Insurer Investment Forum XIV

Important Regulatory Issues

Impacting Insurers’ Investments San Diego, CA

13 March, 2014

CHRIS ANDERSON, CFA

AI 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

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

Page 7

0 50 100 150 200

Net Premiums Written 2012 BUSINESS 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.)

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

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 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 CHRIS@ANDERSONINSIGHTS.COM

+1 212 753-5791