With the rising number of cases concerning fund manager misbehaviour in the United States and Canada, the regulation and formal monitoring of segregated funds are subject to increased scrutiny from government, investors and industry participants. As a result, many insurers are stepping up to the plate with strict self-monitoring programs.
The movement to better monitor segregated funds gained steam with the late-trading episodes that took place in 2000.
First, a glitch in the valuation system at Standard Life led to the firm firing 13 employees and paying out half a million dollars to its unit-holders. The employees had found a flaw in the pricing mechanism of two of the company’s segregated funds, and profited from the defect (time zone difference).
Standard Life was able to catch employees through its internal compliance monitoring, it reimbursed the entire fund and in turn fixed its trading system, says Suzy Davidkhanian, a company spokesperson. In turn, the insurer eliminated the time difference between the closing of markets in Europe and the posting of those unit values in Canada.
In the same year, Transamerica Life Canada encountered a similar problem. A group of its employees exploited a flaw in the valuation method in one of the technology funds. Based on the six-hour time difference between Toronto and Luxembourg, where the fund was administered, employees would make late day trades in Toronto.
Taking heed from these insurers, Manulife Financial, Great-West Life and Maritime Life today all have specific segregated fund monitoring programs in place, none of which are part of a regulatory requirement.
Manulife’s Investment Watch – also known as i-Watch – began over two years ago, but Catherine Owens, vice-president of investment management services explains that in the past year it has become more of a formal process.
“i-Watch is just as the name says; we are watching our investments within our product offering for all of our consumers.” She adds the program is a spin-off of the original concept that began in the insurer’s Boston operation.
Ms. Owens explains that the program has expanded to include its retail segregated funds, but more recently this fall, it included all its life insurance products since it has money management products within its universal life products.
The insurer also does a quantitative review of the funds and fund managers and conducts high-level screening. “Where we may be a little different in the marketplace is that we don’t just look at performance, we also look at the quality of the firm we are dealing with,” Ms. Owens remarks.
To do this, Ms. Owens along with a team of five analysts make up Manulife’s Investment Review Committee. The full-time job of this division is to monitor the funds and managers on a monthly basis. “We evaluate every manager,” she adds. “Even though it is not a regulatory requirement we feel that it is prudent to do due diligence on managers.”
With the market volatility it has also become very common for fund mangers to merge two segregated funds together, which can often raise red flags. Ms. Owens assures that this is also closely watched. “If funds are merged and it has the potential to impact our investors then it goes through a due diligence process. If companies merge, then we actually meet with the merged companies and evaluate the impact.”
Whether more regulation is needed on the segregated fund side, Ms. Owens briefly answers that it is a topic among all regulators and insurers and if there are going to be any changes, they should be made collectively based on the opinions of the whole industry.
Alf Goodall, vice-president of marketing, individual retirement and investment services at Great-West, explains that the insurer has a very formal fund governance review process. “We have a fiduciary responsibility that comes with managing money…we have a committee of 12 to 15 people that represent both our individual and pension side of the business,” he says.
Mr. Goodall explains that the committee meets with the segregated fund managers twice a year. The company looks at compliance and performance issues, he explains.
The insurer then uses a rating system based on a red, yellow and green light system. With green being no cause for concern and red being a huge warning sign. “If a manager is on yellow or red, they are on watch and we may need to take action and we have had situations where we have had to remove a manager.”
Mr. Goodall explains that this system has been in place since 1996, but most recently it has been much more refined because of the changing market and investor profile.
“We have to evolve as the consumer demand changes…. We have become much more public with what we do,” says Mr. Goodall. More money on the table and financial scandals have attributed to this change. “People are concerned, as they rightfully should be. It is their money and they want to know what we are doing with it.”
As to whether there are sufficient regulations in place, Mr. Goodall says that the marketplace is the ultimate decider. “From an investment management perspective, there are sufficient regulations in place, but I think there is always a balance between good regulation for good protection.”
The market is one of the best regulators, he says. “If investors have free choice within the marketplace they will not tolerate misbehaviour by any company.”
At Maritime Life, Serge Pépin, director of investment products, says that segregated funds are taken as seriously as mutual funds. He explains that the insurer has a segregated fund monitoring program called Performance Excellence Standard Tracking – also know as PEST.
Mr. Pépin explains that the performance of each manager is looked at but other factors are also taken into account. “If we feel that the manager is outperforming his benchmark then we may have a problem because the manager may be chasing performance and may be doing stuff that puts you and the holders at risk,” he says. “We don’t want the extra risk and we are not shy about terminating the manager if we feel he or she is not doing their job.”
PEST is also not part of segregated fund regulations but it is needed for the auditing process, he explains. Mr. Pépin adds that the insurer also has a Segregated Fund Investment Committee (SFIC) – which is also not part of any regulatory requirements.
“SFIC meets on a monthly basis to discuss the performance of the fund managers. Most of the members are internal for SFIC.”
He also notes, “A lot of our funds are managed externally so there is an extra layer of governance put forward.”
As for stricter regulations in segregated funds, Mr. Pépin feels that they are as regulated, if not more than mutual funds.
Jean-Pierre Bernier, vice-president and general counsel for the Canadian Life and Health Insurance Association (CLHIA), strongly agrees.
He explains that over a year ago, a 100-point comparison was carried about by the Joint Forum of Financial Market Regulators, an organization committed to harmonizing mutual funds and segregated funds.
“Corporate governance was one of areas that was compared and the comparison came to the conclusion that there is more corporate governance in segregated funds. I would think that within this area it is the mutual fund industry that has to catch up,” says Mr. Bernier.
He adds, “Segregated funds are regulated. There are areas where we are weaker, but there are areas where we are stronger, such as corporate governance, which includes supervision and the monitoring of compliance.”
The reason for the comparison was to clarify the misinformation that segregated funds are not sufficiently regulated. Mr. Bernier explains that was one of the sentiments expressed in a 1994 report prepared by Glorianne Stromberg, a commissioner at the Ontario Securities Commission (OSC). In the report, Ms. Stromberg reviewed the investment funds industry in Canada.
Mr. Bernier reveals, however, that there are one or two areas that segregated fund regulations can be made stronger, most notably at the fund manager level. “There is a set of rules fund managers must follow on mutual funds in regards to training and regulation and we don’t have the equivalent to those rules.”
He adds, “Though not much exists, the insurer is responsible for the wrong doing of its people, so obviously if a company has poor fund managers, it will be responsible for its actions.”
The Joint Forum task force could propose more regulations for segregated funds, but Mr. Bernier says that may not be the best solution. “We just keep adding to the rules and what I think is needed is a better approach to all this. We need smarter regulations and we need new approaches to detailed regulations,” he says.
He suggests a principle base rather than a law. “For example saying, ‘You shall invest prudently on an ongoing basis,’ as opposed to enumerating pages and pages of qualitative and quantitative tests on investments.”
Two suggestions often heard to help better regulate segregated funds is to only allow dually licensed advisors to sell the funds, and to require an independent board of directors to oversee segregated funds.
Mr. Bernier is not a fan of either idea. He explains that it is a regulatory requirement that every insurer have a board of directors with some independent representation. The board oversees all products and to impose one solely for segregated funds would be too costly and not needed. “For life companies you cannot have a board for every fund, …it would be unnecessary, extremely costly and unproductive,” he remarks.