Insurer Investment Forum XIVImportant Regulatory Issues

Impacting Insurers’ Investments

San Diego, CA13 March, 2014

CHRIS ANDERSON, CFAAI ANDERSON INSIGHTS, LLC

CHRIS@ANDERSONINSIGHTS.COM+1 212 753-5791

WHAT’S HAPPENING?We’ve already discussed Solvency II and Dodd- Frank…. So now:

Regulatory/rating agency treatment of insurer investments

What you need to know to invest in flavors other than vanilla

What about RBC? Federal regulation (and globalization) Insurance investment radar screen

Page 1

WHAT’S HAPPENING? Economics Regulatory / Rating Agency

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“INVESTED ASSETS” Do we really need to know how the

NAIC and rating agencies look at insurer assets? Yes:

If you are on a yield quest If you need to know the RBC of your assets

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RBC FOR ASSETS ONLY MATTERS FOR LIFE Non-life companies take their risk on

the liability side -- and are susceptible to a multitude of liability risks they must manage

Because non-life companies in general invest in conservative, liquid assets their investments are simply not matters of much concern

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RBC FOR ASSETS ONLY MATTERS FOR LIFE Scenario 1: Eliminate R1

Result: 2,023 companies (or 78%) have less than a 1% reduction in ACL 2

Scenario 2: Double the R1 chargeResult: 2,023 companies have less than a 3.1% increase in ACL….

“What I have found makes me doubt the benefit of such a change relative to the costs.”

--Memo dated February 20, 2014 from Richard Marcks, Chief Actuary, Connecticut Insurance Department

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RBC FOR ASSETS ONLY MATTERS FOR LIFEInsurance Facts and Stats, November 2013 -- AM Best, Chapter Four

“How Insurers Make Money” “Insurance companies primarily make

money two ways, by investing premiums and turning an underwriting profit; that is, collecting premium that exceeds insured losses and related expenses.”

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RBC FOR ASSETS ONLY MATTERS FOR LIFE

Page 70 20 40 60 80 100 120 140 160 180 200

Net Premiums Written 2012BUSINESS LINE

COMBINED RATIO 2012 / 10 YEAR

-- Data source: AM Best Insurance Facts and Stats, November 2013

Commercial Multiple Peril                                 112.0 / 99.9 Commercial Auto Liability                                  106.1 / 97.8 Commercial Multiple Peril - Non-Liability       112.1 / 99.9 Commercial Multiple Peril (Total)                    105.1 / 100.2 Workers' Compensation                                    110.4 / 107.4 Other Liability                                                      104.2 / 104.9 Private Passenger Auto Physical Damage       102.0 / 93.7 Homeowners' Multiple Peril                              104.1 / 87.3 Private Passenger Auto Liability                        103.2 / 102.3 All Auto                                                                  102.6 / 98.6  

“INVESTED ASSETS” RBC C1/R1 factors, at the most fundamental

level, are based on asset type.So what are the asset types? Equity (common stock) Mortgage Loan (MEAF eliminated y/e 2013) Real Estate Preferred Stock Other Assets (e.g.: limited partnership

interests) Debt (bonds, notes, debentures, etc.)

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INVESTED ASSETS -- DEBT “Bonds shall be defined as any securities

representing a creditor relationship whereby there is a fixed schedule for one or more future payments.”

--NAIC Statement of Statutory Accounting Principles #26 ¶2

“Definition of 'Creditor’: An entity… that extends credit by giving another entity permission to borrow money if it is paid back at a later date.” -- Investopia.com

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INVESTED ASSETS -- DEBT? Premise: Very few phenomena cannot

be modeled… Periodic payments: If the dollar

amounts of periodic payments (“interest”) are uncertain -- given that likelihood of receipt of promised cashflows is reasonably certain…

Repayment: If there is no promise to repay the investment amount (“principal”) Must failure to repay be an event of

“default”?Page 10

INVESTED ASSETS -- DEBT Interest rate floaters? Non-interest rate floaters?

Indexed to high yield bond TRR S&P 500 (floored at zero) First loss on high yield synthetic

portfolio Indexed to the outcome of a single

coin flip Catastrophe bonds (loss

absorption/parametric) Residual interests

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INVESTED ASSETS -- DEBT “Credit analysis” of “bifurcated

credits/assets” -- Return of principal is straightforward As to periodic payments, is the risk:

Credit: The failure (inability or unwillingness) of the obligor to pay as promised

Disappointment: The probability of receiving an “unacceptable” return (e.g.: zero!) Paradox: Does an “unacceptable” return indicate high credit quality?

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INVESTED ASSETS -- DEBT So how is NAIC charged with evaluating

debt instruments? “Credit risk is defined as the relative financial

capability of an obligor to make the payments contractually promised to a lender. Credit analysis is performed solely for the purpose of designating the quality of an investment made by an insurance company to enable the NAIC member's department of insurance to determine regulatory treatment.”

-- Part One, Purposes and Procedures of the Securities Valuation Office of the National Association of Insurance Commissioners

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INVESTED ASSETS -- DEBT What about “other non-payment risk”? The SVO has the authority “to quantify the

possibility that such contracts (bond indentures) will result in a diminution in payment to the insurer so this can be reflected in the NAIC Designation assigned to the security through the application of the notching process described in paragraph (iii) below.”

-- Part One, Purposes and Procedures of the Securities Valuation Office of the National Association of Insurance Commissioners

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INVESTED ASSETS -- DEBT “Any security or financial instrument

that is denominated as fixed income and that contains a promise to pay that is otherwise conditional may be notched….”

-- Part One, Purposes and Procedures of the Securities Valuation Office of the National Association of Insurance Commissioners

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INVESTED ASSETS -- DEBT “In contracts where the insurer agrees to

accept a risk or participate in an activity that may reduce either the interest or dividend otherwise agreed on or the amount to be repaid to less than the original principal investment, the SVO would consider whether the risk of a loss is structurally or otherwise mitigated.” -- Part One, Purposes and Procedures of the Securities

Valuation Office of the National Association of Insurance Commissioners

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INVESTING IN STRUCTURED SECURITIES NAIC-speak: LBAS “Loan-Backed and

Structured Securities” Not full agreement as to how to

define them My working definition -- debt that

is not the direct obligation of a going concern

Examples: SPVs, RMBS, CMBS RMBS modeled (PIMCO Advisory) CMBS (BlackRock)

“Notched” So: If LBASs are notched should all

be notched?

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LIFE RBC FACTORS -- UNDER REVIEW American Academy of Actuaries

developing proposals for factors for life RBC for: Corporates Structured securities

ACLI for Real estate Common stock Derivative instruments (excluding

Schedule BA)Page 18

NAIC SVO FEES With over $100,000,000 “in the bank”

and Having enriched its “unallocated

surplus” by transferring ≈ $10,000,000 from its structured securities activities…

NAIC fees were increased for 2014 Expect:

More frequent fee increases Fees based on work required (new) Higher fees? Page 19

NAIC SVO FEES

Page 20

2012 2013 2014

-- Source: NAIC Budget Proposal 2014

FEDERAL INSURANCE OFFICE“The Dodd-Frank Wall Street Reform and Consumer Protection Act established Treasury's Federal Insurance Office (FIO) and vested FIO with the authority to monitor all aspects of the insurance sector, monitor the extent to which traditionally underserved communities and consumers have access to affordable21 non-health insurance products, and to represent the United States on prudential aspects of international insurance matters, including at the International Association of Insurance Supervisors.  In addition, FIO serves as an advisory member of the Financial Stability Oversight Council, assists the Secretary with administration of the Terrorism Risk Insurance Program, and advises the Secretary on important national and international insurance matters.”

(e

(emphasis added) -- www.treasury.gov

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THE FEDERAL INSURANCE OFFICE Released its long-awaited report… …two years late, on the eve of the Fall NAIC

meeting Relationship with state insurance regulators?

“Perhaps the most egregious example of (an NAIC ‘imperial presidency’) was the unilateral decision by last year’s NAIC President to give the Federal Insurance Office one of the NAIC’s three seats on the IAIS Executive Committee.”

-- Connecticut Insurance Commissioner Thomas Leonardi

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ON THE RADAR

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ON THE RADAR Mutual Funds / residual interests ETFs: are preferred or common stock (SSAPs

30 & 32) Expect greater “granularity” in bond and

preferred stock ratings (“SVO Designations”) From six today (NAIC 1 – 6)… To 16 in the future (using the existing six

with plusses and minuses) Impact????

Federal Insurance OfficePage 24

SHORT TAKES NAIC reviewing the holdings of

“structured notes” Are they different from MBS? If so, how?

NAIC intervention on FHLB claims priority

Working Capital Finance Notes finally are eligible to be admitted assets (SSAP 105)

Ratings of Issues vs. ratings of Issuers

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MORE SHORT TAKES Own Risk Solvency Assessment Global accounting “convergence” Captive insurers:

“Financial alchemy”* “Shadow insurance— a little-known loophole that puts insurance policyholders and taxpayers at greater risk.”*

Private Equity Issues Working Group (NAIC)*Benjamin Lawsky, Superintendent, NY State Department of Financial Services

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KOMMISSIONER KUMBAYA?“When the system turned on its head and the debate turned to who could water down standards the most. “Who could provide the ‘lightest touch’ regulation at the firms they oversaw.“In many ways, this created a race to the bottom in which both regulators and Wall Street firms were willing participants.“At (the New York State Department of Financial Services), we hope our activism at the state level will at least sometimes do the reverse and spur a race to the top…. “…Sometimes, that means DFS may be out in the lead on a particular issue. “But I think that’s healthy….”

-- Remarks of New York Superintendent of Financial Services Benjamin M. Lawsky April 18, 2013 Page 27

KOMMISSIONER KUMBAYA? “We have met the enemy and he is us!*” “The biggest challenge we face is the

dysfunction in our own organization….” “If the companies we regulate had the same

governance issues we have here at the NAIC, we

would be outraged and ‘heads would roll.’” Elections “…most closely resemble those we

experienced in junior high school.”-- Connecticut Insurance Commissioner Thomas Leonardi (and Pogo*, of course)

Page 28

 

Insurer Investment Forum XIVImportant Regulatory Issues

Impacting Insurers’ Investments

San Diego, CA13 March, 2014

CHRIS ANDERSON, CFAAI ANDERSON INSIGHTS, LLC

CHRIS@ANDERSONINSIGHTS.COM+1 212 753-5791