PwC – Directors and trustees should reconsider governance structures

The collapse of global financial markets and the associated credit crisis has resulted in significant downward revaluations of investment values. Although it is common for market corrections to take place, it is the magnitude of the devaluations that has taken many directors and trustees by surprise.

Bryan Ingram, Associate Director from the Asset Management and Retirement Fund division of PricewaterhouseCoopers says, “Many boards, directors and trustees are now questioning the precision of the information they have been using to evaluate the risks associated with the various instruments included in their investment portfolios. Concerns have also been raised by boards as to the robustness of current governance protocols and financial models as well as controls surrounding valuation processes.”

Ingram continues, “Had there been better governance, the severity of the global financial crisis on entities may have been limited. It is imperative that lessons learnt by those with fiduciary responsibilities, as they manage their respective entities out of this financial crisis, are embedded in processes and governance going forward.”

Understanding risks

Directors and trustees generally recognise the importance of risk management relating to liquidity, transparency, valuation and conflicts of interest. But, the extent of the global economic slump has caused these parties to be less confident on how to assess the skills and competence of their investment managers.

Insufficient attention has been given by directors and trustees towards clearly understanding the risks and complexities associated with the different financial instruments included in their investment portfolios. In addition, the financial crisis has unearthed many new risks, which previously would not have been considered by boards, directors and trustees. Some of these risks include:

• Decreased confidence in financial institutions;
• Severe liquidity crunch and significant redemptions;
• Counterparty credit risk;
• Valuation of instruments in inactive markets;
• Non-existence of instruments included in investment portfolios;
• Reduced profit margins; and
• Increased / changing regulatory scrutiny.

What does investment governance entail?

According to Ingram, “Governance relates to decisions that define expectations, grant power, or verify performance. Good governance is about boards, directors and trustees effectively managing the entities they govern in a manner that results in the best interests of their policyholders, members and shareholders being met.”

A sound governance structure creates the foundation for an effective risk management and control environment and should include the following core elements:

• Appropriate committees, like investment and risk committees, with oversight responsibility for various aspects relating to investments; including trading, existence, valuation, risk management, operations and compliance;
• Documented policies and procedures and accounting tailored to the size and complexity of the investments of the entity;
• An assessment on a regular basis of any conflicts of interest to ensure that the investments of the entity are being managed in a manner which is appropriate and fair to all policyholders, members and shareholders; and
• A segregation of responsibilities to minimise the conflicts of interest and potential for fraud, including independent custodial, administrative and accounting functions.

In the current economic climate, entities are required to maintain effective corporate governance policies and procedures. Whether this is done to satisfy policyholder, member or regulatory concerns, it has become essential to demonstrate that corporate governance is not just an exercise in ticking boxes.

Clear investment objectives should be set, implemented and monitored in respect of the entity. For example; setting an investment objective of proper diversification can provide the opportunity to better manage and have lower overall portfolio risk.

Are your satisfied with your investment managers?

One would think that performance is the key driver to the answer, but attention is shifting to transparency and the quality of risk management. The safety net for the numerous processes to manage money is governance. Sound governance policies and procedures with respect to the evaluation of investment managers have become as vital as the returns being generated.

The following are some examples of areas relating to investment managers where boards should be focusing the appropriate time and attention:

• Market standing and reputation;
• Complexity of the organisation;
• Mandates;
• Risk appetite;
• Level of mandate breaches;
• Credit rating; and
• Fidelity cover.

The responsibility for the management of investments is in most cases outsourced to independent third party investment managers, however, it must be emphasised that ultimate responsibility for the governance of investments remains with boards, directors and trustees themselves. The monitoring of the appropriateness of back office procedures often does not get sufficient time and attention. It is imperative that those charged with governance understand how third parties conduct appropriate risk management for delegated or outsourced risks and responsibilities.

Investment managers should provide written reports on the current status of the market and portfolio and or verbal updates to the board, to assist them in discharging their responsibilities with respect to making decisions related to the portfolios investment policies and strategies. Compliance reports should be received by the board from all third party investment managers and these reports should contain any breaches of the investment mandate and how they were rectified, anti-money laundering issues or any complaints from policyholders or members.

How should boards, directors and trustees respond?

Due diligence

People, processes and performance are essential in assessing and monitoring due diligence in the current market environment. The integrity and expertise of individuals are key elements in assessing the whole control environment. It is also crucial that valuation methodology’s are understood and in general, the more illiquid and inactive the asset, the more difficult it will be to value accurately for financial reporting and performance measurement.

Third-party control reports

Questions should be raised if a full controls report has not been made available in respect of the third party investment manager. Understanding the control environment has become even more critical as a result of the heightened risks associated with recent financial market developments.

Asset liability matching

Sufficient focus should be given to the matching of assets to policyholder and member liabilities. Asset mix parameters, benchmarks and mandates in respect of the investment portfolios should be agreed with the investment manager.

Ongoing monitoring and reporting

Effective monitoring requires a certain quality of information; however, investment managers do not always provide user friendly transparency in this regard. Investment managers have not always been able to supply the information required to meet the rigorous disclosure requirements in terms of International Financial Reporting Standards.

The key to reporting is the usefulness to the end user of disclosures in the financial statements and the information included in other policyholder and member communication. Clear communication, on investment and risk management policies, is the basis for disclosing key information on how the board, directors and trustees are effectively managing the respective entities and their financial soundness.

IFRS 7 - Financial instruments: disclosures

To adequately address the extensive disclosure requirements of IFRS 7, boards of entities should:

• Be aware that IFRS 7 requires disclosure of how their results would have been affected if market conditions (such as level of interest rates, exchange rates, commodity, equity or other price risks) were to move by reasonably possible amounts from where they were at the reporting date;
• Assess whether they need to develop new systems and processes to capture the required data for some of the more challenging IFRS 7 disclosures;
• Consider whether the systems used to produce the required disclosure information are subject to the appropriate level of internal control for financial reporting purposes;
• Be aware that IFRS 7 requires disclosure of the information used by key management to measure and manage risk; and
• Develop a communication plan that clearly articulates their strategy for holding financial instruments, how risks from those instruments are managed and how financial instruments are incorporated into the overall value creation strategy.

In most instances, boards of entities will need to work very closely with their respective investment managers to be able to address the above and to comply with the disclosure requirements of IFRS 7.

Ingram concludes, “Boards, directors and trustees should be asking more questions of their investment managers, who should, in turn, be able to justify their investment strategies in line with the investment mandate with the entity. With proper systems and processes in place, boards, directors and trustees will be better placed to appropriately assess the risks within their investment portfolios, and ensure that these risks are being appropriately managed and timely investment decisions are taken.”