Presentation Transcript

1. Investing inCommercial Mortgages

   Presented by: Theron R. Holladay Sr., CFA / President & CEO
2. Presentation Objectives This portion of the presentation will focus on a few of the macro economic factors impacting the commercial mortgage market and several key risk considerations that are specific to the insurance industry. The pay-off expected at the conclusion is a greater awareness of these including: The relationship of the current low interest rate environment to the commercial mortgage market Factors driving the yield expectations in the near future Top performing businesses have cash excesses Significant funds are available to compete for future needs Hidden risks including: Surplus risk when combined with a high annuity product mix The potential to significantly accelerate AVR in a given year
3. The relationship of the current low interest rate environment to the commercial mortgage market Residential mortgages – catalyst behind recession History Structured securities Leverage Commercial mortgages – Fear of same path Reduced volatility versus residential Difference – five year balloons and fixed to float rates Contributing factor in the low interest rate target through 2013
4. 10-Year U.S. Treasury Since 1981
5. Factors driving the yield expectations in the near future An insurer should demand a high risk premium on direct commercial mortgages Market reasons – diversification / cash flow volatility Insurance and company specific – ALM and AVR Factors constraining the risk premium Supply of available funds is at an all time high Top performing businesses have an abundance of cash
6. National Interest Rates 5/23/12 www.bankingmyway.com
7. National Interest Rates 5/23/13 www.bankingmyway.com
8. Cash at U.S. Banks
9. U.S. Treasuries Held by Banks
10. Specific risks an insurer must consider when investing in commercial mortgages The allocation constraints of the investment policy should be structured to limit the volatility of asset cash flow in relation to the liabilities The appropriate allocation limits are unique to each insurer Higher annuity business increases risk and constrains allocations Total allocation to optionality should be limited and commercial mortgages represent a portion of the total
11. The single most effective way to reduce risk is structuring assets to provide for the liabilities
12. Annuities in conjunction with mortgage exposure Annuity cash flow projections contract in a rising rate environment Mortgage security cash flow projections extend in a rising rate environment
13. Annuity risk in a rising rate environment
14. Specific risks an insurer must consider when investing in commercial mortgages The hidden Risk – AVR and surplus surprises Higher AVR factors in general Factors into the risk premium needed on new investments Justified by the NAIC due to cash flow timing uncertainty Potential for acceleration of AVR in any given year Reserve factors increase with credit deterioration If a bond falls in credit it increases the reserve against that bond If a problem develops with a direct commercial mortgage it increases the reserve factor against the entire portfolio and has the ability to significantly lower surplus in a single year, which continue can long after the issue with the mortgage is gone.
15. Understanding AVR on commercial mortgages The reserve objective is 1.2% times an Experience Adjustment Factor (EAF) The EAF is calculated by dividing the company’s experience factor (CEF) by the industry’s experience factor (IEF) The EAF is calculated using the statutory financial history for the last eight quarters Without a five year lending history on the products the minimum reserve is the 1.2% factor (521% higher than that of an NAIC 1 bond)
16. The potential bad news The expectation is a reserve objective around 1.2%; however, should a few defaults occur this can quickly increase to a max of 3.5%. On a $250MM mortgage portfolio, this could increase AVR by $1.75MM resulting in an equivalent reduction in surplus. Additionally this continues to elevate AVR for 8 quarters following the eventual removal of the securities (2 – 5 years in many cases). Implications: Allocation to commercial mortgages must consider this possibility Foreclosures impact the CEF extensively in the formula; therefore, several options outside of foreclosure may be financially prudent to consider. If a foreclosure on a $1MM property and expected loss of $200,000 could reduce surplus by $1MM to $1.7MM the numbers would indicate a disproportional impact.
17. The potential good news Once the experience history of the insurer exceeds five years, the AVR minimum reserve objective is reset to 0.5% (based on 1.2% times the EAF). If the insurer has a better record than the industry average, there is opportunity to add back to surplus.
18. Summary Results Interest rates are currently targeted at low levels due in part to the past fears surrounding commercial mortgages. Insurers need a risk premium to consider commercial mortgages; unfortunately the supply of funds may limit the book yield on future commercial mortgages. There are “hidden” or unique risk that an insurer must consider when investing in commercial mortgages. These should factor into the allocation limits established in the investment plan.