Designing Investment
Policy Statements
Policy and Practice
Andrew Baron, CFA
Head of Group Fixed Income, Butterfield Asset Management
Wes Carter
Director, Laurier Indemnity Limited
Introduction
Designing an Investment Policy Statement is the most
important initial step in the investment process for a
Captive
The structure of this policy is often given perfunctory
attention as something best left to either Investment
Managers or in the case of larger Captives, the
parent’s Corporate Treasury
This presentation will cover:
1. Why the document is important
2. What should be included in a good Investment Policy
3. Pitfalls and why Investment Managers fail to live up to expectations
4. Real-world examples of how to navigate your Board or Investment
Committee through the process
Why is an IPS Important?
1. Well-defined and well-written long-term objectives
ensure a Committee or Board understands the
nature of potential risk and its relationship with
return, liquidity or capital preservation goals
2. The IPS establishes roles and responsibilities in
decision-making
3. Setting asset allocation guidelines, both across and
within asset classes removes a degree of emotion
and behavioral issues that can lead the Captive
away from its long-term objective
Why is an IPS Important?
Global Bonds
T-Bills
S&P 500
Why is an IPS Important?
How to Start – Regulatory Requirements
1. Regulatory Guidance in Cayman Islands
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All Insurance companies are required to
investment strategy and an IPS that details:
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have
an
Asset allocation and any limitations on geography,
markets, sectors, counterparties or currencies
The “overall approach” to the selection of securities
“Details, where applicable, of any restrictions on
assets”
The scope for investment flexibility in active
management
BE AWARE – You are currently limited to 20% Equities
Exposure!
How to Start – Regulatory Requirements
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The Regulatory Guidance is minimal! – only 185
words cover the entire Investment Strategy section
of the CIMA Guidelines
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Asset allocation and any limitations on geography,
markets, sectors, counterparties or currencies
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The “overall approach” to the selection of securities
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Does not specify that any limits on any of those items are
either necessary or appropriate
Does not say “The Dartboard” is an invalid strategy
“Details, where applicable, of any restrictions on
assets”
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Does not specify any suggested restrictions
The Basics
Every Investment Policy Statement should have these
building blocks:
1. Purpose Statement/Introduction/Overview
2. Portfolio Goals and Objectives
3. Definition of Duties
4. Investment Strategy and Asset Allocation
5. Liquidity and Collateral Considerations
6. Monitoring and Review Procedures
7. Investment Limitations
1. Purpose Statement/Introduction/Overview
The purpose statement should include a broad
overview of the material and the reasons for creating
the document.
Example:
ABC Captive Limited is a Limited Liability Company
incorporated under the laws of the Cayman Islands
and regulated by the Cayman Islands Monetary
Authority. This document outlines and determines the
investment policies, goals and limitations of ABC
Captive Ltd and clearly establishes the roles and
responsibilities of each relevant party in the
investment process.
2. Portfolio Goals and Objectives
Goal Setting gives all responsible parties a clear idea
of what is expected in terms of investment returns and
risk tolerance
This section should include both a statement on:
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A return Objective
A specific risk tolerance
Return Objective
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Should state specifically what the primary objective is for investing:
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Principal Preservation
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Liquidity
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Growth
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A numerical target, based on actuarial data
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A target at or above inflation
Risk Tolerance
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Must recognize the existence of market risks in the investment
portfolio
Should also make clear what the priorities are in terms of:
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Volatility (can range between “don’t care” and “Low”
Liquidity
Asset Quality
Diversification
Within this section, some mention can be given to the
following other items:
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Any specified and regular liquidity needs
The Time Horizon of the investment portfolio (nearly always “long)
The existence of taxes, whether things like withholding tax should be
avoided, the Captive files as 953d, no Canadian Source Income, etc
Other unique circumstances (green, ethical, etc)
Example
The objectives under this Mandate are to maximize the rate of return on
invested assets (Total Return Objective) subject to constraints described
herein.
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To grow capital in order to improve the Company's competitive
position and allow for expansion of operations. Stability and growth
of investment income is viewed as critical to assuring a high
probability of success.
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To ensure sufficient cash flow and liquidity to support the Company's
operations. The Investment Committee recognizes the need for
flexibility to manage assets to improve investment returns; however,
it also sees benefits from lowering the risk of forced asset sales in
the event of suddenly adverse market conditions.
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Subject to achieving the first two objectives, pursue favorable riskadjusted, total returns in order to enhance the Company's
competitive position.
This Mandate will be managed using an active management focus, so
liquidity and trade execution are important considerations.
3. Definition of Duties
At a minimum, each of the relevant parties that has
some responsibility for the IPS should be identified
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The Board of the Captive
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Has ultimate Fiduciary responsibility for the Captive company
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If there are employees of the Captive Manager on the Board
of the company, they should know and recognize that they
have a fiduciary responsibility in this regard.
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Should state whether monitoring the compliance to the IPS is
the responsibility of an Investment Committee or the Board
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Investment Committee
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Common in Captive governance, but not required
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Usually responsible for recommending investment strategies,
service providers, brokers, custodians, etc to the full Board
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Investment Managers
Investment Consultants
Custodian
Actuarial provider – may have an effect on Investment Policy
4. Investment Strategy and Asset Allocation
The Importance of Investment Philosophy
Ideally, an Investment Committee will have done some
research into what they believe is achievable in the
portfolio and how to reach their goals
There are a few different ways to articulate this
“Investment Philosophy”
Although it can be incorporated into the section that
details what the investment strategy and asset
allocation will be, thought should be given to whether
a separate statement/paragraph could be useful
This is an idea that is incorporated LEAST in Captive
IPS (and indeed in other types of institutional clients)
The Importance of Investment Philosophy
Items that can be covered include:
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Whether costs are important
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Whether inflation is a concern
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Whether any contrarian views are desired
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The purpose of inclusion of Alternative asset classes
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Whether Active Management is desired or if there is a belief that an
active manager can add value
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Whether any tactical shifts in asset allocation are going to be
employed and who is responsible for those decisions
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Whether equities should have any inherent size bias (small, medium,
large-cap
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Whether equities should any kind of style tilt (Value, dividends, etc)
Step 1 - Define Allowable Asset Classes
• “Equities” and “Bonds” is not an asset allocation
• Specifically set the type of assets that are allowable,
unless you want a “go anywhere” global manager
• Set a strategic allocation that makes sense in the
context of the objectives of the Captive – attempt to
incorporate a forward Capital Markets assumption
• Be Realistic
• Set allowable ranges for the strategic or tactical
allocation – this avoids the possibility of getting overemotional and potentially acting without an
Investment Committee vote
Step 2 - Define Allowable Allocations
Example
Asset Class
Minimum %
Target %
Maximum %
Global Equity
10%
15%
20%
Commodities
5%
8%
11%
Total Risk Assets
15%
23%
31%
High Yield Debt
5%
8%
11%
EM Debt
5%
8%
11%
Global Investment
Grade Fixed Income
42%
50%
58%
US TIPS
7%
11%
15%
Cash/Short Duration
0%
0%
16%
Total debt Instruments
69%
77%
95%
Step 3 - Define Proper Benchmarks
Define expectations
benchmarks
clearly
and
use
appropriate
Pitfalls include:
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Asking a manager who shows a track record in S&P 500 stocks to
manage a global portfolio
Choosing benchmarks that are popular, but don’t reflect the
composition of the portfolio or the investment philosophy
Example
Captive YYZ gives a mandate to Super-Alpha Advisors to manage a
balanced portfolio. The Chairman’s Brother in-Law is an investment
manager who says everyone nowadays uses the MSCI World Index
as a benchmark, so the MSCI World Index is used in the IPS. No one
in the Committee discusses the fact that the MSCI World Index is the
total world equity market, including Emerging Markets. In fact,
Super-Alpha Advisors is a specialist asset manager that has beaten
the S&P 500 over the last 7 years using a high dividend, value
strategy.
5. Liquidity and Collateral Considerations
Captive Companies often have specific collateral needs
based on an LOC or Collateral Trust Program
Be sure that you IPS directly addresses the collateral
needs and limitations and take care to avoid conflicts
between the IPS and externally controlled restrictions
that may severely limit the ability to take incremental
risk and earn a rate of return that is acceptable
6. Monitoring and Review Procedures
Review
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The IPS should not be static, the document itself
should be formally reviewed on an annual basis – it
is meant to be a document that is portable in the
instance that Committee members change or
service providers change and should be updated in
light of market developments in some instances
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Set a timeframe for formal review of the document
and include all relevant parties, including your
investment manager
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Review procedures is one area that CIMA does have
guidance on. Sections 6 and 7 of the Statement of
Guidance provide good guideposts for review
procedures
Review
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The periodic reviews procedures should also state
how professional managers hired on behalf of the
portfolio will be judged and what procedures can be
implemented in the event a manager needs to be
replaced
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Detail Index measurements and time frames
Repeat any specific numerical goals
State whether peer groups matter and over what
time frame
Clearly state the time-frame
Specify a reporting frequency requirement
7. Investment Limitations
Investment Limitations
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Many Captives spend a great deal of time on this
section, which says little about the investment
goals of the company
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Limitations should be reasonable in the context of
the goals and care should be taken not to create
either an incentive structure that encourages risk
taking, nor one that is over-conservative for the
circumstances
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In general, this section tends to be heavily used for
defining specific limitations on credit quality,
concentration and interest rate risk
Investment Limitations
A Word on Credit Ratings Agencies
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Reliance on Credit ratings agencies, or NRSRO’s as they are termed,
should be limited to whatever degree possible within collateral
requirements
Post-2008, many assumed that the credibility of the agencies (like
S&P and Moody’s) was completely broken and agreed that there had
to be a better way to quantify credit risk – little has been done
The agencies are slow to recognize problems when there is
deterioration and equally slow to improve their opinions – the
markets do this for them through price
Be absolutely certain that if you have to include a threshold for
ratings, that it is applied consistently in the IPS, the benchmark you
use is appropriate and that the Investment Manager and the
Committee agree on the scope for outperformance
If your manager uses credit products, understand what they plan to
use and understand how they manage credit risk and analyze
securities – this is the best way to protect yourself – it cannot be
outsourced to a rating agency
Investment Limitations
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If possible, state specifically what instruments are
allowable, rather than a long list of what is not
allowable (except a prohibition on derivative
instruments, which should be stated)
Example – Permitted Fixed Income Securities
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Government and Government Agency Securities, excluding mortgage
derivative securities whose underlying collateral is in the form of
mortgages or mortgage backed securities.
Supranational agencies and international development banks.
Sovereign Country debt, issued in US dollars
State and Municipal debt
Corporate Bonds, including convertible bonds and bonds with
warrants
Mortgage Backed Securities, who’s underlying collateral is in the form
of U.S. Agency mortgages
Pooled short-term Money Market funds
Exchange-Traded Funds listed on recognized global stock exchanges
Investment Limitations
Example – Restrictions and Limitations
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For diversification purposes, the maximum investment in any single
issue is 5% and funds invested in any one issuer shall not exceed
5% of total invested assets
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No purchases are permitted for individual fixed income assets with
Standard & Poor's (or Moody’s equivalent) rating of below BBB-. To
the extent the credit rating of a previously purchased fixed income
asset falls below BBB-, it is not required that the asset be sold;
however, the Company is to be immediately notified. In addition,
updates on the financial condition of the credit are to be given to the
Company, in writing, on a regular basis.
CASE STUDIES
Case Study - CFA Institute IPS
One might expect an industry body tasked with promoting best practice in
the Investment Management industry to have a decent IPS document and
they do
Purpose
The purpose of the portfolio is clearly laid out, with special mention made of
the process by which the company models their targeted reserve levels –
very similar to how a Captive, through internal forecasting and modeling, or
with the use of an outside consultant, can measure the liability structure of
the Captive and predict insured losses.
Investment Objectives
The three return goals, in order of importance are clearly laid out, with
emphasis given to properly balancing the needs – included is a mention of
preserving the purchasing power of the portfolio
Captives rarely recognize the importance or even the existence of inflation in
the return objectives
Case Study - CFA Institute IPS
Investment Objectives, Continued
The existence of market risk is recognized and a commitment to a specific
portion of the capital markets is made (determination of how this is measured
can be left to later in the document):
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Moderate Volatility
Highly liquid
High quality
Asset Allocation
Very clearly lays out the investment philosophy within the asset allocation
section of the document:
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Committed to Global investing for both return and diversification purposes
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Committed to equities investing for long-term capital growth
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Committed to the higher quality portion of fixed income investments for
volatility purposes
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Committed to using inflation-protected securities
Case Study - CFA Institute IPS
Asset Allocation, Continued
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Committed to diversification of asset classes by adding specific examples
(REITs, EM Debt, Commodities)
Committed to some degree of dynamic or tactical asset allocation
Committed to specific currency exposure
Investment Management Strategy
Here, the IPS makes clear its views on investment vehicles and the potential
to produce excess return through dynamic asset allocation
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Specifically mentions the existence, usefulness and economy of passive
mutual funds
Case Study - CFA Institute IPS
Asset Class
Minimum %
Target %
Maximum %
Global Equity
36%
41%
46%
Commodities
5%
8%
11%
Global REITs
5%
8%
11%
EM Debt
5%
8%
11%
Opportunity Fund
0%
0%
5%
Total Risk Assets
60%
65%
70%
Global Fixed Income
18%
23%
28%
US TIPS
9%
12%
15%
Cash/Short Duration
0%
0%
10%
Total Safe Assets
30%
35%
40%
Case Study - CFA Institute IPS
Evaluation and Monitoring of Investment Managers
The selection of managers, including passive strategies is laid out in detail
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“At a basic level, any active manager hired should exhibit skill”
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Qualitative factors are clearly laid out
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Fee levels are important
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Past Performance should be evaluated on a risk-adjusted basis
(important philosophical point)
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Manager incentives considered (organizational structure)
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Specific attributes are included
What this IPS does not say:
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It does not say that the manager needs to be a global giant
It does not say that the manager needs to beat the index every year
It does not set benchmarks arbitrarily and ask managers to compare
themselves against unattainable benchmarks
Lastly, it does not have any credit ratings restrictions
Case Study – Captive XYZ
IPS is from an actual client of Butterfield Asset Management
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Biggest problem - Existence of contradictory restrictions within the IPS
 The index construction is allowed to contain issuers with an “A”
rating by one of the agencies, but the portfolio is restricted to
“Aa3/AA-” or better – the manager cannot replicate the index, even
if he desired to do so
 Index has a plethora of Canadian issuers and the IPS bars the
portfolio from Canadian issuers
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All securities and issuers must be within a narrowly defined Index,
making the investable universe is too small
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Allocation is overly conservative and does not recognize the existence of
inflation
 The loss history of the Captive is close to zero in 6 years of
management, yet the portfolio is 25% cash
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Lastly, these points come up at least annually and they ignore the
advice of people they pay to give them advice