Sara Hakim, Callan
17 September 2019

Captive governance and the investment portfolio

Over the past few years, there has been a shift in the captive insurance industry from informal, passive boards that meet annually, to more formal, active boards meeting multiple times a year. This shift stems from the industry’s growth, which has made serving on a captive board more complex. The journey of captive board governance has been long, but more captive boards are embracing best practices regarding board governance and education as they evolve, mature, and grow.

“As investment income becomes a bigger contributor to captive insurance portfolios, adopting a more rigorous and documented framework will become a best practice within the captive industry.”

For captive boards, the governance focus is on board membership and diversity, internal controls, service provider accountability, board meeting guidelines, and communications, to name a few. With the captive investment portfolio, the focus is on investment beliefs, objectives, and constraints; the asset mix; the manager structure; performance; policy guidelines and statements; and overall fees. Both require an understanding of fiduciary oversight and how it is applied.

Educating captive boards
To educate captive boards about their investments, we address the gap between the governance standards and principles for the board and the similar standards and principles for the captive investment portfolio.

Figure 1 is an institutional governance framework depicting a methodology that guides institutional investors building investment portfolios. Institutional investors have followed this model for many years and it is considered a best practice.

Many medium to large-sized captive pools would benefit from this framework. Although it will require more time and involvement from the captive board or its committees, if they do not use the framework this could negatively impact the performance of the total investment portfolio and protection of the insurance assets. Let us review each step of the framework.

Figure 1: Best practice institutional captive governance model

Step 1: investment objectives
The first step of managing any portfolio is to understand the investment beliefs, objectives, and constraints. The investment beliefs documents the philosophy of the captive board with respect to the investment portfolio. The objectives address the risk tolerance and expected return.

The constraints address liquidity, time horizon, taxes, regulations, and anything else unique to the captive portfolio. The results are incorporated into the investment policy statement—an important governance document that is communicated to applicable stakeholders and reviewed periodically.

Step 2: asset-liability modelling
Asset-liability modelling is key to developing the strategic asset allocation (SAA). The modelling includes thousands of scenarios using capital market projections, the premium cash flows, and the captive’s liabilities. Its output produces an array of portfolios. The asset allocation process determines the optimal mix of a portfolio among broad asset classes based upon the investment beliefs, objectives, and constraints identified in step 1.

Step 3: strategic asset mix
The SAA becomes the baseline for the portfolio and the investment structure and manager selection steps. In many cases, captives begin with step 5 (manager research and selection) without completing previous steps. This puts the captive investment portfolio at risk since the due diligence was not completed before constructing the portfolio.

Skipping these steps leaves critical questions unanswered, such as which manager to select, whether it should be active or passive, how much of the allocation the manager should receive and how many managers the captive should hire. The SAA is included in the investment policy statement and identifies appropriate performance benchmarks which will be used in a later step.

Step 4: investment manager structure
After the asset mix is identified, the investment manager structure addresses the questions raised above and helps the captive board make rational decisions on how many managers it needs to hire, which are active or passive, and how large each mandate will be.

Step 5: manager research and selection
This is one of the most important steps in the institutional framework. The captive board can now conduct its asset class searches and follow a due diligence process that selects the most optimal manager for each mandate. The rigour used in this step helps protect captive boards when choosing managers.

Institutional asset managers are hired based on criteria such as their process, philosophy, performance, people, and fees. As the captive industry continues to evolve, we anticipate more captive boards adopting the due diligence involved in this step.

Step 6: investment performance monitoring
The final step is performance and fee monitoring. Performance reviews can be quarterly and semi-annual at a minimum. This is an important step as manager performance is compared on an after-fee basis against the benchmarks and peer groups approved by the board during the selection process. A dashboard can be used to provide an executive summary of each manager’s performance.

A governance framework: the captive board’s fiduciary responsibility
As investment income becomes a bigger contributor to captive insurance portfolios, adopting a more rigorous and documented framework will become a best practice within the captive industry. We see captive pools of $100 million or greater considering adopting this methodology, and we believe they would benefit from the due diligence process.

By adopting this framework, the board is protecting itself by completing its fiduciary responsibility in how it selects and monitors asset managers. The process is well documented and transparent, and can be shared with shareholders (for a risk retention group), the parent (for a single captive), or other stakeholders.

Who should guide the board in applying this framework? Does the asset manager act as the adviser? Does the captive manager provide the investment expertise or make recommendations on which asset managers to hire? Unfortunately, the answer is no.

The board should seek professional, fiduciary guidance from an independent institutional investment consultant. The investment consultant acts in the sole best interest of the client in a prudent fashion. In addition to the board’s actuary, auditor, and lawyer, it would now have a professional investment consultant on its team.

Sara Hakim is a senior vice president at the investment consultant firm Callan. She can be contacted at:  hakim@callan.com.