Insurer Investment Forum XIV Important Regulatory Issues Impacting Insurers’ Investments San Diego, CA 13 March, 2014

1. Insurer Investment Forum XIV Important Regulatory Issues Impacting Insurers’ Investments San Diego, CA 13 March, 2014 Chris Anderson, CFAAIAnderson Insights, LLC Chris@andersoninsights.com +1 212 753-5791

2. 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 What’s Happening? Page 1

3. Economics Regulatory / Rating Agency What’s Happening? Page 2

4. 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 “Invested assets” Page 3

5. 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 RBC for assets only matters for life Page 4

6. 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 RBC for assets only matters for life Page 5

7. 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.” RBC for assets only matters for life Page 6

8. RBC for assets only matters for life BUSINESS LINE COMBINED RATIO 2012 / 10 YEAR -- Data source: AM Best Insurance Facts and Stats, November 2013 Page 7

9. 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.) “Invested Assets” • Page 8

10. “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 Invested Assets -- Debt • Page 9

11. 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”? Invested Assets -- Debt? • Page 10

12. 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 Invested Assets -- Debt • Page 11

13. “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? Invested assets -- debt Page 12

14. 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 Invested assets -- debt Page 13

15. 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 Invested assets -- debt Page 14

16. “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 Invested assets -- debt Page 15

17. “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 Invested assets -- debt Page 16

18. 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? Investing in structured securities • Page 17

19. 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) Life RBC Factors -- under review • Page 18

20. 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? Naic SVO fees Page 19

21. Naic svo fEES 2012 2013 2014 -- Source: NAIC Budget Proposal 2014 Page 20

22. “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 Federal insurance office Page 21

23. 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 The Federal Insurance Office Page 22

24. On the radar Page 23

25. 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 On the radar Page 24

26. 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 Short takes Page 25

27. 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 More Short takes Page 26

28. “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….” KommissionerKumbaya? -- Remarks of New York Superintendent of Financial Services Benjamin M. Lawsky April 18, 2013 Page 27

29. “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) KommissionerKumbaya? Page 28

30. Insurer Investment Forum XIV Important Regulatory Issues Impacting Insurers’ Investments San Diego, CA 13 March, 2014 Chris Anderson, CFAAIAnderson Insights, LLC Chris@andersoninsights.com +1 212 753-5791