DON'T LET THE TAIL WAG THE DOG: FOR INSURERS, IT'S INVESTMENT DISCIPLINE FIRST, CAPITAL EFFICIENCY SECOND - Insurance Investment Practice Group ...
←
→
Page content transcription
If your browser does not render page correctly, please read the page content below
DON’T LET THE TAIL WAG THE DOG: FOR INSURERS, IT’S INVESTMENT DISCIPLINE FIRST, CAPITAL EFFICIENCY SECOND Insurance Investment Practice Group November 2018
DON’T LET THE TAIL WAG THE DOG: FOR INSURERS, IT’S INVESTMENT DISCIPLINE FIRST, CAPITAL EFFICIENCY SECOND Insurance Investment Practice Group November 16, 2018 This year was the year of the dog, markets strategy. The most common according to the Chinese zodiac. For is a separately-managed account or a NEPC’s Insurance Investment Practice, traditional limited partnership (or LLC) 2018 was the year of rated-private-debt structure. While the two structures have funds. As the search for yield has insurers advantages and disadvantages in terms of, looking to more complex and less liquid for instance, size, accounting complexity investments in private markets, we have and reporting, the capital charges are well fielded a significant number of requests defined. from asset managers to review their capital-advantaged strategy. Although there are a host of unique structures available, capital-optimized Referred to as “rated” or “capital- solutions usually fall into two broad optimized”, these funds are usually private categories: (credit and infrastructure) debt vehicles structured to avoid the Structure Type Methodology typical risk-based capital charges of Rated Fund Typically, this is a limited similarly pooled private investments. As the National Association partnership vehicle. The fund is of Insurance Commissioners rated by a NRSRO. The public rating (NAIC) considers changes to the is equated to an NAIC-equivalent accounting treatment of these vehicles, we would like to remind bond rating. insurers that their due diligence Debt-Equity The investment portfolio is housed process should stay the same. Only in a structured product. Like a once the strategy is cleared and collateralized loan obligation (CLO), approved for investment, should the implementation vehicle be the portfolio is split into tranches considered. A fund that is made up comprising rated notes and an of non-investment-grade securities equity tranche. The distribution has that level of ultimate risk, regardless of the pooled rating. mechanism can vary by structure. HOW DOES THE FUND ACHIEVE CAPITAL RELIEF? RATED FUNDS There are multiple mechanisms for Currently, the rated fund only benefits life an insurer to invest in a private insurers, but the NAIC is also reviewing DON’ T LE T THE TAIL WAG THE DOG | 2
them for health and property and casualty to understand statutory accounting insurers. The rated fund is similar to the guidance or concepts, please refer to traditional limited partnership structure, the NAIC Accounting Practices and and is still a single-line item held on Procedures Manual. schedule BA. The fund has risk-based Source: NAIC Memorandum, “Proposal capital relief because it is rated by the to Add Comprehensive Instructions for Securities Valuations Office (SVO) or has Fund Investments to the P&P Manual”, an equivalent rating (the filing-exempt January 31, 2018 process) from a Nationally Recognized Statistical Rating Organization (NRSRO), DEBT-EQUITY often in the form of a private side letter. The debt-equity methodology creates NEPC’s understanding is that the a structure made up of fixed-income equivalency mechanism will likely be tranches, for instance, senior and junior, made unavailable to insurers after January and an equity tranche. The differentiated 1, 2019: fixed-income pools are rated and held on Schedule D, like any similar security, and b. Condition to Eligibility – The “fixed- the equity tranche is held on Schedule BA income–like” regulatory treatment as a traditional alternative asset. The level accorded under this Section 8 only of subordination, that is, the percentage applies to funds that the SVO has of equity, can vary significantly. verified meet eligibility criteria established by the VOS/TF and SHOULD INSURERS INVEST been assigned NAIC Designations IN RATED AND/OR CAPITAL- or reviewed under the verification OPTIMIZED STRATEGIES? procedures and added to an NAIC List or other NAIC compilation process as At NEPC, we prefer well-researched, hereafter discussed in this Section 8. credit-intensive private debt strategies The use of NAIC CRP credit ratings over public assets that are rated below under the filing exempt process investment grade. While the insurance discussed in Part Three, Section 1 ratings overlay creates an additional level (b) of this Manual shall not be an of risk that should be analyzed, it should acceptable basis to apply for and not impact the investment process from receive the regulatory treatment a traditional due diligence perspective specified in this Section 8. A private other than to potentially constrain the fund reported on Schedule BA, guidelines. acquired prior to January 1, 2019 and reported with an NAIC Designation As with all private markets research, the produced under filing exemption, insurer should evaluate the investment can continue to be reported on the team, firm resources, opportunity set, basis of a credit rating until sold or investment thesis, track record, and back- disposed of, provided the insurer also office capabilities. Once the strategy has reports the investment on the Fund GI passed all investment due diligence tests (General Interrogatory). Funds that do and has been approved for investment, not qualify for the exceptions identified then the implementation vehicle should be in this Section 8 would continue to considered. be reported as common stock on Schedule D-2-2 or as other invested Under the current regulatory and ratings assets on Schedule BA without NAIC environment, it is understandable that Designations. Note: In all cases insurers want to take advantage of the where it is necessary for the reader potential capital relief for private markets DON’ T LE T THE TAIL WAG THE DOG | 3
investment. It is important that insurers secondary consideration. History has not keep in mind that these are long-term looked kindly on strategies that have investments and that the future regulatory been engineered to overcome regulatory environment may change. To this end, we challenges. suggest insurers consider the following questions: ADDENDUM • Will a change in regulatory or rating The objective of this article was to focus agency methodology cause investors to on private markets and the regulation and exit the rated vehicle? accounting treatment for structures that • If so, will the structure survive a “run exist in that universe. We deliberately on the bank”? This is a dual threat: avoided the discussion of how AM Best, The run on the bank could generate a another NRSRO, would incorporate these forced sale if the lock-up clauses don’t structures into its BCAR calculation hold, but if the lock-up clauses do hold, (another key solvency model for US capital can be tied up in a suboptimal insurers). We are of the understanding vehicle. that AM Best has constructed an • What responsibility does the General investment working group that will assist Partner/Investment Manager have if with the evaluation of pooled investment the structure breaks? vehicles. We strongly recommend • Do we understand the inputs and that insurers discuss private markets factors employed by the different allocations and the capital impact with NRSROs? While the NAIC “has no their designated analyst. discretion to ignore an NRSRO credit rating” (NAIC Valuation of Securities DISCLAIMERS AND DISCLOSURES (E) Task Force, September 2018), an insurer can evaluate and differentiate • Past performance is no guarantee of between agencies. future results • If there is a change in the standing of an NRSRO, would there be a willing • All investments carry some level of replacement for any annual review risk. Diversification and other asset process? allocation techniques do not ensure • If yes, what would a potential rating profit or protect against losses. change look like? This highlights the additional level of downgrade risk. • The information in this report has The strategy is subject to downgrade been obtained from sources NEPC risk from the selected NRSRO, believes to be reliable. While NEPC has but should an NRSRO fail, the exercised reasonable professional care replacement may apply a downgrade. in preparing this report, we cannot guarantee the accuracy of all source Thorough due diligence should information contained within. determine the viability of any private markets investment. An insurer should • The opinions presented herein evaluate each opportunity agnostic represent the good faith views of NEPC to the implementation vehicle, and as of the date of this report and are capital optimization should be a distant subject to change at any time. DON’ T LE T THE TAIL WAG THE DOG | 4 BOSTON | ATLANTA | CHARLOTTE | CHICAGO | DETROIT | LAS VEGAS | PORTLAND | SAN FRANCISCO 255 State Street, Boston, MA 02109 | P. 617.374.1300 | F. 617.374.1313 www.nepc.com www.nepc.com
You can also read