DON'T LET THE TAIL WAG THE DOG: FOR INSURERS, IT'S INVESTMENT DISCIPLINE FIRST, CAPITAL EFFICIENCY SECOND - Insurance Investment Practice Group ...

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DON'T LET THE TAIL WAG THE DOG: FOR INSURERS, IT'S INVESTMENT DISCIPLINE FIRST, CAPITAL EFFICIENCY SECOND - Insurance Investment Practice Group ...
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 ...
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

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DON'T LET THE TAIL WAG THE DOG: FOR INSURERS, IT'S INVESTMENT DISCIPLINE FIRST, CAPITAL EFFICIENCY SECOND - Insurance Investment Practice Group ...
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

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DON'T LET THE TAIL WAG THE DOG: FOR INSURERS, IT'S INVESTMENT DISCIPLINE FIRST, CAPITAL EFFICIENCY SECOND - Insurance Investment Practice Group ...
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

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