The compliance factor

Risk & Insurance, May, 2003 by Dan Whitcomb

Compliance is a critical issue in the choice of any investment firm to manage your portfolio if you're an insurance company. Every prospective investment manager must be able to monitor compliance with your investment guidelines and government regulations. Insurance companies are subject to a host of regulations in addition to those of the individual investor making the quality and effectiveness of an ongoing compliance program even more important in the decision to hire an asset manager.

An investment manager should provide an automated guidance compliance system. A periodic, manual check of the investment portfolio against specific, written guidelines will not provide sufficient protection from portfolio violations.

The investment manager should be able to screen prospective trades in an account in real time. The compliance system should screen pretrade, so that any trade violating investment guidelines is automatically rejected from your account. Another screening should occur post-trade to ensure that if any attributes of the security change, such as a ratings downgrade, changes are caught quickly.

In addition to real-time guideline checks against specific transactions, the portfolio should be subject to daily, automatic guideline checks on the entire account. In the event that the market value of your securities changes significantly, one of your guidelines might be violated during the course of a day, such as a maximum percentage of market value allowed in below investment-grade bonds. You want to be sure the compliance department of your investment manager is capable of identifying these changes on a daily basis.

Tracking Ratings and Restrictions

The compliance department should be able to monitor adherence to a number of specific guidelines that pertain to the insurance industry. How well can the manager track nationally recognized statistical rating organizations such as Moody's, S&P and NAIC ratings? While most managers can actively track ratings, the ability to track NAIC ratings on a real-time basis can be more difficult. Managers want to see a tracking system that can identify current rating information and filing status of all securities in the portfolio. This allows a manager to comply with insurance guidelines that are stated in NAIC numeric ratings. This is important because most statutory investment guidelines are stated in NAIC ratings.

Other guideline considerations include restrictions on securities in regard to quality, maturity and duration, as well as certain security types such as Rule 144A, municipal bonds, convertible bonds and preferred stocks. For insurance companies in particular, tracking where your portfolio stands in relation to any constraints on capital gains and losses is imperative. Is the manager accurately accounting for gains and losses and monitoring them according to the levels you agreed upon? All of these checks should be automated to reduce the risk of human error in the portfolio.

Automation and Oversight

Another question to ask is, how are these guidelines automated and monitored? Is there one person whose sole responsibility is to monitor compliance in managed accounts? This person should be involved in daily and monthly guideline checks, guideline updates and should be available to respond to any of your compliance questions immediately. Meet this person before the firm is chosen to handle the account.

To help the investment manager achieve the most effective compliance possible, the insurance company should write comprehensive and realistic guidelines. The guidelines must be tailored to meet compliance with appropriate state insurance regulations. The guidelines should specify the kinds of securities that the company doesn't want purchased in the portfolio. Those restrictions should be discussed with the portfolio manager. Effective compliance begins with a complete set of guidelines. And, after the investment manager is hired, it's necessary to talk regularly with the compliance manager to update guidelines.

For insurance companies, strong compliance can be an essential link in determining how effectively and efficiently your portfolio is managed.

Dan Whitcomb is a compliance manager with Standish Mellon Asset Management.