Insurer Investment Forum XIV
Important Regulatory Issues
Impacting Insurers’ Investments
San Diego, CA
13 March, 2014
CHRIS ANDERSON, CFA
AI ANDERSON INSIGHTS, LLC
[email protected]
+1 212 753-5791
WHAT’S HAPPENING?
We’ve already discussed Solvency II and DoddFrank…. 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

Page 2
“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
Page 3
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

Page 4
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 charge
Result: 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
Page 5
RBC FOR ASSETS ONLY MATTERS FOR LIFE
Insurance 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.”
Page 6
RBC FOR ASSETS ONLY MATTERS FOR LIFE
BUSINESS LINE
COMBINED RATIO 2012 / 10 YEAR
Commercial Multiple Peril
Commercial Auto Liability
Commercial Multiple Peril - Non-Liability
Commercial Multiple Peril (Total)
Workers' Compensation
Other Liability
Private Passenger Auto Physical Damage
Homeowners' Multiple Peril
Private Passenger Auto Liability
All Auto
Net Premiums Written 2012
112.0 / 99.9
106.1 / 97.8
112.1 / 99.9
105.1 / 100.2
110.4 / 107.4
104.2 / 104.9
102.0 / 93.7
104.1 / 87.3
103.2 / 102.3
102.6 / 98.6
0
50
100
150
200
-- Data source: AM Best Insurance Facts and Stats, November 2013
Page 7
“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.)
Page 8
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
Page 9
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

Page 11
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?

Page 12
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
Page 13
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
Page 14
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
Page 15
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
Page 16
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?

Page 17
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
2012
2013
2014
-- Source: NAIC Budget Proposal 2014
Page 20
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
Page 21
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
Page 22
ON THE RADAR
Page 23
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 Office
Page 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

Page 25
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
Page 26
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 XIV
Important Regulatory Issues
Impacting Insurers’ Investments
San Diego, CA
13 March, 2014
CHRIS ANDERSON, CFA
AI ANDERSON INSIGHTS, LLC
[email protected]
+1 212 753-5791