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Prudent Person Principle
Investment & Solvency II
© 2015 Towers Watson. All rights reserved.
Agenda
1. Definition
2. Regulation
3. Issues arising
4. Things to consider
5. Asset governance
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2
Prudent Person Principle
A definition….
“A legal rule requiring investment advisers to only make investments for their clients' that a "prudent person" would make…..It does not require that the investment adviser always make correct decisions; it merely requires him/her to make decisions that will be generally accepted as sound for someone of average intelligence……stating that trustees must manage the affairs of others as if they were managing "their own affairs."
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3
Regulation
Solvency II Directive
Delegated Regulation
Guidelines
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4
Regulation
Article 132 of Solvency II Directive
“…properly identify, measure, monitor, manage, control and report….”
“…ensure security, quality, liquidity and profitability…..availability”
“…linked…close matching”
“…best interest of policyholders” [Conflict of interest]
“derivatives…reduction of risk…efficient portfolio management”
“…not admitted to trading on regulated markets kept to prudent levels…”
“…properly diversified….”
“…excessive concentration….”
“Member States can restrict….”
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5
Regulation
EIOPA Guidelines on System of Governance 25-30
Investment risk management
Assessment of non routine investment activities
Unit linked and index linked contracts
Not admitted for trading on regulated financial market
Derivatives and Securitised Investments
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6
Assessment of Investment Risk Management
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7
“well structured,
disciplined and
transparent”
“duty to protect
policyholders and
beneficiaries interest”
Assessment of Non Routine Investment Activities
Ability to perform/manage Risks specifically related Consistency with
policyholders/beneficiaries interests and liabilities
Impact on quality, security, liquidity, profitability
Inform AMSB New ORSA
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Security, Quality, Liquidity, Profitability of Portfolio
Overall basis
Liability constraints
Consistency with risk appetite
Characteristics of the asset
Events that could change characteristic
Issues relating to localisation and availability of assets
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9
Unit linked and index linked contracts
Best interest of policyholders and beneficiaries and disclosed objectives
Liquidity
Interests of remaining unitholders
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10
Assets not admitted for trading/Derivatives
Implement, manage, monitor,
control procedures in
relation to investments not
admitted to trading or
complex products
Mark to market = Risk Function
sign off on modelBack up models
Should show how derivatives
enhance portfolio not create
additional risks
Where used in unit linked funds,
additional enhancements in place to protect policyholders
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11
Issues Arising
• Principles rather than rules
• Raising the bar
• Complex products
• Structured products
• Independent expertise
• “Look through”
• Portfolio Bonds
• Mandates
• New asset classes
• Legal risks
• Derivatives
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12
If you don’t understand it…..
….don’t invest in it!
To consider
• Independent investment expertise
• Review processes, procedures, controls
• Clear policyholder literature
• Communication (type/frequency)
• Solvency I rules
• UCITS rules
• Diversification
• Documentation
• PRIIPS
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13
Talk to Joe
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14
Plato’s account of the trial of Socrates (Translated by Benjamin Jowett.)
© 2015 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
15
towerswatson.com
πρὸς ἐμαυτὸν δ᾽ οὖν ἀπιὼν ἐλογιζόμην ὅτι τούτου μὲν τοῦ
ἀνθρώπου ἐγὼ σοφώτερός εἰμι· κινδυνεύει μὲν γὰρ ἡμῶν
οὐδέτερος οὐδὲν καλὸν κἀγαθὸν εἰδέναι, ἀλλ᾽ οὗτος μὲν
οἴεταί τι εἰδέναι οὐκ εἰδώς, ἐγὼ δέ, ὥσπερ οὖν οὐκ οἶδα,
οὐδὲ οἴομαι· ἔοικα γοῦν τούτου γε σμικρῷ τινι αὐτῷ τούτῳ
σοφώτερος εἶναι, ὅτι ἃ μὴ οἶδα οὐδὲ οἴομαι εἰδέναι.
I am wiser than this man, for neither of us appears to
know anything great and good; but he fancies he knows
something, although he knows nothing; whereas I, as I
do not know anything, so I do not fancy I do. In this
trifling particular, then, I appear to be wiser than he,
because I do not fancy I know what I do not know.
Wisest is he who knows he knows nothing
How TW provides consulting to insurers
towerswatson.com
16
© 2015 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
P/C insurance 350 professionals
RCS software75 professionals
Life insurance350 professionals
Insurance Mgmt consulting25 professionals
TW EMEA Risk Consulting & SoftwareTW Global Investment
Investment research230 professionals
Client Consulting400 professionals
850 people worldwide490 in Europe
Investment strategy150 professionals
Insurance and
Investment team
for
insurers
Risk team Capital mgmt Inv functionBoard
Inv. model
solutions
Investment
strategy
Insurance
capabilities
Investment
governance
Implement
efficiently
CRO CEO CFO CIOFIA
Governance & Organisational design
© 2015 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
17
towerswatson.com
Mission and goals
Beliefs
Organisational
Design
Value chain
Culture
and
leadership
Talent and
reward
Frameworks
Manager
line-up
Portfolio optimisation:
strategy, asset
allocation, risk
Execution
Strategic Principles Enablers Investment Policy
Bonds and
derivatives
Return-
seeking (&
alternative)
assets
Monitoring
Bond manager
selection advice
Manager selection
- hedge funds
Manager monitor /
access to Dream
(TW’s manager
research
database)
Smart Beta
manager selection
Manager selection
- Smart Beta
Asset manager
fee review
Independent
opinion of
derivative
strategies
Manager selection
– equity
Implementation of
Interest rate/
inflation/credit/
extreme risk
hedging
Manager selection
–private markets
Portfolio
construction
Modelling
solution
Model
validation /
calibration
Full asset
allocation review
STAR model Model validation
Partial or ‘flash’
asset allocation
review (eg fixed
income only)
SAA tool Model / quantify
market / credit
risk
Smart Beta /
hedge fund
portfolio
construction
Consulting
support linked
to model
Dynamic asset
allocation
Risk Agility EC
and C-ALM
(MoSes)
Implementing portfolio
solutions
Improving inv. risk
management and
governance
Maximising
risk-adjusted returns
Risk
Management
Governance
Stochastic ALM to
articulate
the risk budget
Review capability of
Internal asset manager
Economic scenario /
extreme risk analysis
Investment
beliefs/objective
workshop
Investment Health
Check
Review investment
decision making
structure
Liquidity management
process and scenarios
Board and Executive
training
Operational Due
Diligence
ALM governance and
processes
© 2015 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.towerswatson.com
18
A selection of recent investment projects
The issue with screening for past performance
0
500
1000
1500
2000
2500
3000
Skilled Mediocre Bad
Number of managers
Good performers Not good performers
Source: Penfold, Robin. “Do not hire managers for past performance” Towers Watson Limited, 2011
Narrowing the universe
© 2015 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.towerswatson.com
19
..c
om
pe
titi
ve
ad
va
nta
ge
Towers Watson manager research framework…S
us
tain
ab
ilit
y o
f..
Investment professionals
Approach/insight generation
Portfolio management
Firm and team stability
Opportunity set
Alignment
• Is the opportunity set large enough for the manager to exploit effectively given
their particular process?
• How might this change over time?
• How does the manager think about capacity?
• Is there evidence of competitive advantage in the way a team generates
investment ideas?
• Is the philosophy compelling and consistent with the resources and skill set
available?
• Is there evidence that both the firm’s and the key investment professionals’
interests are aligned with those of clients via well structured performance fees
and co-investment?
• Is the product’s fee too high?
• What are historical levels of personnel turnover and corporate activity?
• Looking forward, what is the culture and what mechanisms do they have in
place to help retain people?
• How effectively does the manager convert ideas into portfolios?
• Does the manager think enough about risk and overall portfolio construction?
• What is the calibre of key people?
• Do they exhibit the traits of great investors?
• Are resource levels sufficient?
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20
‘Skill thesis’’ is a detailed (19
pages for this EM equity
manager) written document
explaining in full the rationale
for a manager rating.
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21
ABCFund ManagersEmerging market equities ‒ Emerging Market Equity
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22
Skill summary
Executive summary
We have a positive view on ABCFund Managers' (ABC) Global Emerging Markets (GEM) team and product. Key strengths are the team's deep belief in its investment philosophy and process, as well
as the team's willingness to look further than many peers for ideas. We are, however, conscious of the broader team's limited experience relative to some peers and the relatively short time it has been
running this strategy for (since 2008). Also, whilst we believe there are some issues from ABC being a publicly listed firm, there is material alignment of interests through employee ownership
(approximately 30% of the business), co-investment and performance related fees.
Success factors Strengths Weaknesses or issues
Investment
professionals
The strategy's Portfolio Manager XX YY and Co-Portfolio Manager WW
ZZ appear to be insightful and pragmatic investors
The investment team appears to have a strong investment culture and be
motivated to succeed
The analyst team is less experienced than that of some peers in this space, though this is
somewhat mitigated by its access to broader firm resources, including the new global equity team
Potential for lack of challenge to XX
As the product gains traction with investors, there may be increased distractions for marketing
purposes for XX and ZZ, although the firm is partly addressing this by increasing its client
servicing resources
Approach/insight
generation
There is an apparent deep belief in and adherence to the investment
philosophy and process
The GEM team will be leveraging the house research base for inputs into
its analysis (for example, for views on commodities prices)
South African base may give local insight
Assessment of environmental, social and corporate governance (ESG) risks appears to lack
rigour
Portfolio
management
Strong thinking on portfolio management and risk control from XX
Ability and willingness to invest up to 25% of the portfolio in developed
market-listed companies with significant exposure to emerging markets
Structural style bias and benchmark agnostic portfolio (50-60 stocks with small-/mid-cap bias) will
provide, at times, volatile returns relative to a market index
Some evidence of shareholder engagement, but largely limited to voting proxy shares
Firm and team
stability
Long-term focus on asset management business
Profitability and diversity of local business
Unclear plans for accepting senior investors into the managing partnership
The business has a concentration in South African equity products
The firm's development of a global equity product has the potential to create a distraction for the
team
Opportunity set Ability and willingness to look further for ideas than many peers The team's investment philosophy leads to significant numbers of stocks being discarded at the
start of the process and opportunities are potentially missed
The strategy's capacity target seems somewhat high, and discipline in management of capacity
has been questionable in South African strategies. However we believe capacity issues are not a
major concern at the current level of assets under management
Alignment Strong processes in place to improve alignment of interests, including
employee share ownership and co-investment in ABC’s internal funds
Significant percentage of asset base on performance-based fees
Willingness to invest materially in new product launches, ahead of having
asset growth
Being a publicly listed firm may bring some external pressures to the business, although the
management team is focused on minimising this and the firm's employees are the largest (around
30%) shareholder group
Equity ownership offers limited direct alignment to the success of the Emerging Markets product,
given the strategy's small size relative to the firm's South African business
Co-investment in the GEM strategy is limited due to local tax regulations
Skill 1
Expected deviation Absolute return
Soft risk Average
Key: Significant strength Strength Neutral Weakness
UVWXEmerging Markets Equity
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23
Investment professionals
1 Primary professional
experience
26 years industry experience
2 Portfolio manager
experience
26 years industry experience
3 Analysts experience 18 years industry experience
4 Primary professional
tenure
20 years on the product
5 Portfolio manager
tenure
21 years at the firm
Approach/insight generation
6 Three year returns 1.5%pa net relative return, 0.25 net information ratio
7 Five year returns 6.2%pa net relative return, 0.83 net information ratio
8 Seven year returns 3.8%pa net relative return, 0.42 net information ratio
Portfolio management
9 Downside protection 0.13 Calmar Ratio over last seven years
(Percentile: 92.9 in a universe of 183 products)
10 Risk level 7.5%pa tracking error over last five years
11 Portfolio turnover 28.9%pa
12 Active share 83% versus MSCI EM-ND
Source: eVestment
Firm and team stability
13 Firm asset growth 19% growth rate over the last year
14 Product asset growth 9% growth rate over the last two years
15 Portfolio manager
turnover
0 known gains, 0 known losses over the last three
years
16 Analysts turnover 18% gains, 0% losses over the last three years
Opportunity set
17 Manager asset class
capacity
49,832 million USD in active equities
(Percentile: 91 in a universe of 721 managers)
18 Product capacity 411 million USD per stock
(Percentile: 99 in a universe of 134 products)
Alignment
19 Significance of
product to firm
61.9% of firm assets in product
20 Ownership 0.0% employee ownership
21 Manager alpha share 38% of alpha assuming a 95.0 bp fee
Notes: The performance used in factors 6 to 10 and 21 is for the Emerging Markets Equity ‒ SA vehicle. Returns are in USD. Benchmark is FTSE All-World All Emerging.
* The universe displayed is the Towers Watson Snapshot analysis for all active long-only equity products with at least 10 factors calculated as at 31 March 2015 (5,022 products).First quartile = Below lower quartile, Second quartile = Lower quartile to median, Third quartile = Median to upper quartile, Fourth quartile = Above upper quartile
5th percentile Lower quartile Median Upper quartile 95th percentile
Key: Strength Neutral Weakness Not rated Product score
Snapshot as at 31 March 2015
First quartile versus equity universe*
Operational Due Diligence
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24
Internal & external fund governance
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Joseph O’Dea
Senior Investment Consultant
joseph.o’[email protected]
Colin Murray
Senior Consulting Actuary