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 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
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