Alternative Investments: A look at Strategy, Risk, Return & Reporting Implications

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2 Alternative Investments: A look at Strategy, Risk, Return & Reporting Implications Session 503 IASA 87 TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW

3 Learning Objectives Discuss the overarching alternatives market, along with various alternative asset types Illustrate how alternatives can be employed in your investment strategy Consider the unique features/risks that come with alternative assets Review accounting and regulatory guidance for alternatives, and how this can affect your RBC IASA 87 TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW

4 Panel Members Rachel Evans Associate Investment Accounting BLACKROCK Responsible for US GAAP, US Statutory and IFRS research Works with clients on regulatory & financial statement filings Eight years investment and insurance accounting experience IASA National Volunteer Scott Ferrante President ConVista Consulting Co-CEO ComnServ 30+ years investments, accounting and systems experience Works with clients and software providers to build optimal investment operating models Presenter at numerous industry events and IASA speaker IASA 87 TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW

5 What are Alternative Investments? Broadly, alternatives are anything that fall outside of the three primary asset types stocks, bonds, and cash Includes: Private equity Including mezzanine and distressed debt Hedge funds Bank loans Commodities Real assets e.g., real estate, REITs, mortgage loans Some derivatives

6 What are Alternative Investments? Most alternatives are held by institutional investors or accredited, high-net-worth individuals due to their complex nature, limited regulations and relative lack of liquidity Primarily reported on Sch. A and BA, but depending on asset types, alternatives could also be on Sch. B, Sch. D or Sch. DB Schedule A Alternatives Real Estate Schedule BA Alternatives Limited Partnerships or LLCs Transportation equipment (e.g., aircraft or motor vehicle trust certificates) Hedge funds Schedule D Alternatives Bank Loans Schedule DB Alternatives Managed futures

7 Why Consider Alternatives? Higher returns Although alternatives can have lower returns in the short-term, longterm returns generally outperform the broad market 104.6% Hedge fund returns over last 10 years (as of Jan. 2014) 82.7% 75.3% 75.1% 66.2% 56.3% 47.0% 29.6% 32.3% 11.3% 16.8% 13.9% 1 Year 3 Year 5 Year 10 Year BarclayHedge, LTD. Hedge Fund Index 60/40 equity bond portfolio S&P 500 Source: Deloitte 2014 Alternative Investment Outlook. Data from BarclayHedge, Bloomberg, Deloitte IASA 87 TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW

8 Why Consider Alternatives? Less correlated to traditional markets As standard market assets continue to have moderate to high correlations, alternatives can offer low, or even negative correlation to various sectors Source: BLACKROCK Investment Insight: Diversifying with Alternatives IASA 87 TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW

9 Worst Best Why Consider Alternatives? Greater diversification With different risk profiles and less correlation to traditional assets, alternatives offer greater protection of value through diversification Yearly Total Returns: Selected Hedge Fund Subindicies compared to the S&P Distressed Distressed Managed Convertible S&P 500 Global Macro S&P 500 Global Macro S&P 500 S&P 500 Debt Debt Futures 15.8% 17.4% 15.1% 6.4% 16% 32.4% 15.6% 11.7% 18.3% 47.4% Long/Short Equity 11.6% S&P % Global Macro 8.5% Fixed Income 6.9% Equity Market Neutral 6.5% Managed Futures 6% Risk 5.5% Convertible 2% Long/Short Equity 9.7% Global Macro 9.3% Equity Market Neutral 6.1% S&P % Risk 3.1% Fixed Income 0.6% Managed Futures -0.1% Convertible -2.6% Distressed Debt 15.6% Long/Short Equity 14.4% Convertible 14.3% Global Macro 13.5% Equity Market Neutral 11.2% Fixed Income 8.7% Risk 8.2% Managed Futures 8% Long/Short Equity 13.7% Equity Market Neutral 9.3% Risk 8.8% Distressed Debt 8.4% Managed Futures 6% S&P % Convertible 5.2% Fixed Income 3.8% Risk -3.3% Global Macro -4.6% Long/Short Equity -19.7% Distressed Debt -20.5% Fixed Income -28.8% Convertible -31.6% S&P % Equity Market Neutral -40.3% Fixed Income 27.4% S&P % Distressed Debt 21% Long/Short Equity 19.5% Risk 12% Global Macro 11.5% Equity Market Neutral 4.1% Managed Futures -6.6% IASA 87 TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW Source: BLACKROCK: Seeking Broader Diversification using Hedge Funds Data from Morningstar as of 12/31/2013 Global Macro 13.5% Fixed Income 12.5% Managed Futures 12.2% Convertible 11% Distressed Debt 10.3% Long/Short Equity 9.3% Risk 3.2% Equity Market Neutral -0.8% Fixed Income 4.6% Equity Market Neutral 4.5% S&P % Convertible 1.1% Risk 0.8% Managed Futures -4.2% Distressed Debt -4.2% Long/Short Equity -7.3% Distressed Debt 11.8% Fixed Income 11.1% Long/Short Equity 8.2% Convertible 7.8% Global Macro 4.6% Risk 2.8% Equity Market Neutral 0.9% Managed Futures -2.9% Long/Short Equity 17.7% Distressed Debt 16% Equity Market Neutral 9.3% Convertible 6% Risk 4.9% Global Macro 4.3% Fixed Income 3.8% Managed Futures -2.6%

10 Alternatives in a Low Yield Environment The Quest for Yield in a multi year, low yield market has driven insurers and other financial institutions to allocate more assets to non-traditional investments Growth toward derivatives, private equity, hedge funds, etc. Schedule DB and BA are growing at the expense of Schedule D Assets (e.g., Stocks and Bonds) Insurers of all sizes are increasing allocation to more complex investments

11 BA Assets in the Insurance Industry BA assets have grown to be a larger percentage of assets % 5.00% 4.50% 4.00% 3.50% 3.00% 2.50% BA Assets (billions) BA % Total Admitted Assets Source: IASA 87 TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW

12 BA Assets in the Insurance Industry BA assets have grown across all insurance company types Health 175 Title 150 Fraternal 125 P&C 100 Life (in billions) Source: IASA 87 TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW

13 Real Estate in the Insurance Industry Real estate has also grown steadily in insurers portfolios Mortgage loan holdings have also grown significantly Real Estate BACV BACV of Commercial Mortgage Loans by Date Acquired* (in billions) (in billions) Life P&C Fraternal Title Health *as of 2013 Source: IASA 87 TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW

14 Operational Challenges Title VII of Dodd-Frank requires that most derivatives contracts, formerly traded exclusively in the OTC market, be subject to central clearing With the central clearing issue (mostly) behind us, the focus of discussion is now on alternatives Central clearing uses an agency to act as a central counterparty to remove individual counterparty credit risk and distribute risk among the clearing agency s participants that must satisfy the agency s capital and margin requirements

15 Operational Challenges Security Master Data Data can often be sparse and may require additional sources e.g., bank loan holders often contract with Markit Partners Cash Processing and Reconciliation Payment predictions can be challenging due to data limitations/availability or change in terms System Limitations Accounting systems may not support certain asset types

16 Operational Challenges Valuation Lack of fair value sources Likely reported as Level 3 securities Delays in valuation availability from sources e.g., statements aren t received timely for partnerships/hedge funds Reporting Reporting on some alternative asset types is often delayed e.g., hedge fund or partnership statements received one month behind Creates a burden for both insurance accountants and traditional insurance investment accounting systems

17 Impact on Accounting Accounting for alternatives varies greatly by the asset type Joint Ventures, Partnerships, and LLCs: SSAP No. 48 Equity method of accounting if greater than 10% ownership Less than 10% ownerships is reported at cost, but adjusted by any cash flows that exceed earnings (i.e., return of capital) Real Estate: SSAP No. 40 Depreciated cost or LOCOM (if held for sale) Bank Loans: SSAP No. 26 Mezzanine Loans: SSAP No. 83 Accounted for as a mortgage loan (SSAP 37) LLCs with Real Estate, single owner/asset: SSAP No. 40 Recent change from using SSAP No. 48

18 Impact on Accounting: GAAP vs. STAT Accounting for private equity, hedge funds, real estate partnerships, etc. is particularly challenging for insurers GAAP employs the equity method of accounting STAT reports at cost, but is adjusted based on cash flows As a result, the cost and unrealized gains/losses will be different between GAAP and STAT, even though the valuation of the investment will be equal

19 Impact on Accounting: GAAP vs. STAT STAT reports at cost, but is adjusted based on cash flows STAT requires an evaluation of the cumulative earnings of the investment when cash distributions are received If the cash distribution has been paid from positive cumulative earnings Recorded as ordinary income (i.e., dividends received), assuming the remaining cumulative earnings exceeds the cash distribution received If the cash distribution exceeds cumulative earnings Cash received is recorded as ordinary income only up to the amount of cumulative positive earnings Any cash received in excess of positive earnings (or from cumulative losses) is treated as a return of capital The cost of the investment is reduced by the ROC, and the impact flows through unrealized gains and losses

20 Other Accounting Considerations Risk-Based Capital charges Varies based on the asset type Often larger than standard fixed income securities BA assets for P&C companies use a flat 20% charge BA assets for Life companies varies based on underlying assets/characteristics Admission of assets Statutory limitations will vary by state IASA 87 TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW

21 Impact on Technology Insurance investment accounting systems have struggled to completely automate the multi basis accounting challenges of Schedule BA assets affected by SSAP 48 and the timeliness of tax information (K1) As a result, many insurance companies making these investments have had to develop accounting workarounds using tools such as Excel or Access

22 Impact on Technology Any time key accounting information is maintained outside of the core accounting system on user s desktops, it creates operational and audit risk The flow of data to management reporting, the general ledger, Schedule BA, etc. is then subject to manual intervention and possible compromised control

23 Alternative Investment Considerations Consequences (Unintentional and Intentional) Complex regulation generally creates less black and white rules and regulations (i.e. Dodd-Frank) Data regarding alternatives are generally not as transparent in the public domain Systems need to be more flexible since valuations and operational issues are subject to interpretations The need for more expertise to handle the complexities caused by regulations and system structuring requirements has created staffing challenges both in quality and quantity

24 Alternative Investment Considerations Consequences (Unintentional) Systems increasingly becoming more flexible to different accounting interpretations and operational work flows Higher cost solutions Greater openness to the outsourcing of systems i.e., cloud/bpo Lack of data availability

25 Alternative Investment Considerations Consequences (Intentional) Provide higher yields vs. bonds (historically) Adds diversification to the portfolio Good for long term asset and liability management Regulations have allowed for growth in alternatives with minimal problems (yet)

26 Questions? Rachel Evans Associate BLACKROCK Investment Accounting Group Scott Ferrante President ConVista Consulting Co-CEO ComnServ

27 Please Complete the Session Evaluation Form on the Conference App and Include Your Conference Registration ID# to be Included in a Drawing for a Free Conference Registration for the 2016 Annual Conference! NOTE: Your Conference Registration ID# is Located at the Bottom Left Hand Corner of Your Badge. IASA 87 TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW