evaluation: On a periodic basis (at least quarterly), the Board of Directors should review a listing of all transactions completed during the quarter, for compliance with the Investment Policy and the Wisconsin Statutes. The Board should also review the listing for any evidence of excessive trading activity, and should promptly investigate any unusual/excessive activity. On a periodic basis (at least annually), reports on the performance of the investment portfolio should be presented to the Board of Directors. The report should provide commentary as to whether the portfolio is in line with the investment guidelines and performance metrics (as prescribed by the Investment Policy).

Investment Policy: Recommended Components Cash Management: The Policy should discuss how ongoing cash needs will be monitored against available cash/short-term investments, and how any deficiencies will be rectified. Investment Roles and Responsibilities: The Policy should clearly articulate how investment functions are to be delegated, and the roles and responsibilities of the delegated parties (e.g. – Board of Directors, Management, Investment Manager, and Custodian).

Roles and Responsibilities: Board of Directors The Board of Directors is responsible for: Approving the Investment Policy (and annually reviewing the Investment Policy for appropriateness). Reviewing completed investment transactions (at least quarterly) for compliance with the guidelines/limitations set-forth in the Investment Policy and Wisconsin Statutes. Reviewing the performance of the Investment Portfolio (at least annually) against appropriate benchmarks (including the metrics prescribed by the Investment Policy). Approving agreements for the delegation of investment functions to third parties (e.g. Investment Managers/Advisors, Custodians, etc.). Periodically reviewing the agreements for vendor compliance/appropriateness.

Roles and Responsibilities: Management The company’s Management is responsible for: Monitoring compliance with the Company’s Investment Policy on ongoing basis, and reporting any deviations to the Board of Directors. Coordinating investment reporting to the Board of Directors on a quarterly basis. Performing due diligence reviews of potential third party vendors (e.g. Investment Managers/Advisors, Custodians, etc.) and recommending qualified third party vendors to the Board. Ongoing review of third party vendors for compliance with executed (Board approved) third party agreements.

Roles and Responsibilities: External Investment Advisors/Managers For many insurers, it might not be practical to maintain an investment management department (due to size, lack of internal expertise, etc.). If the Company chooses to delegate investment management activities to a third party, the duties and responsibilities the external Investment Advisors/ Managers should be clearly articulated within the Investment Advisory/Management Agreement, which should include the following recommended provisions:

Roles and Responsibilities: External Investment Advisors/Managers – Agreements – Recommended Provisions Services to be provided/Assignment: The Agreement should clearly specify the services to be provided by the Advisor/Manager, and should state that those services may not be assigned to another party without prior client consent. Fiduciary Responsibility: The Agreement should acknowledge whether or not the Advisor/Manager is serving as a fiduciary in advising the insurer. [This is an important legal distinction that may help to protect the insurer’s interests in the execution of the company’s investment strategy.] Investment Selection: The Agreement should set clear guidelines with respect to acceptable investments (including reference to the insurer’s Investment Policy and applicable state investment statutes).

Roles and Responsibilities: External Investment Advisors/Managers – Agreements – Recommended Provisions Level of Authority: The Agreement should clearly articulate the Advisor’s/Manager’s level of authority in executing transactions. There are two basic types of authority, defined as follows: Discretionary Authority: The Advisor/Manager assumes full authority in making and executing investment transactions without any obligation of prior notice to the Client or the Custodian. Non-discretionary Authority: The Advisor/Manager must seek Client approval prior to executing any transactions on behalf of the Company. It is important to note that regardless of the level of authority, the Advisor/ Manager is obligated to ensure that investment transactions entered into on behalf of the Client are suitable.

Roles and Responsibilities: External Investment Advisors/Managers – Agreements – Recommended Provisions Calculation of Fees: The Agreement should clearly articulate how the Investment Advisor’s/Manager’s fees are to be calculated. [Note: If the fee is based on the volume of transactions, the insurer should closely monitor the frequency of trades to avoid excessive fees.] Conflicts of Interest: The Agreement should clearly articulate the manner in which conflicts of interest (or potential conflicts of interest) should be addressed. [This is to ensure that Advisor/Manager biases resulting from business relationships will not interfere with the proper execution of the insurer’s investment strategy.]

Roles and Responsibilities: External Investment Advisors/Managers – Agreements – Recommended Provisions Performance Evaluation: The Agreement should clearly articulate how the Investment Advisor’s/Manager’s performance will be evaluated, including information to be provided to the insurer to aid in its review of the Advisor’s/Manager’s performance and execution of the company’s investment strategy. Termination: The Agreement should clearly articulate the process for termination of the Agreement by either party. Governing Law: The Agreement should stipulate which state law will govern interpretation of the Agreement in the event of dispute.

Roles and Responsibilities: Investment Custodian A Custodian is a bank or trust company that can act as an agent and exercise legal authority over the financial assets of its client companies. Custodians typically performs the following activities on behalf of their client companies: Safeguarding the Client’s invested assets. Settlement of investment transactions. Periodic reporting of investment activity/holdings to the Client. Tax compliance and reporting.

Custodial Agreements Chapter 610.23, Wis. Stats. Power to hold property in other than own name. Under Custodial or Trust Arrangements With a Bank or Banking & Trust Company In Bearer Form (instrument which is payable to whoever has possession). New issuances of bearer bonds were banned in the United States in 1982 and so very few of these exist any longer.

Custodial Agreements Required Wording for Town Mutuals INDEMNIFICATION: Notwithstanding any other provision of this Agreement, [TOWN MUTUAL CUSTODIAL BANK] is obligated to indemnify the Depositor for any loss of securities of the Depositor in [TOWN MUTUAL CUSTODIAL BANK]'s custody occasioned by the negligence or dishonesty of the officers or employees of [TOWN MUTUAL CUSTODIAL BANK] or any agent or subcustodian of [TOWN MUTUAL CUSTODIAL BANK], or burglary, robbery, holdup, theft, or mysterious disappearance, including loss by damage or destruction. In the event of a loss of the securities for which [TOWN MUTUAL CUSTODIAL BANK] is obligated to indemnify the Depositor, the securities shall be promptly replaced or the value of the securities and the value of any loss of rights or privileges resulting from said loss of securities shall be promptly replaced. NOTICE TO DEPOSITOR’S REGULATOR: If this Agreement has been terminated or if 100 percent of the assets of the Account have been withdrawn, [TOWN MUTUAL CUSTODIAL BANK] shall provide written notification, within three business days of termination or withdrawal, to the Depositor’s domiciliary commissioner. ACCESS TO RECORDS RELATED TO DEPOSITOR’S ACCOUNT: During regular business hours, and upon reasonable notice, an officer or employee of the Depositor, an independent accountant selected by the Depositor, or a representative of the Depositor’s domiciliary commissioner shall be entitled to examine, on the premises of [TOWN MUTUAL CUSTODIAL BANK], [TOWN MUTUAL CUSTODIAL BANK]’s records relating to securities, if [TOWN MUTUAL CUSTODIAL BANK] is given written instructions to that effect from an authorized officer of the Depositor.

Custodial Agreements Subcustodians Most banks don’t have a direct account with the Depository Trust Corporation and so must use a larger bank or broker as their custodian. If securities that are subject to a Custodial Agreement are held by one or more sub-custodians (another bank, broker, investment advisor, etc.): Custodial agreement should clearly identify the Custodian’s responsibilities for the securities held under custodial care. Specifically, the Custodial Agreement should state that the Custodian should indemnify the company for any loss of securities due to negligence or dishonesty of the officers or employees of the Custodian or any agent or subcustodian of the Custodian.